J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST 1 CHAPTER 3. The Basics Sales/Use Tax JACK CRONIN

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1 0001 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST 1 CHAPTER 3 The Basics Sales/Use Tax JACK CRONIN Retired Partner, Deloitte & Touche, LLP THOMAS HENRY Partner, KPMG, LLP SYNOPSIS 3.01 Introduction 3.02 Requirements for Sales or Use Tax to be Applicable [1] General Imposition [2] Definition of Sale [3] IRC 351 and 721 and Companion LLC Provisions [a] Federal Income Tax Implications [b] State Sales and Use Tax Implications [c] Casual or Isolated Sale Rules 3.03 Mixed Sale Transactions [1] General Overview [2] True Object Test [3] The Economic Consequentiality Test [4] The Functional Consequentiality Test 3.04 Resale Exemptions 3.05 Manufacturing Exemptions [1] Manufacturing Defined [a] Physical Transformation Theory 3 1

2 0002 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST STATE AND LOCAL TAXATION 3 2 [b] Adaptation of Materials for Commercial Use Theory [c] Integrated Plant Theory [2] Manufacturing Related Exemptions [a] Property That Becomes a Component Part of Property [i] Essentiality Test [ii] Primary Purpose Test [iii] Substantial Ingredient Test [b] Property or Utilities Used or Consumed in Manufacturing Process [i] Property Used or Consumed in Manufacturing Process [ii] Utilities Used or Consumed in Manufacturing Process [c] Machinery and Equipment 3.01 INTRODUCTION The purpose of this chapter is to provide a basic introduction to state and local sales and use tax concepts. In particular, this chapter describes general rules regarding imposition of sales and use tax including typical definitions of the taxable sales tax base and the types of exemptions that typically apply. This chapter also discusses sales and use tax issues associated with mixed transactions and transfers that qualify for tax free treatment under the Internal Revenue Code ( IRC ) 351 and 721 and companion Limited Liability Company ( LLC ) provisions. This chapter is not intended to specifically address the sales and use tax issues associated with individual states. To the contrary, this outline is solely intended as a general reference alerting the reader to the general issues that should be considered when determining the sales and use tax implications of particular transactions. Any state specific conclusions contained herein are based on facts as stated and tax authorities, which are subject to change and varying interpretation.

3 0003 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST SALES/USE TAX BASICS 3.02[3] 3.02 REQUIREMENTS FOR SALES OR USE TAX TO BE APPLICABLE [1] General Imposition Most states impose sales tax on retail sales within a state of tangible personal property and specifically enumerated services unless specific exemptions apply. Use tax is typically a complementary tax that is imposed on the storage, use or consumption in the state of tangible personal property and enumerated services. Sales and use taxes do not typically apply to sales and/or purchases of real or intangible property. Sellers of tangible personal property are typically required to collect appropriate sales and/or use tax from their customers. Purchasers of tangible personal property are typically required to self assess use tax if appropriate sales tax was not paid to vendors. [2] Definition of Sale States normally define the term sale to include every transfer of title and/or possession for consideration of tangible personal property and/or enumerated services. Unless specifically excluded by statute, transfers of tangible personal property and enumerated services for consideration are presumed to be sales for sales and use tax purposes. Unless specifically excluded by statute, consideration would include cash, property (i.e., tangible or intangible), stock, assumption of indebtedness and services or any other value exchanged for tangible personal property and/or enumerated services. [3] IRC 351 and 721 and Companion LLC Provisions [a] Federal Income Tax Implications IRC 351 provides that no federal income tax gain or loss should be recognized when property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation when such person or persons controls the

4 0004 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST 61 1/1 3.02[3] STATE AND LOCAL TAXATION 3 4 corporation immediately following the exchange. IRC 721 provides that no federal income tax gain or loss should be recognized on transfers of property to partnerships in exchange for an interest in the partnership. Transfers of property to an LLC that elects to be regarded as a corporation under Federal Check the Box rules would receive non-recognition treatment if they meet the requirements of IRC 351. Transfers of property to an LLC that elects to be regarded as a partnership would receive non-recognition treatment if they meet the requirements of IRC 721. [b] State Sales and Use Tax Implications Although some states have incorporated into their sales and use tax statutes and regulations the treatment of 351, 721 and various other mergers and reorganizations, most states do not have provisions that specifically exempt IRC 351 and/or IRC 721 transactions. However, the majority of states provide exemptions and/or exclusions that effectively exempt these types of transactions from sales and use tax. For example some states specifically exclude specified transfers between corporations and their controlling shareholders and/or to partnerships and their partners from the definition of sale. Other states may exclude such transactions under an occasional or isolated sales exemption. Careful reading of state statutory exclusions and exemptions is imperative, as IRC 351 and IRC 721 type transactions are presumed to be subject to sales and use tax unless specific exclusions and exemptions apply. For example, in California, sales or use tax does not apply to a transfer of tangible personal property to a commencing corporation in exchange solely for the first issue stock of the corporation. 1 Tax does apply, however, if the transferor receives consideration such as cash, notes, or assumption of indebtedness and the transfer does not otherwise qualify for an exemption. The tax is measured by the amount of the consideration attributable to the transferred 1 Cal. Rev. and Tax. Code (b); Cal. Sales and Use Tax Regulation 1595(b)(4).

