Does a metal roller-leveling process that flattens coiled metal and changes its hardness count as manufacturing or processing, so the wrapping/packaging and equipment used with it are tax-exempt?

Subject

Leveling Process — Metal Undergoes Physical Change

Plain-English summary

This file bundles two letters from a 1996 Texas sales-and-use tax audit dispute: the taxpayer's representative's letter to the Comptroller laying out the case for "Company A" (through its plant, "Company B"), and the Comptroller's Tax Policy Director's reply.

Company B buys coiled metal (aluminum, stainless steel) and runs it through a precision roller "leveler" to remove flatness defects like coil set, crossbow, and wavy edges before cutting it to length, applying a protective PVC or paper film, and bundling it for shipment to manufacturers and fabricators (for example, truck manufacturers) who order metal to specific physical and molecular tolerances. The audit assessed tax on Company B's wrapping and packaging material purchases on the theory that Company B was just cutting and repackaging metal, not manufacturing or processing it, and so didn't qualify for the wrapping/packaging exemption in 34 TAC § 3.314 (which is only available to manufacturers/processors as defined in 34 TAC § 3.300).

The taxpayer's letter argued Company B is a manufacturer (or custom manufacturer) because leveling changes the metal's physical, metallurgical, and surface characteristics under 34 TAC § 3.300(a)(10) ("processing"), and because leveling causes the metal to "work harden" -- test data showed an average 24.92% increase in yield strength after leveling, well above what the taxpayer described as the Comptroller's informal 5% threshold for treating a change as merely incidental. The taxpayer also argued the leveler could qualify as manufacturing equipment as "rebuilding" or "remodeling" tangible personal property under 34 TAC § 3.300(a)(9), and separately asked the Comptroller to waive interest on disallowed manufacturing-equipment refund claims (because the Comptroller's own earlier audit and hearing, Decision No. 29,287, had already reviewed and refunded some of the same claims) and to drop tax assessed on asbestos abatement services, citing a settlement in another taxpayer's case.

The Comptroller's reply (the actual "ruling" holding here) is narrower and more cautious than the taxpayer's letter. Tax Policy Director Wade Anderson focused only on the leveling/hardening issue and did not agree the leveler is manufacturing equipment on the facts given. He explained the real question is whether the hardening caused by leveling is necessary to meet the customer's specifications (in which case it matters and the process would look more like manufacturing) or is merely an incidental byproduct of leveling and cutting the sheet to the customer's requirements (in which case it wouldn't). He gave a numeric example: if a customer needs the exact tensile/yield strength that only leveling produces, leveling is critical; but if the customer's minimum specs were already met by the metal before leveling, the added hardness is incidental and doesn't help make the sale. He asked the taxpayer to determine and show which scenario applied. He also corrected the taxpayer's citation: 34 TAC § 3.300(a)(9) covers "rebuilding," not "remodeling," of tangible personal property.

What this means for you

Metal processors, coaters, and similar "value-added" fabricators

Whether an operation like leveling, flattening, hardening, or otherwise conditioning material counts as exempt manufacturing/processing in Texas can turn on whether the resulting physical change is actually necessary to meet a customer's stated specifications, versus just an incidental side effect of an operation performed for another reason (like cutting to length). Keep before/after test data and, critically, keep customer specification sheets so you can show the change was required to make the product salable -- not simply a byproduct.

Businesses relying on a "5%" incidental-change threshold

The taxpayer's letter references what it describes as the Comptroller's "long standing policy" of treating a change as incidental if it's 5% or less. This letter doesn't confirm or adopt that number as Comptroller policy -- it's the taxpayer's characterization in their own letter, and the Comptroller's reply does not endorse or repeat it. Don't treat 5% as a safe-harbor without a current, direct ruling on point.

Accountants and tax professionals in audit disputes

Note the letter's precise, narrow correction of the taxpayer's rule citation: 34 TAC § 3.300(a)(9) does not address "remodeling" -- it addresses "rebuilding" tangible personal property. That distinction mattered enough to the Comptroller to flag it even while leaving the larger manufacturing-equipment question open. The letter also illustrates that a Comptroller Tax Policy response to an audit dispute may resolve only the specific issue addressed (here, the leveler/hardening question) and not necessarily every issue raised in the taxpayer's letter (interest waiver, asbestos abatement) -- this letter does not state a holding on those other points.

