When a Texas manufacturer diverts self-made goods to its own use, is the cost of raw materials that were wasted or damaged during production included in the use-tax base?

Plain-English summary

This 1993 letter answers a manufacturer's question: when raw materials are wasted or damaged during production, does the cost of those wasted or damaged materials get included in the use-tax base when the manufacturer diverts its own finished goods to its own use (rather than selling them)?

The Comptroller's answer turns entirely on whether the manufacturer can identify actual costs:

• If the manufacturer can identify actual costs of the raw materials that went into the specific items diverted to its own use, tax is due only on that actual cost. Under this method, defective raw materials that were never selected for use in the finished goods (for own use or resale) never became part of those products, so they are not included in the tax base for the diverted goods. Instead, the wasted or damaged materials are separately identified as wasted/damaged in the course of manufacturing for own use, or wasted/damaged in the course of manufacturing for resale, and are taxed according to whichever category they fall into.
• If the manufacturer cannot identify actual costs, then the cost of materials wasted or damaged during the manufacturing process must be included in the tax base for the products used in a divergent manner (i.e., taken for the manufacturer's own use).

The letter illustrates this with the taxpayer's own example: Corporation A must buy 10,010 units of a component to yield 10,000 salable finished goods (a small percentage is inevitably wasted or damaged). If actual cost identification isn't possible and Corporation A uses 1% of the salable finished goods for its own purposes, Corporation A must accrue tax on the component cost included in that 1% of finished goods — and it also owes tax on 1% of the cost of the wasted or damaged component materials, proportionate to its own-use percentage.

The letter closes by noting the opinion is based on the facts presented and could change if the facts are different.

What this means for you

Manufacturers who divert self-made goods to their own use

If you take goods you manufactured out of inventory for your own business use (rather than selling them), you owe use tax on the cost of materials in those goods. This letter clarifies that your record-keeping method affects the calculation: if you can trace actual raw-material costs to the specific diverted items, waste and damage from production do not inflate your tax base — that spoilage is taxed separately (or not at all, if it never went into any finished, own-use, or resale product). But if you can only estimate costs using an average or yield ratio (like the "10,010 units in, 10,000 salable units out" example), your own-use tax base must include a proportional share of the wasted/damaged material cost, not just the cost embodied in "good" finished units.

Accountants and tax professionals

When advising a manufacturer on accruing use tax for self-consumed inventory, ask whether the client uses actual-cost accounting or an averaging/yield-based costing method for raw materials. That choice determines whether waste and scrap costs get folded into the divergent-use tax base. Under actual-cost identification, wasted/damaged materials are tracked and taxed based on what they were being manufactured for (own use vs. resale) rather than being allocated across finished units.

Common questions

Q: Does a manufacturer ever owe tax on raw materials that were wasted or damaged and never became part of a finished product?
A: Under actual-cost identification, defective raw materials not selected for use in manufacturing (for own use or resale) do not become part of the diverted products, so they're not included in the tax base for those diverted goods — but the letter says wasted or damaged materials are still "taxed accordingly" based on whether they arose while manufacturing for own use or while manufacturing for resale.

Q: What if I can't trace exactly which raw materials ended up in which finished goods?
A: Then you cannot use actual-cost identification, and the cost of materials wasted or damaged during production must be included in the tax base for the finished goods you diverted to your own use, allocated proportionately (as in the letter's 1%-of-production example).

Q: Is this ruling specific to one taxpayer's facts?
A: Yes. The letter explicitly states the opinion is based on the facts presented and could change if the facts are different, and it was issued to a specific (redacted) taxpayer.

Citations and references

No statutes or rules are cited in this letter.

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9303981L

Original ruling text

March 8, 1993

Dear **:

I am responding to your letter questioning whether wasted materials or goods
damaged in production should be included in the tax base for the cost of
materials taken for the manufacturer's own use.

If the manufacturer is able to identify the actual costs of raw materials
expended in manufacturing items diverted to the manufacturer's own use, then
tax is due only on the actual cost of those items. Under actual cost
identification, defective (not selected for use in manufacturing for own use or
for resale) raw materials do not become part of the products used in a
divergent manner and therefore are not included in the amount on which the
company must accrue tax. Materials that are wasted or damaged during the
manufacturing process are specifically identified as wasted or damaged while
manufacturing for the company's own use or as wasted or damaged while
manufacturing for resale and should be taxed accordingly.

However, if the manufacturer cannot identify the actual costs of raw materials
expended in manufacturing items diverted to the manufacturer's own use, then
the cost of materials wasted or damaged during the manufacturing process should
be included in the tax base for the products used in a divergent manner by the
manufacturer.

You stated as an example, Corporation A has determined through experience that
it must buy 10,010 units of a given component part in order to create 10,000
salable finished goods. Presuming actual cost identification is not possible
and taking your example a step further, say Corporation A uses 1% of the
salable finished goods. Corporation A must accrue tax on the cost of component
materials included in the 1% of finished goods that Corporation A uses.
Likewise, Corporation A owes tax on 1% of the cost of the wasted or damaged
component materials.

This opinion is based upon the facts presented. If there are additional or
different facts, the opinion may change.

Sincerely,

Tax Administration Division