5 0005 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST 64 2/2 3 5 SALES/USE TAX BASICS 3.02[3] tangible personal property. In Beatrice Co. v. State Board of Equalization, 863 P.2d 683 (Cal. 1993), the California Supreme Court held that the assumption of a parent-transferor corporation s liabilities by its wholly owned commencing subsidiary corporation in an IRC 351 transaction constituted taxable consideration for the transfer so that the parenttransferor was subject to sales tax, even though the parent remained primarily liable for the debt. An assumption of liabilities by a partnership or joint venture upon a contribution of assets by a partner has also been deemed subject to sales and use taxes in California. 2 In New York, sales and use tax statutes provide that a taxable retail sale does not include the transfer of tangible personal property to a corporation upon its organization in consideration for the issuance of its stock. 3 IRC 351 transactions may qualify for this exemption if they occur upon the organizations of a new corporation. Only transfers made at the time of commencement of the corporation s business, or within a reasonable time thereafter, while the corporation is still in the process of organizing its business, are eligible for the exclusion. Corporate existence is deemed to begin upon the filing of a certificate of incorporation with the Secretary of State. 4 Transfers made to commencing corporations in exchange for stock and other property can result in tax to the extent of nonstock consideration. Transfers of property solely in exchange for stock in an already existing corporation would not qualify for the exclusion notwithstanding the fact that the may qualify for IRC 351 federal income tax treatment. Due to New York s unfavorable treatment of IRC 351 transfers involving the receipt of stock in existing corporations, it may be beneficial to structure New York IRC 351 type exchanges as capital contributions wherein the transferor does not receive any stock or other consideration in exchange for the assets. Capital contributions of property to existing 2 Cal-Metal Corp. v. State Board of Equalization, 161 Cal. App. 3d 759 (1984); Industrial Asphalt, Inc. v. State Board of Equalization, 5 Cal. App. 4th 1237 (1992). 3 N.Y. Tax Law 1101(b)(4)(iv)(D). 4 N.Y. Reg (d)(5)(ii).

6 0006 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST 65 5/5 3.02[3] STATE AND LOCAL TAXATION 3 6 corporations are not subject to sales and use tax provided no stock and/or other consideration is received in exchange for the property and the acquisition of the property is properly documented as a legitimate contribution of capital. 5 When a transfer of property is made to a corporation upon its organization in consideration for the issuance of stock and the assumption of debt and liabilities representing security interests in the property transferred, the transfer remains eligible for exclusion from the definition of retail sale. 6 Unsecured liabilities, however, are treated as taxable consideration. 7 Conversely, a corporate partner s contribution of assets to a partnership that also assumes the partner s unsecured liabilities is not subject to New York sales and use taxes because the partner (unlike a shareholder) still has an interest in assets transferred to a partnership and is not relieved of the liabilities upon a partnership assumption. 8 [c] Casual or Isolated Sale Rules Most states have an exemption from sales and use taxes for occasional, casual, or isolated sales. Depending on the state, any, all, or none of these terms may be used to describe this type of exemption. In some states, the exemption is crafted very narrowly and applies only to garage and attic sales. However, most states extend these exemptions to a broader range of transactions (e.g., the sale of an entire business). In its simplest application, the casual or isolated sale exemption applies to a sale of tangible personal property made other than in the ordinary course of one s business. In most states, the exemption would apply to sales of business assets that the taxpayer acquired for its own use and is not ordinarily in the 5 N.Y. Reg (d)(8)(ii); Anacola Trucking Service, Inc. (Advisory Opinion), State Tax Commission, Petition No. S840404A, June 12, 1985 (TSB-A- 85[27]S), Sales Tax. 6 N.Y. Reg (d)(5)(v). 7 See, e.g., In the Matter of the Petition of Tops, Inc., DTA No (N.Y. Div. Tax App. Dec. 5, 1991). 8 Matter of Beautiful Visions Co., Nos (N.Y. Div. of Tax Apps. Jan. 6, 1994).

7 0007 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST 69 9/9 3 7 SALES/USE TAX BASICS 3.02[3] business of selling. Examples of sales that might qualify for a states occasional, casual or isolated sales exemption might include sales of the following: an entire business or a business unit, office furniture initially acquired for own use, machinery and equipment initially acquired for own use, etc. In most states, the exemption would not apply to sales of property held for resale. 9 Some states may limit the number of exempt transactions an individual or organization may conduct during a year. In other states, qualifying as a retailer can taint what might otherwise be a casual or isolated sales transaction. For example, California has a two-sale rule. This rule provides that a service enterprise s first two sales are exempt occasional sales, but would be required to hold a permit for any additional sales made during any 12-month period. 10 Approximately 17 other states have a similar rule. 11 Further, many jurisdictions do not extend the exemption to motor vehicles, watercraft, aircraft and other titled property. The following paragraphs will discuss additional ways in which states may narrow the application of the occasional, casual or isolated sale type exemptions. In California, the occasional sale exemption is somewhat narrow. Persons required to hold permits do not qualify for the exemption. The law is written such that most persons making sales are required to hold a permit. California exempts a sale of property not held or used by the seller in the course of activities for which he or she is required to hold a seller s permit provided that the sale is not one of a series sufficient in number, scope and character to constitute an activity for which he or she is required to hold a seller s permit. 12 In Chemed Corporation v. State Board of Equalization, California Court of Appeal, Second District, Division One, 9 See 3.04, infra, for resale certificate discussion. 10 See Cal. Sales and Use Tax Reg. 1595(a)(1). 11 The 17 states are Arkansas, Connecticut, Florida, Idaho, Iowa, Kansas, Kentucky, Massachusetts, Nevada, New York, Pennsylvania, Rhode Island, South Dakota, Texas, Utah, Virginia, and West Virginia. 12 Cal. Rev. & Tax. Code (a).