Common questions

Q: Did the Comptroller decide that Company B's leveling process is or is not manufacturing?
A: No final determination is stated in this letter. The Director explained what the taxpayer would need to show (that the hardening is necessary to meet customer specs, not merely incidental) to change his view, and asked the taxpayer to research and report back.

Q: Does a 24.92% average increase in yield strength automatically mean the change isn't "incidental"?
A: The taxpayer's letter argues that, citing an informal 5% incidental-change threshold, but the Comptroller's reply doesn't adopt or confirm that percentage test -- it instead asks whether the change is taken into account in meeting the customer's specific required specifications.

Q: Does 34 TAC § 3.300(a)(9)'s manufacturing definition cover "remodeling" tangible personal property?
A: No. The Comptroller's letter specifically states that section addresses rebuilding, not remodeling.

Q: Were the interest-waiver and asbestos-abatement issues resolved in this letter?
A: The taxpayer's letter raised both issues and asked for relief, but the Comptroller's reply letter included in this file addresses only the leveling/hardening manufacturing-equipment question.

Citations and references

Rules:

• 34 TAC § 3.300(a)(2) (custom manufacturing definition)
• 34 TAC § 3.300(a)(9) (manufacturing definition, including rebuilding of tangible personal property)
• 34 TAC § 3.300(a)(10) (processing definition)
• 34 TAC § 3.300(g) (manufacturing equipment refund claims)
• 34 TAC § 3.314 (wrapping and packaging exemption)
• 34 TAC § 3.357 (repair, remodeling, and restoration of tangible personal property, cited regarding asbestos abatement services)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9605231L

Original ruling text

May 15, 1996

Dear **:

I received your letter of May 8, 1996 concerning the COMPANY A audit. As you
will recall from our meeting, I felt it was important whether the hardening of
the metals was taken into consideration in selling the product or whether it
was merely an incidental part of leveling the metal. The figures you sent me
show that changes occur in the metal when it is leveled, they do not show
whether these are taken into account in reaching the specifications desired by
the company's customers.

For example, if a roll of metal as a tensile strength of 30.1 and a yield
strength of 12.2 before leveling and a tensile strength of 30.5 and a yield
strength of 14.8 after leveling, it would be of critical importance if the
requirements of the customer were a tensile strength of 30.4 and a yield
strength of 14.0. Without leveling, the product would not meet the customer's
specifications. On the other hand, if the customer required a minimum tensile
strength of 30.0 and a yield strength of 12.0, the leveling would not add to
the salability of the metal sheet and the increase in strength would merely be
incidental to the process of leveling and cutting the sheets to the customer's
requirements.

Basically, I am having a real problem with agreeing with your position that the
leveler is a piece of manufacturing equipment because of the decision in
** which we discussed. If you can show me that the hardening of the
sheets is not merely incidental but is necessary to make the product salable, I
would be more inclined to agree that the leveler is a piece of manufacturing
equipment. I realize you probably will have to do more research to determine
whether the hardening is necessary and taken into account in selling the
product. Please let me know when you have determined the facts.

Also, you mention on page 6 of your letter that Comptroller's rule 3.300(a)(9)
states that manufacturing includes repairing or remodeling. The section does
not address remodeling. It does include rebuilding.

If you have additional questions, please write me at 111 E. 17th Street,
Austin, Texas 78774, or call me at 1-800-531-5441, extension 3-4004.

Sincerely,

Wade Anderson
Director, Tax Policy

cc: **, ****
Mike Borkland, Chief Hearings Attorney

May 8, 1996

Mr. Wade Anderson
Assistant Director
Comptroller of Public Accounts
Post Office Box 13528
Austin, Texas 78711

RE: COMPANY A
Texas Sales & Use Tax Audit

Dear Wade:

Thank you for meeting with Mr. ** and me to discuss the Texas sales
and use tax audit of COMPANY A. Our objective in presenting this case to you is
to ascertain the Comptroller of Public Account's ("Comptroller") position on
several tax and policy issues. We believe that resolving these issues will
prevent a costly administrative hearing.

Audit Status

The Comptroller has conducted an audit of COMPANY A's Texas sales and use tax
procedures for the period February 1, 1990 through February 28, 1994. As a
result of this audit, the Comptroller assessed COMPANY A tax on purchases
deemed taxable. After receipt of the Notice of Tax Due, COMPANY A timely filed
a petition for redetermination. COMPANY A requested a Dispute Resolution
Conference during the sixty day review period.

