Kentucky sales tax
Restoration of the supplies exemption
Issue 3
July 22, 2019
By Steve Lenarz, JD, CPA
The decision
On March 27, 2019 the Kentucky Claims Commission issued a ruling that, if it withstands the rigors of the appellate process, will profoundly affect all manufacturing and mining companies in Kentucky. The Commission ruled that the Department of Revenue failed to follow the rules of statutory construction mandated by the Kentucky Supreme Court when it failed to “harmonize” the conflict between the exempt “supplies” statute and the taxable “repair, replacement and spare part” statute. Century Aluminum of Kentucky, GP v. Department of Revenue, KCC Order No. K-25903, File No. K17-R-39 (March 27, 2019). The result of the ruling is that certain supplies held taxable by the Department, including welding wire, furnace lining, industrial gases and refractory materials were ruled exempt from tax as supplies by the Claims Commission.
Background
From the beginning of sales tax in 1960 until 1992 the New and Expanded Industry exemption for new machinery was administered in a consistent manner. Among the rules for the exemption was the requirement that the machinery and equipment cannot be a repair, replacement or spare parts. In Revenue Cabinet v. Armco, Inc., 838 S.W.2d 396 (App. 1992) the Court ruled that the words spare parts did not appear in the statute and, therefore, the spare parts purchased as part of a new machine were exempt contrary to Revenue’s ruling that they were taxable. To prevent future cases concerning the exemption of spare parts the legislature in 1994 added the words “spare parts” to the already present repair and replacement parts language making repair, replace, and spare parts taxable. At the same time the legislature added the spare parts language to the statute concerning supplies making repair, replacement, and spare parts taxable. The legislature also added the definition of repair, replacement, and spare parts. According to the Revenue Cabinet at that time, the definition of repair, replacement and spare parts was added only to prevent the further erosion of the tax base and did not change the enforcement of supplies exemption. That is, if a supply had a useful life of less than one year, was used in manufacturing at a manufacturing facility, and was consumed during the manufacturing process it was exempt.
The 1994 legislative changes did not affect the enforcement of the supplies exemption with the exception that spare parts could no longer be supplies. That was until around the year 2000 when Revenue changed its administrative interpretation of an exempt supply. Starting in 2000 if a part maintained, restored, mended, or repaired any machinery or equipment it was a taxable repair, replacement, or spare part regardless of whether it met the definition of an exempt supply and was consumed in the manufacturing process. The result of this change in enforcement criteria made almost all supplies taxable and the statute concerning exempt supplies null, void, and without meaning.
The law
KRS 139.470(9) provides an exemption from sales and use tax for “supplies” sold to manufacturers and industrial processors if certain criteria are met. The supplies must be tangible personal property used directly in manufacturing or industrial processing process at a plant facility. The exempt supplies include “supplies such as lubricating and compounding oils, grease, machine waste, abrasives, chemicals, solvents, fluxes, anodes, filtering materials, fire brick, catalysts, dyes, refrigerants, and explosive.” They do not have to come into direct contact with a manufactured product to be exempt.
“Supplies does not include repair, replacement or spare parts of any kind.”
KRS 139.010(35) defines repair, replacement, or spare parts as “any tangible personal property used to maintain, restore, mend, or repair machinery or equipment.” “Repair, replacement, or spare parts does not include machine oils, grease, or industrial tools.”
The highest court in Kentucky ruled in Mansbach Metal Company v. Department of Revenue, 521 S.W.2d 85, 87 (Ky. 1975) that “a distinction can be drawn between materials and supplies which are designed and intended to be used up in the manufacturing process, and parts which simply wear out.” Supplies and materials intended to be used up are exempt supplies and parts that simply wear out are taxable repair and replacement parts.
The Supreme Court in Department of Revenue v. Cox Interior, 400 S.W.3d 240, 242 (Ky. 2013) stated, “we presume the General Assembly intended for the statute to be construed as a whole, for all of its parts to have meaning, and for it to harmonize with related statutes.” Almost all supplies that meet the criteria of an exempt supply are considered taxable by Revenue, making the supplies exemption null, void and without meaning. At the hearing, Revenue’s witness was asked how firebrick (which is specifically mentioned in the statute) could ever be an exempt supply. He answered that he did not see how it could be exempt.
The ruling
The Claims Commission stated, “Revenue’s analysis for determination of whether a part is an exempt supply or a taxable repair, maintenance, or spare part is flawed. In using Revenue’s analysis, the supplies exemption statute under KRS 139.470(10) (subsequently changed to KRS 139.470(9)) has to be ignored thereby making it null, void, and without meaning. This type of analysis is contrary to the statutory construction rule dictated to us by the Supreme Court that all words in a statute must have meaning and if there is a conflict in the statutes then they must be harmonized. In harmonizing applicable statutory law, the items at issue are exempt supplies under KRS 139.470.”
Harmonization of the statutes
To give meaning to both the exempt supplies exemption statute and the taxable repair, replacement, and spare parts statute the Claims Commission suggests the following:
Determine the useful life of the tangible personal property at issue if the machine or equipment that the tangible personal property allegedly maintains, restores, mends, or repairs is operated without the introduction of the product being manufactured.
Determine the useful life of the tangible personal property at issue if the machine or equipment that the tangible personal property allegedly maintains, restores, mends, or repairs is operating with the introduction of the product being manufactured.
If there is a difference in the useful lives of the tangible personal property between a. and b. above then the tangible personal property is being consumed in the manufacturing process and is exempt from tax.
If there is no difference in the useful life of the tangible personal property between a. and b. above then the tangible personal property is a taxable repair, replacement or spare part.
Current status of the case
This case is far from final. Revenue has appealed the decision and it is currently at the Franklin Circuit Court. The Claims Commission decision cannot be used as precedent nor can any decision from the Franklin Circuit Court. Only if the Court of Appeals issues a “published” decision does it become precedent and, therefore, the law. However, it should be remembered that the Claims Commission decision is not an expansion of the supplies exemption, it merely restores the exemption to the criteria used before Revenue administratively changed its interpretation in the year 2000.
About the author: Steve Lenarz, JD, CPA, of Steve Lenarz Attorney at Law in Louisville. He can be reached at slenarz@kytaxfirm.com.