8 0008 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST 72 13/ [3] STATE AND LOCAL TAXATION 3 8 No. B023104, June 3, 1987, a taxpayer s sale of the tangible personal property of one of its subdivisions was not exempt from sales tax as an occasional sale. The taxpayer held a seller s permit, as did four of its five subdivisions doing business in California. The fifth subdivision was engaged in a service business that did not require a seller s permit. The taxpayer sold all of the assets of the five subdivisions to a third party and argued that the sale of the assets of the fifth subdivision should be treated independently, thereby making it exempt from sales tax as an occasional sale. However, because the taxpayer and not the particular subdivision was the seller, all sales made by the taxpayer within the 12-month period preceding the sale in question were included in the determination that there was a series of sales sufficient in number, scope, and character to constitute a taxable sale, and that therefore, the sale was not exempt as an occasional sale. Kentucky s occasional sale exemption is worded very similar to exemptions provided in many states, but has been narrowly interpreted by Kentucky case law. According to a Kentucky statute, an occasional sale is one involving property not held or used by a seller in the course of an activity for which the seller is required to hold a seller s permit, and one that is not part of a series of sales sufficient in number, scope, and character to constitute an activity requiring a seller s tax permit. 13 Kentucky case law has interpreted this exemption to apply only to sales of non-retail assets. Retail assets include not only inventory, but also other property used in a retail function, such as fixtures. Moreover, a sale of tangible personal property not characteristically used in a retail function, e.g., manufacturing equipment, may still be a retail sale if two similar sales occurred within a twelve month period. Once traditionally non-retail assets have been tainted as retail, all subsequent sales of similarly situated assets will be sales at retail subject to Kentucky sales tax. New York s casual sale exemption is very narrow. New York only exempts sales by a person at his or her private 13 KY Rev. Stat (1)(a).

9 0009 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST 74 14/ SALES/USE TAX BASICS 3.03[1] residence of up to $600 in sales per year. As a practical matter, New York s casual sale exemption will not provide material savings. 14 While New York s casual sale exemption is very limited, certain transactions may be structured as a series of otherwise excluded transactions that effectively exempt the transaction from New York sales and use tax. For example, in NY Division of Tax Appeals, Petition of the TJX Companies, Inc., DTA No (Feb. 13, 1997), a corporation s sale of an entire group of chain stores by means of an exchange of stock through a subsidiary was not a bulk transfer and was exempt from New York sales and use tax because the sale was structured as a stock acquisition for legitimate business purposes, and not specifically to avoid sales and use taxes. The two-step transfer occurred when the taxpayer transferred all of the assets of one division (consisting of 18 New York stores) to a wholly owned subsidiary. This initial transfer was exempt under IRC 351 as a contribution of capital to a controlled subsidiary. The subsidiary s stock was then immediately sold. The purchaser made an election pursuant to IRC 338, which allowed the subsidiary to treat the stock sale as a sale of all of its assets, thereby allowing the taxpayer to avoid recognizing gain on the sale of the subsidiary s stock. The Administrative Law Judge concluded that the transfer of the assets by means of a capital contribution to subsidiaries was not a bulk transfer subject to sales tax due to the exclusion for capital contributions provided for in 20 NYCRR 526.6(d)(8)(ii). The second transfer was considered a nontaxable sale of intangible property (i.e., stock) MIXED SALE TRANSACTIONS [1] General Overview A mixed transaction is a transaction that contains both taxable and nontaxable elements. Mixed transactions inherently give rise to a number of difficult questions for taxpayers 14 See N.Y. Tax Law 1115(a)(18).

10 0010 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST 80 15/ [1] STATE AND LOCAL TAXATION 3 10 in their efforts to properly comply with the sales and use tax laws. In establishing policies regarding mixed transactions, it is generally necessary for a taxing authority to address the following questions: Is the mixed transaction subject to sales and use tax in whole or in part? How is taxability of the overall transaction determined given the existence of both taxable and non-taxable elements? If the transaction is subject to sales and use tax, is the entire transaction subject to sales and use tax or just the portion related to the taxable elements? If the non-taxable elements are not separately stated from the taxable elements, can they still be excluded from the tax base? If non-separately stated, non-taxable elements can be excluded from the sales and use tax base, how should they be valued? Once a taxing jurisdiction determines that a mixed transaction is subject to sales and use tax (in whole or in part), the next consideration is the tax base upon which a sales tax is imposed. The following three methods are commonly used to determine the tax base: tax may be imposed on the total value of the transaction (i.e., gross receipts); tax may be imposed on the entire value of the transaction unless charges for property and services are separately stated; and the transaction may be broken down into its taxable and non-taxable components based on the ascertainable value of each component, and tax imposed only on those components that are subject to sales and use tax within the state. In these states, nontaxable components can be excluded from the tax base even if they are not separately stated.