Currently, Mr. Michael J. Borkland, Chief Hearings Attorney, has agreed to
extend the sixty day period in order for us resolve the issues with the Tax
Policy Section to avoid a hearing. We requested an extension of the
** Audit Office's response date to May 31, 1996.

Cut-to-Length Sheeting Line

In **, Texas, COMPANY A operates COMPANY B, a "cut-to-length"
sheeting line operation. The State's auditor assessed tax on wrapping and
packaging material purchases during the audit period. The basis for the
assessment was that COMPANY B was simply cutting coiled metal to length and
then repackaging the metal. As a result, the auditor determined that COMPANY B
was not a manufacturer/processor as defined by 34 TAC Sec. 3.300 and would not
qualify for the wrapping and packaging exemption provided by 34 TAC Sec. 3.314.
The amount of tax assessed on these purchases is an estimated $****.

If COMPANY B's operation consisted of cutting and repackaging only, we likely
would have agreed with the auditor. However, after several meetings with Mr.
**, General Manager of COMPANY B, and a detailed plant tour, it is
apparent that there is much more to COMPANY B's operations than simply cutting
coiled metal to a specific length.

COMPANY B's Manufacturing Process

The manufacturing process at COMPANY B's facility begins with the purchase of
coiled metals (such as aluminum, stainless steel, etc.) from a producer or
metal mill. The coiled metal has flatness characteristics, metallurgical
characteristics, and surface characteristics.

An example of a flatness characteristic is the "coil set." The coil set is the
longitudinal bow in an unwound coil in the same direction as curvature of the
wound coil. This condition is caused by plastic bending during coil processing
operations or by residual coil set from the winding operation. An example of a
metallurgical characteristic is "temper." Temper is the hardness of metal. Work
hardening (See discussion below) changes temper on metal and must be
controlled. An example of a surface characteristic is a "chatter." Chatter is
the occurrence of intermittent lines that are usually across full width and
perpendicular to the rolling direction. Cyclic vertical vibration in or near
the roll bite cause this surface condition.

In order to produce a finished product acceptable for COMPANY B's customers,
many of these characteristics must be changed or removed from the coiled metal.
To perform this task, COMPANY B uses a very sophisticated piece of machinery
called a "leveler." Specifically, COMPANY B utilizes a roller leveler
manufactured by VOSS. The VOSS roller leveler is a precision machine tool for
corrective leveling of flat rolled strips, sheets, or plates. It is designed to
remove shape defects such as crossbow, coil set, wavy edges, etc.

There are two main sources of out-of-level conditions in flat-rolled metal
products. One condition is that in the process of cold rolling the strip,
deflections in the rolling mill cause some parts of the strip cross section to
be reduced in thickness more than others. This generally results in the thinner
portions of the strip being slightly longer that the thicker portions, causing
a waviness in the longer area. The second condition occurs while uncoiling the
strip. The uncoiling causes a lengthwise stretching of the inside surface
relative to the outside surface of the uncoiled stock. This lengthwise
stretching causes a widthwise shrinking resulting in crossbow.

The underlying principle in roller leveling is the selective elongation of
portions of the metal strip or sheet so that tighter (shorter) areas are
proportionally stretched beyond the material's yield point to achieve
essentially uniform strip fiber length. This is done by subjecting the coiled
metal strip to a series of up/down bends over small radii as it passes through
the machine in such a way that the shorter strip "fibers" travel longer path
lengths. As the metal strip proceeds toward the exit of the machine, the depth
of these up/down bends is gradually reduced to eliminate the curvature caused
by the severe bending at the machine entry. When the lengths of all "fibers"
are essentially the same, the metal strip is flat or "leveled."

These bend reversals are achieved by passing the metal strip between upper and
lower sets of parallel "work rolls" that are offset by half the roll spacing
thereby forcing the strip to take a wavelike path through the machine. With the
proper settings of the rollers, the coiled metal's crossbow or coil set can be
eliminated. Other variations in the length of the metal strip from one edge to
the other edge (giving wavy edges or center buckle, for example) can also be
eliminated by adjusting work rolls. Widthwise, differential path length is
achieved by appropriate adjustment of individual rollers.

