Was the full capitalized cost of a contractor-refurbished production machine subject to Virginia use tax?

Plain-English summary

Virginia removed the refurbished production machine from the audit and abated the assessment in full. The capitalized fixed-asset amount did not represent one taxable maintenance purchase.

An outside contractor supplied replacement parts, labor, and expertise to rebuild the exempt production machine. The ruling treated the replacement parts and associated contractor labor as qualifying under the manufacturing exemption. Other capitalized amounts were the machine's pre-refurbishment net book value, freight on replacement parts, and separately purchased replacement parts.

Tools, equipment, and supplies used in refurbishment but not incorporated into the machine were taxable. The taxpayer had already paid tax on its items, while the contractor was responsible for tax on the items it used.

Because the documented capitalized amount consisted of nontaxable components and already-taxed inputs, the Department removed it from the audit.

What this means for you

• A fixed-asset capitalization entry does not by itself establish the sales-tax result.
• Separate replacement parts and contractor charges from tools and consumable supplies.
• Replacement parts incorporated into exempt production machinery can qualify for exemption.
• Preserve contracts, freight records, book value, and proof of tax on noncomponent supplies.

Citations and references

• Va. Code § 58.1-609.3(2)(iii).
• 23 VAC 10-210-920(C)(2).
• The source discusses P.D. 96-279 and P.D. 88-53.

Subject

Use tax on refurbished production machine, capitalized as a fixed asset during audit

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 06-121

Original ruling text

October 17, 2006

Re: § 58.1-1821 Application: Retail Sales and Use Tax

Dear *:

This will reply to your letter in which you seek correction of a retail sales and use tax assessment issued to * (the "Taxpayer") for the period November 2001 through October 2004. I apologize for the delay in the Department's response.

FACTS

The Taxpayer was audited by the Department and assessed use tax on the value of a refurbished production machine that was capitalized as a fixed asset during the audit period. The Taxpayer maintains that the refurbished machine qualifies for the industrial manufacturing exemption. The Department treated the charge for the refurbished machine as a taxable maintenance cost. The Department agrees that the Taxpayer is a manufacturer and qualifies for the industrial manufacturing exemption on purchases of tangible personal property used directly in the manufacturing process.

DETERMINATION

Manufacturing Exemption

Virginia Code § 58.1-609.3 2 (iii) provides an exemption from the retail sales and use tax for:

machinery or tools or repair parts therefor or replacements thereof, fuel, power, energy, or supplies, used directly in processing, manufacturing, refining, mining or converting products for sale or resale.

Title 23 of the Virginia Administrative Code (VAC) 10-210-920 interprets the manufacturing exemption in Va. Code § 58.1-609.3. Title 23 VAC 10-210-920 C 2 discusses production activities conducted by manufacturers and states that tangible personal property used to perform repairs or maintenance on exempt production machinery is taxable. The regulation notes that replacement parts for exempt production machinery and equipment may be purchased exempt from the tax.

The Department's policy with respect to taxable maintenance activities performed by manufacturers is longstanding. Public Document (P.D.) 96-279 (10/16/96) and P.D. 88-53 (4/4/88) both discuss cases in which the Department ruled that the rebuilding of production machinery and equipment was a taxable maintenance activity. The tools, equipment and supplies used to rebuild and maintain production machinery and equipment were taxable because they were not "used directly" in production, as the manufacturing exemption requires. The replacement or repair parts that became a component part of the exempt production machinery or equipment qualified for the manufacturing exemption.

Costs to Refurbish the Production Machine

The Taxpayer contracted with a business (the "Contractor") to refurbish the production machine at the Taxpayer's manufacturing facility. The Contractor provided replacement parts and the labor and expertise to refurbish the machine. It is clear that the Contractor performed the taxable maintenance activity (refurbishment of the machine), not the Taxpayer. Consistent with the public documents cited above, the Taxpayer's purchase of the replacement parts and associated labor to rebuild the machine qualify for the manufacturing exemption. Only the tangible personal property that was used to refurbish the machine and that did not become a component part of the machine, such as tools, equipment and supplies, was taxable. The Taxpayer paid the tax on its purchase of such items. The Contractor was responsible for the tax on its purchase and use of these types of items.

The Taxpayer's payments to the Contractor account for almost 70 percent of the capitalized cost of the machine. The Taxpayer notes that the original cost of the machine had not been fully depreciated. Thus, the amount capitalized also includes the net book value of the machine prior to its refurbishment. The capitalized amount also includes freight charges paid to ship some of the machine's replacement parts to the Taxpayer's production site and the purchase of replacement parts that were not provided as part of the contract. These costs all represent nontaxable components of the capitalized amount of the machine.

CONCLUSION

The Taxpayer has shown that the actual activity of rebuilding the machine was conducted by another business and that most of the capitalized amount of the production machine consists of nontaxable charges. The Taxpayer also paid sales and use tax on the purchase of taxable tools and supplies used during, the refurbishment of the machine that were included in the capitalized cost of the machine. Accordingly, the capitalized amount of the production machine will be removed from the audit and the assessment will be abated in full.

The Code of Virginia section and the regulation cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this determination, please contact * in the Office of Policy and Administration, Appeals and Rulings at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/54620S