11 0011 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST 94 15/ SALES/USE TAX BASICS 3.03[1] Most states include the entire charge for a taxable mixed transaction in the tax base unless charges for the non-taxable elements of the transaction are separately stated. Generally, the sales price or gross receipts of a sale includes the price of the tangible personal property sold and any services that are a part of the sale. 15 Some states specifically exclude particular services or charges for services, such as installation charges, from the sales price provided they are separately stated. 16 At least one state, Maine, has held it unnecessary that a separate statement of taxable and nontaxable amounts be made on the invoice of the seller. Any verifiable record showing the amount charged is acceptable proof. 17 In the alternative, Ohio law provides that certain mixed transactions must be broken down into their component parts. The tangible personal property delivered and the service rendered are each considered distinct consequential elements having a fixed and ascertainable relationship between the value of the property and the value of the service. Even in the absence of separately stated charges, there are two separate transactions. The one attributable to the sale of tangible personal property is subject to tax while the one attributable to the service or intangible is not taxed. 18 When taxable and non-taxable elements are not separately itemized, states typically characterize the entire transaction to be either taxable or non-taxable based on certain predominate characteristics of the overall transaction. In determining taxability of these types of mixed transactions, most states apply one of the following approaches in determining taxability of these types of mixed transactions: True Object Test; 15 Fla. Stat. Ann (17); and Tenn. Code Ann (25). 16 Cal. Rev. & Tax. Code 6011(c)(3); Ky. Rev. Stat (3)(c); La. Rev. Stat. 47:301(13). 17 Scott Paper Co. v. Johnson, 159 A.2d 319 (Me. 1960). 18 See, e.g., Accountant s Computer Services, Inc. v. Kosydar, 298 N.E.2d 519 (Ohio 1973); and Federated Department Stores, Inc. v. Lindley, 456 N.E.2d 1209 (Ohio 1983).

12 0012 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST [2] STATE AND LOCAL TAXATION 3 12 Economic Consequentiality Test; and Functional Consequentiality Test. A discussion of each of these approaches follows. [2] True Object Test In mixed sale transactions, the true object test asks whether or not the true object of the purchaser was to acquire a taxable product or service. The test considers whether the receipt of a taxable product or taxable service was the overriding purpose of the transaction or whether the taxable element was incidental to the receipt of a non-taxable product or service. The true object test originated in case law. In Emery Industries, Inc. v. Limbach, 539 N.E.2d 608 (Ohio 1989), the Ohio Supreme Court emphasized that the true object test considers the essential reason a buyer enters a sales transaction either to obtain a service or tangible property produced by a service. If the buyer s overriding purpose of the transaction is to obtain a service, then the entire transaction is exempt from sales tax. In Bullock v. Statistical Tabulating Corp., 549 S.W.2d 166 (Tex. 1977), the court held that the receipt of tangible personal property must constitute the essence of the transaction, the basic purpose of the customer in entering into the transaction. In Touche Ross & Co. v. State Board of Equalization, No. A (Cal., August 16, 1988), the sale of a taxpayer s entire library of custom computer programs to another corporation was subject to sales tax because the true object of the transaction was to sell the computer programs as tangible personal property and not to provide a service. Under the true object of the transaction test, the use of a storage media to transfer the custom computer programs is only incidental to the performance of service. However, a subsequent sale by the original customer to another person is a taxable sale because the true object is to sell the computer programs as tangible personal property. The true object behind the transaction between the taxpayer and the seller was to sell the

13 0013 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST / SALES/USE TAX BASICS 3.03[2] computer programs as tangible personal property because (1) the computer software was custom-made only for the taxpayer and not for the buyer, (2) the taxpayer was not engaged in the development and maintenance of computer software for the buyer, and (3) the buyer did not seek service from the taxpayer, but bought the computer software as part of a number of other assets. In Navistar International Transportation Corporation et al. v. State Board of Equalization, No. S (Cal., November 28, 1994), drawings, designs, manuals, and procedures that contained trade secrets involving the manufacturing of turbine engines were tangible personal property subject to sales tax when transferred as part of a business deal. Although the principal purpose of the sale of the documents was the transfer of the trade secrets, the sale did not qualify as an exempt transaction under Reg. 1501, because the sale of the documents was neither incidental to the performance of a service, nor did it involve a separate and distinct transfer of an intangible property right (e.g., copyright). The documents lack of physical usefulness in the actual manufacturing process was irrelevant. The physical usefulness in the manufacturing process was not a prerequisite to taxation. Computer programs produced in-house for use by a taxpayer and transferred, as part of the sale of the taxpayer s business did not qualify for the custom computer program sales tax exemption. The custom computer program exemption available under CA Rev. Stat was enacted in recognition that the sale of a tangible custom computer program is incidental to the service performed in the program s design, development, and creation. Once the taxpayer had designed the program for its own inhouse use, the service had been completed. The subsequent sale involved only the transfer of tangible personal property and was not a tax-exempt service transaction. Many states have adopted the true object test either as part of the state statute or by regulation. For example, a California statute provides that the basic distinction in determining whether a particular transaction involves a sale of tangible