Additionally, some materials (such as aluminum and 300 series stainless steel)
will "work harden." Thus, the more it is flexed, the harder it becomes. "Work
hardening" is the process that occurs when metal is worked or deformed to
produce a desired shape. This is because as the metal is worked, the "slip
planes" are gradually "used up." Slip planes represent, very roughly, the ways
in which metal crystal aggregates can be deformed. Atomic forces prevent the
atoms themselves from being crowded much closer together when the metal is
squeezed, but the atoms can slide or slip along these imaginary planes. In
general, metals tend to deform along the planes that intersect the greatest
number of atoms. If the deforming force is continued beyond the ultimate point,
the metal fractures.

It is important to note that before a deforming force causes a fracture of the
metal, the metal must be heated to recrystallize it and to restore the slip
planes which have been "used up." This process which softens the metal is
called "annealing."

Once the metal meets the desired customer specifications (See discussion of
COMPANY B's Market below), the metal is cut to the appropriate length. After
the cut, COMPANY B will normally apply to the metal a very durable, thin sheet
of PVC plastic. Certain customers occasionally request the attachment of paper
rather than PVC. Paper can be attached with a gum-glue or with static
electricity. In rare instances, a customer will order sheet metal without PVC
or paper. The PVC or paper allow an end user to work with the metal without
damaging the surface. For example, if a piece of sheet metal in a fabrication
process is exposed to the iron or steel presses, dies, or punches, undesired
markings, dents, scratches, or gouges occur. However, the PVC protects the
metal from these undesired blemishes. The PVC also helps move the sheet metal
through the dies like a lubricant and will prevent the metal from becoming
"hung up" in the dies.

Additionally, the PVC can allow a customer to bend or stretch metal without
fracturing. As an example, one customer needed to "draw" a piece of sheet metal
to a specific shape. However, the stress of the procedure continually caused
fracturing of the metal. In order to allow the customer to perform the
procedure without fracturing the metal, COMPANY B produced the sheet blanks
with PVC on both sides of the sheet metal. The results of this application
allowed the customer to successfully produce the desired shape.

The last operation COMPANY B performs is stacking and bundling the metal for
shipment. The bundles of metal sheets are placed on wooden skids/pallets. To
facilitate the bundling, COMPANY B uses cardboard to protect the top, bottom,
and edges of the sheet metal. Metal bands are used to keep the sheets from
shifting or moving during handling or transit.

COMPANY B's Market

COMPANY B's market or customer base consists primarily of manufacturers and
fabricators. These customers are normally using COMPANY B's products for
specialized precision manufacturing operations. For example, many of the
nation's tractor truck manufacturers utilize sheet metal produced by COMPANY B.

COMPANY B's customers submit a Customer Specification Form (See attached copy)
with or prior to an order placement. This form will specify the customers'
requirements for both the physical and molecular characteristics of the metal.

As discussed above, certain metals will "work harden." For your convenience,
attached are the test results of metal before and after the leveling process.
These tests show that the molecular properties of the raw material, coiled
metal, and the finished product, sheet metal, are indeed different. As per Mr.
**, many customers have a tolerance level for each of these
properties. This is because their operations may call for metal which will more
easily form. As a result of these types of specifications, COMPANY B must
consider the metal's properties and process of leveling work hardening to
ensure that after leveling the properties meet the customers' requirements.
These requirements are taken into consideration by COMPANY B when specifying
properties of the coiled metals purchased from the producers or mills.

Discussion of Law

Pursuant to 34 TAC Sec. 3.300:

(a) Definitions.

(2) Custom manufacturing - producing tangible personal property to the special
order of the customer . . .

(9) Manufacturing - Every operation commencing with the first stage of
production of tangible personal property and ending with the completion of
tangible personal property. . . . Manufacturing includes repairing inventory or
rebuilding tangible personal property owned by the manufacturer for the purpose
of being sold . . .

(10) Processing - The physical application of the materials and labor necessary
to modify or to change the characteristics of tangible personal property. . . .

Based on the guidelines provided by the Comptroller's rule, COMPANY B is a
manufacturer. As previously discussed, COMPANY B is changing the physical and
molecular characteristics (flatness characteristics, metallurgical
characteristics, and surface characteristics) of the metal as required by Sec.
3.300(a)(10). Additionally, if we consider the definition of custom
manufacturing and COMPANY B's Customer Specification Form, COMPANY B may be
considered a custom manufacturer.

In the alternative, Sec. 3.300(a)(9) states that manufacturing includes
repairing or remodeling tangible personal property for the purpose of being
resold. Coiled metal is unusable in COMPANY B's customers' operations. COMPANY
B's process could be considered the remodeling or repairing of the coiled
metal's impurities resulting in a consistently flat sheet of metal.