14 0014 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST / [3] STATE AND LOCAL TAXATION 3 14 personal property or the transfer of tangible personal property incidental to the performance of a service is one of the true objects of the contract; that is, is the real object sought by the buyer the service per se, or the property produced by the service. 19 The true object test has been held applicable only when the nontaxable component is inseparable from the sale or transfer of the taxable component. For example, in Advance Schools, Inc. v. California State Board of Equalization, 2 Bankr. 231 (N.D. Ill. 1980) the true object test was held to be inapplicable to a correspondence school whose services rendered, such as grading, monitoring student progress, and consulting with instructors, were separate and distinct from books, lessons, and other tangible property provided. [3] The Economic Consequentiality Test In mixed sales transactions, the economic consequentiality test, considers whether the cost or value of the taxable product or service is inconsequential or insignificant compared to the cost or value of the overall product or service. If the cost or value of the taxable product or service is inconsequential, then the transaction is deemed to be a non-taxable. If the cost or value of the taxable product or service is a consequential element of the overall transaction, the transaction would be subject to sales and use tax. Similar to the true object test, the economic consequentiality test originated in case law. A Florida court of appeals held that the purchase of artwork for incorporation into yellow pages was exempt as the sale of a service because the value of the services performed by artists was much greater than the value of the tangible personal property transferred. 20 The Missouri Supreme Court held that the sale of $135,000 worth of custom data and computer programming sold on computer 19 Cal. Code Reg. tit. 18, See also Colo. Spec. Reg. No. 42, Service Enterprises; Pa. Cons. Stat. 201(o)(5); and Wis. Admin. Code 11.67(1). 20 Southern Bell Telephone and Telegraph Co. v. Department of Revenue, 366 So.2d 30 (Fla. Ct. App. 1978).

15 0015 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST / SALES/USE TAX BASICS 3.03[4] tapes worth $50 was an exempt sale of intangible property because the value of the tangible personal property was inconsequential relative to the intangible information. 21 The District of Columbia Circuit Court held that comic strip drawings delivered to the taxpayer newspaper were not taxable. The taxpayer paid $30 for each of the impressed mats, but the cost of a blank mat was only 22 cents. The court concluded that the cost of the tangible mat was an inconsequential value of the sale and that the newspaper had contracted for the non-taxable right to reproduce a comic strip, which happened to be transferred in tangible form. Massachusetts regulations apply the economic consequentiality test when determining the taxability of repair parts and repair services. When charges for repair services and repair parts are not separately stated, the entire charge is subject to sales tax, but only if the repair parts represent a consequential amount of the total charge. 22 [4] The Functional Consequentiality Test In mixed sales transactions, the functional consequentiality test considers whether the taxable personal product or service is a consequential element of the mixed transaction without regard to the cost or value of the components. This test is employed infrequently and often subsumed under the true object test. The test inquires whether the taxable property is retained by the purchaser or if it has no continuing use after used in the process for which it was created. If the property is an inconsequential part of the sale, the transaction is deemed to be the nontaxable performance of services or the receipt of nontaxable intangible information. Similar to the true object and the economic consequentiality tests, the functional consequentiality test originated in case law. For example, in Minnesota, the rental of mailing lists was held not taxable because the lists were merely 21 James v. TRES Computer Service, Inc. 642 S.W.2d 347 (Mo. 1982). 22 Mass. Reg. Code tit. 830 CMR 64H.1.1.

16 0016 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST / STATE AND LOCAL TAXATION 3 16 incidental to the receipt of the incorporeal information contained on those lists. 23 In New York, the physical properties of books used to transmit credit and financial information regarding various businesses were held to be an inconsequential element of the services performed and the intangible information received. 24 The New Jersey Tax Court held that the rental of computer mailing lists transferred by magnetic tape was the rental of intangible information because the magnetic tapes were incidental to the receipt of the computer information. 25 The Missouri Supreme Court held that the purchase of a magazine by advertising agencies from an outof-state publisher for subsequent in-state distribution was subject to use tax as the taxable use of a magazine rather than an exempt use of advertising services. The court reasoned that the magazine was the consequential element of the taxpayers purchase agreements with the publisher of the magazine RESALE EXEMPTIONS Most states provide an exemption or exclusion for sales for resale. The purpose of the resale exemption is to avoid multiple levels of taxation on the same product. A sale for resale is a sale of tangible personal property (or taxable services) to a purchaser who will resell the goods (or taxable services) in the regular course of the purchaser s trade or business. With few exceptions, states that impose tax on the lease of tangible personal property generally offer a sale for resale exemption for taxpayers who lease tangible personal property in the same form acquired. When property is purchased for use in the performance of a service, the resale exemption may not be available. Factors to consider are: 23 Fingerhut Products Co. v. Commissioner of Revenue, 258 N.W. 2d 606 (Minn. 1977). 24 Dun & Bradstreet, Inc. v. City of New York, 11 N.E.2d 728 (N.Y. 1937). 25 Spencer Gifts, Inc. v. Director, Div. of Taxation, 3 N.J. Tax 482 (1981). 26 Travelhost of Ozark Mountain Country v. Director of Revenue, 785 S.W.2d 541 (Mo. 1990).

17 0017 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST / SALES/USE TAX BASICS 3.04 Is the service itself taxable? Will title to the property transfer to the purchaser in the performance of the service? How will the purchaser use the property to perform the service? A hotel s purchases of guest room amenities did not qualify for the resale exemption because they were not essential to the occupancy of a hotel room or a component part of property produced for sale. 27 The seller of tangible personal property has the burden of establishing that the sale to the purchaser was for purposes of resale. In the vast majority of states, the seller must obtain a resale certificate 28 from the purchaser in order to satisfy this burden of proof. 29 A seller may be permitted to establish its right to the sale for resale exemption in the absence of obtaining a valid resale certificate from the purchaser if the seller can establish with independent evidence that a sale was for resale Adamar of New Jersey v. Director, 17 N.J. Tax 80 (1997). See also, (D.Ct. App. Fla. 1994) (a hotel s purchases of consumables such as soap and stationery were not purchases for resale); Greensburg Motel Assocs., L.P. v. Indiana Dep t of State Revenue, 629 N.E.2d 1302 (Ind. Tax Ct. 1994) (a motel s purchase of consumable items such as shampoo, soap, pens, and stationery were not purchases for resale); Sine v. State Tax Comm n of Utah, 390 P.2d 130 (Utah 1964) (a motel s purchases of guest room items such as towels, blankets, soap, postcards, etc. were not tax exempt). 28 All states have their own resale certificate requirements. Most states permit the use of a multistate certificate, issued by the Multistate Tax Commission. However, there are a handful of states that require the submission of a resale certificate that is specifically tailored to that particular state. Accordingly, it is important for the purchaser to fill out and submit the correct resale certificate to properly qualify for the exemption. 29 See, e.g., Ariz. Admin. Comp. R E.; Minn. Stat. 297A.10; and Tex. Admin. Code tit. 34, See, e.g., Steelcase, Inc. v. Director, Div. of Taxation, 13 N.J. Tax 182 (1993); Tri-America Oil Co. v. Dep t. of Revenue, 464 N.E.2d 1076 (Ill. 1984) (if all of a seller s sales are at wholesale, then resale certificates need not be secured from purchasers); Cal. Rev. & Tax. Code 6091 (resale certificate required unless seller can satisfy burden of proof with other evidence of resale).

18 0018 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST / STATE AND LOCAL TAXATION 3 18 The right to use other documentation is more prevalent in states that exclude sales for resale from the tax base rather than providing an exemption for sales for resale. Sometimes, it is difficult to determine whether the property has been acquired for resale or for use by the purchaser in providing other goods or services at retail. The inquiry often focuses on whether the vendor is the ultimate consumer of the goods and services. Generally, states look for three elements for a sale to qualify as a sale for resale: 31 a transfer, barter, or exchange; title or ownership passage to tangible personal property; and consideration. Meals purchased by airlines to serve to airline passengers have been held to be non-taxable sales for resale by some states. 32 A vendor that distributes free samples is generally considered the consumer of the samples distributed. Samples purchased for distribution to customers or prospective customers do not generally qualify for the resale exemption because the items are not resold (i.e., upon subsequent distribution, no consideration is received). In some jurisdictions, if the distributor produced the samples, it may be subject to use tax based on the value of the samples distributed See, e.g. McDonnell Douglas Corp. v. Director of Revenue, 945 S.W.2d 437 (Mo. 1997). 32 Ogden American Food Services, Inc. v. Department of Treasury, Mich. (CCH) (Mich. BTA, 1975). But see American Airlines, Inc. v. Department of Revenue, 319 N.E.2d 28 (Illinois 1974) (however, other states, such as Illinois, have taken the position that airline food is not resold and is ineligible for the resale exemption). 33 But see, Syntex Laboratories, Inc. v. Michigan Dep t of Treasury, 470 N.W.2d 665 (Mich. Ct. App. 1991) (a pharmaceutical company was not required to pay use tax on sample prescription drugs provided to physicians).