In our meeting, you inquired whether or not the molecular changes to the metal
were incidental. It is also our understanding that the Comptroller's long
standing policy for determining if a change or activity is immaterial or
incidental is based on whether the change or activity is less than or equal to
five percent (5%). As evidenced by the enclosed test results, certain strength
tests increase by more than five percent. For example, the average yield
strength test of the eleven (11) samples tested before and after leveling of
coiled metal resulted in an approximate 24.92% increase after leveling. As
discussed, this change in the metal must be taken into consideration based on
the customers' specific requirements.

In light of this discussion, we contend COMPANY B is a manufacturer and the
proposed adjustments for wrapping and packaging materials should be deleted
from the audit.

Interest on Disallowed Manufacturing Equipment Refunds

In addition to the adjustments discussed above, the auditor made a number of
adjustments for disallowed manufacturing equipment refunds. These refunds
resulted from refund claims filed by COMPANY A pursuant to 34 TAC Sec.
3.300(g). Although many of these adjustments may indeed be correct, COMPANY A
believes that based on the Comptroller's prior review of these items, interest
should be waived. The amount of interest at issue is an estimated
$**.

COMPANY A filed a number of refund claims for qualifying manufacturing
equipment purchases between January 1, 1990 and September 30, 1991 as allowed
by law. The original claims filed were greatly reduced based on a review by the
Comptroller. After filing the refund claims, COMPANY A was contacted by several
Comptroller's auditors from Audit Headquarters in Austin.

At the auditor's request, the Plant Controller sent computer runs which
corresponded to the refund claims filed by COMPANY A. The auditor then
requested a number of actual invoices for review. Copies of these invoices were
sent to Austin. For the next several months, a series of letters and telephone
conversations between the Plant Controller and the auditor attempted to
determine how various items listed in the refund claim were used in the
manufacturing process.

As a result of this review, the auditor disallowed certain claims and the
remainder was refunded to COMPANY A. COMPANY A requested a refund hearing to
dispute the disallowed items. As a result of this proceeding, the Comptroller
issued Decision No. 29,287 upholding the auditor's adjustments. Based on this
comprehensive examination and hearing, COMPANY A understood the Comptroller was
in agreement with the claims which had been refunded and relied on that
understanding.

During the course of the current COMPANY A's audit, the ** Audit
Office decided to re-audit the 1990 and 1991 manufacturing machinery and
equipment refund claims. As a result, the * Audit Office has
disallowed a number of the claims previously allowed by the Comptroller.
COMPANY A understands that the Comptroller may recover erroneous refunds which
fall within the open statute of limitations and COMPANY A does not propose to
contest these items other than the adjustments already agreed by the
*** Audit Office.

Because the law was new, vague, and confusing, COMPANY A relied heavily on the
knowledge and expertise of the Comptroller's auditors to determine whether the
refund claims filed were correct. Apparently, the Comptroller's first auditor
did not completely understand the law. By assessing COMPANY A interest on these
items, the Comptroller is penalizing COMPANY A for errors in the Comptroller's
first audit of these items.

COMPANY A respectfully requests that the Comptroller waive interest on
disallowed refund claims which the Comptroller previously audited and refunded.
We would hope that the Comptroller would not want to penalize taxpayers for
errors of the Comptroller. Had COMPANY A been properly advised of the
Comptroller's position in the earlier audit and hearing for this period, this
interest expense would not have been incurred.

Asbestos Abatement Services

The auditor also made a number of adjustments for asbestos abatement services
on which COMPANY A did not pay tax. The amount of tax assessed on asbestos
abatement services is an estimated $**. These items were scheduled
based on the auditor's interpretation of 34 TAC Sec. 3.357. Although the
Comptroller's previous position may have been that asbestos abatement services
constitute repair or remodeling, COMPANY A is aware that the State recently
settled with a taxpayer on this issue in district court.

Since the COMPANY A issue involves these same types of hazardous waste removal
services, we request the adoption of a consistent position in this case and the
removal of these items from the audit schedules.

Once again, thank you for your assistance in resolving these issues. In the
next week, I will call you for direction on how we should proceed. In the
interim, if you have any questions or if you need additional information,
please call me at (214) 934-0022.

Sincerely,

Taxpayer's Representative

cc: **