19 0019 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST SALES/USE TAX BASICS 3.05[1] 3.05 MANUFACTURING EXEMPTIONS Manufacturing exemptions are offered by most states to entice businesses to relocate or expand operations within the state. However, very little uniformity exists among the states making it difficult for multistate corporations to capture such incentives. Many states provide exemptions for certain tangible personal property (e.g., materials, tools, supplies, and equipment) used in manufacturing. These manufacturing exemptions vary in scope, with some states providing very limited manufacturing exemptions, while other states provide manufacturing exemptions that are very broad in scope. In order to determine if a particular state s manufacturing exemption is available to a taxpayer, the following questions must be answered: Whether the activity constitutes a manufacturing activity? Does the property become a component part of manufactured property? Is the property used or consumed in the manufacturing process? Is the property manufacturing machinery or equipment? Is the property used directly in the manufacturing process? Is the property used primarily or predominantly in the manufacturing process? [1] Manufacturing Defined An activity that constitutes manufacturing in one state may not be considered manufacturing in another state. This is because manufacturing is defined differently by each state. The critical questions lie in when the manufacturing process begins and ends. Only a few states defined when the manufacturing process begins and ends. Generally, states have employed the following theories to define manufacturing: Physical Transformation Theory;

20 0020 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST / [1] STATE AND LOCAL TAXATION 3 20 Adaptation of Materials to Commercial Use Theory; and Integrated Plant Theory. [a] Physical Transformation Theory Under the Physical Transformation Theory, a process is considered manufacturing if a physical transformation or change in the form or composition of the materials being worked on in order for the event to be considered manufacturing or processing. This theory is based on the U.S. Supreme Court decision in East Texas Motor Freight Lines, Inc. v. Frozen Foods Express, 351 U.S. 49 (1956). In the instant case, the Court ruled that there must be a transformation of materials into a new and different article that has a distinctive name, character, and use. The definition of manufacturing in some state statutes embodies the Physical Transformation Theory. For example, in Ohio, manufacturing is defined as a transformation, or conversion, of material or things into a different state, or form, from that in which they originally existed. 34 Similarly, Pennsylvania defines manufacturing as operations which place tangible property in a form, composition, or character different from that in which it is acquired. 35 [b] Adaptation of Materials for Commercial Use Theory States following the Adaptation of Materials for Commercial Use Theory define manufacturing as the adaptation of materials to commercial use. For example, Kentucky defines manufacturing as a process where materials, which have no commercial value for taxpayer s intended use before processing, have appreciable commercial value for the taxpayer s intended use after processing by the machinery. 36 Additionally, a Kentucky court held that machinery used in such a 34 Ohio Rev. Code Ann Pa. Code Ky. Rev. Stat. Ann (11), 103 Ky. Admin. Reg. 28:030.

21 0021 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST / SALES/USE TAX BASICS 3.05[2] process was exempt when the taxpayer turned virtually unusable and non-marketable damaged drums into a serviceable and marketable commodity. 37 [c] Integrated Plant Theory The Integrated Plant Theory expands the definition of manufacturing under the Physical Transformation Theory to include activities that are essential or indispensable functions of the manufacturing operations. States adopting the Integrated Plant Theory provide sales and use tax exemption to assets which may or may not physically alter the tangible product. Under this theory, the following equipment would qualify for the manufacturing exemption: storage equipment, intra-plant transport machinery, safety and protective equipment and generally packaging equipment. 38 [2] Manufacturing Related Exemptions Many states provide exemptions for certain tangible personal property used and/or consumed in the manufacturing process. Manufacturing exemptions typically fall into one of three classifications: property that becomes a component part of property that will be resold in the normal course of business; property or utilities (e.g., gas, electric, or oil) that is used or consumed in the manufacturing process; and machinery and equipment that is used in the manufacturing process. [a] Property That Becomes a Component Part of Property The sale of property that will become an integral part of a finished product, which ultimately will be sold at retail, is 37 Department of Revenue v. Allied Drum Service, 561 S.W.2d 323 (Ky. 1978). 38 See Niagara Mohawk Power Corp. v. Wanamaker, 144 NYS 2d 458 (4th Dept. 1955); Floyd Charcoal Co. v. Director of Revenue, 599 S.W.2d 173 (Mo. 1980); and Richardson v. State Tax Comm n, 604 P.2d 719 (Idaho 1979) for cases discussing the Integrated Plant Theory.

22 0022 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST / [2] STATE AND LOCAL TAXATION 3 22 generally tax exempt under a state s manufacturing exemption. The exemption is based on the sale for resale concept in that these materials will be included in the product ultimately sold at retail. The exemption was created to avoid double taxation or the pyramiding of the sales and use tax. For property to qualify under this exemption, it must physically become an integral or component part of the final product. Example 1: A Michigan Tax Tribunal decision held that a software producer was not a manufacturer when it produced customized software because the software was viewed as intangible property. 39 Example 2: Fabric and thread purchased by a clothing manufacturer, which was used to produced clothing, qualified for this exemption. Example 3: Paper purchased by a clothing manufacturer, which was used to produce clothing patterns which were not incorporated into the finished product, did not qualify for the exemption. Different tests are used to determine whether the purchase or use of tangible personal property qualify for the Ingredient or Component Part exemption. These tests include the Essentiality Test; Primary Purpose Test; and Substantial Ingredient Test. In connection with each test, manufacturers that purchase property under a Component Part exemption should submit a resale certificate to the vendor with respect to that property. [i] Essentiality Test The Essentiality Test looks to the importance (i.e., essentiality) of the item in the production of the final product made available for sale. Example 1: In New York, solvents used in producing drafting film constituted non-taxable components of the film even though only 0.1 to 3.5 percent of the solvents remained as part of the finished products Professional Guidance Sys. v. Michigan Dep t of Treasury Mich. Tax Tribunal, Docket No (May 11, 1992). 40 In re Petition of Keuffel & Esser Co., TSB-H-82(86)(5), (1982).

23 0023 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST / SALES/USE TAX BASICS 3.05[2] Example 2: Illinois applied an Essentiality Test in American Distilling Co., in holding that the function of the barrels used to age the bourbon were vital to production, even though only a small part (i.e., wood extracts) was incorporated in the final the product. 41 In both cases, the component was essential in producing the product. Therefore, the component was exempt from sales tax. [ii] Primary Purpose Test Other jurisdictions allow the exemption only if the primary purpose of the article is to be incorporated into the final product. For example, pig iron and other materials used by a steel manufacturer did not qualify for the exemption because the materials were purchased for use as an aid in the manufacturing process, as opposed to becoming a component part of the finished product. The fact that a portion of the materials remained in the steel as a finished product was irrelevant. 42 [iii] Substantial Ingredient Test The Substantial Ingredient Test generally requires the article to become a substantial ingredient of the final product. Example: A Nebraska court applied the substantial ingredient test to determine that cellulose casings used in manufacturing skinless meat products did not qualify for the Component Part exemption. The casing is filled with meat, subjected to a series of processes and is then removed. During the processes, an undetermined amount of the casing is absorbed into the meat. The court reasoned that the casing does not become an ingredient or component of the meat in any real sense because it does not reach the ultimate consumer of the meat product American Distilling Co. v. Department of Revenue, 368 N.E.2d 541 (Ill. App. 1977). See also, Souffle, Inc. v. Director of Revenue, Missouri Admin. Hearing Comm n No RV (June 7, 1993). 42 Kaiser Steel Corp. v. State Board of Equalization, 593 P.2d 864 (Cal. 1979). 43 American Stores Packing Co. v. Peters, 277 N.W.2d 544 (Neb. 1979).

24 0024 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST [2] STATE AND LOCAL TAXATION 3 24 The Substantial Ingredient Test falls somewhere between the Essentiality and Primary Purpose Tests. Accordingly, if the Primary Purpose Test was applied by the Nebraska Court, in the above example, the casings would not qualify for the Component Part exemption and if the Court applied the Essentiality Test, the casings would likely qualify for the Component Part exemption. [b] Property or Utilities Used or Consumed in Manufacturing Process [i] Property Used or Consumed in Manufacturing Process The sale of tangible personal property that is used or consumed in the manufacturing process (e.g., lubricants, coolants, catalysts, and reagents) are exempt in many states. This exemption generally covers property that is used or consumed in the manufacturing process or used directly to produce tangible personal property. Example 1: Chemicals, lubricants, molds, or patterns that cannot be reused are all examples of items that may be used or consumed in a manufacturing process. Example 2: Tools, molds, color separations, and other manufacturing aids that are used by manufacturers in the production process, but which normally do not become part of the finished product, are examples of property that often qualify for this exemption. To qualify for the exemption, the manufacturer generally must provide the vendor with either an exempt-use certificate or a direct-pay permit to support the non-taxable use. Without such evidence, the vendor would normally be required to collect sales or use tax from the manufacturer. [ii] Utilities Used or Consumed in Manufacturing Process The sale of utilities directly used in manufacturing will most likely qualify for exemption if such charges and costs are

25 0025 VERSACOMP (4.2 ) COMPOSE2 (4.35) 05/30/02 (12:25) J:\VRS\DAT\01125\3.GML --- r1125.sty --CTP READY-- v2.8 10/ POST SALES/USE TAX BASICS 3.05[2] clearly identifiable to the manufacturing process. For example, gas used solely to operate machinery used in the manufacturing process may qualify as exempt based on a particular state s definition and scope of their manufacturing exemption. Electricity that is jointly used by both the production facilities and the sales offices of a company may fail to qualify for the manufacturing exemption based on the states definition of directly used in production. Even if the electricity did qualify, states vary in their interpretation of what portion of such charges are exempt from sales tax. If the utility is used only partially in the manufacturing process, the state may require the cost of the purchased utilities to be apportioned between the exempt and taxable use. The establishment of when and where the manufacturing process begins helps to determine what items are exempt and what items are taxable. For example, states generally will allow an exemption for fuel used to heat or cool a product during the manufacturing process, however, the exemption will be disallowed for that portion of the fuel that is used to maintain the temperature after processing has been completed (e.g., the manufacture and subsequent storage of ice cream). Administrative requirements may be used to support an exemption related to utilities. For example, some states require that separate meters be employed for the exempt and taxable uses. Other states will require the manufacturer to use an energy study to develop an acceptable ratio of exempt consumption to taxable usage. [c] Machinery and Equipment Most states manufacturing exemption applies to machinery and equipment used in the manufacturing process. Among the states with manufacturing exemptions, most states provide a full exemption for the machinery and equipment, while some states only provide a partial exemption (e.g., a reduced rate of tax). The definition an scope of qualifying machinery and equipment vary widely from state to state. In some states, the