After proposing and withdrawing the regulation on several occasions, the Department of Revenue has formally enacted its Reg. 1-107, which governs the manufacturing machinery and equipment exemption for Nebraska sales/use tax. We believe that this regulation makes a number of substantive, taxpayer adverse changes to the rules for claiming the exemption, including:
1. The regulation defines a “manufacturer” as a “person who is primarily engaged in the business of manufacturing.” Under the regulation, persons are primarily engaged in the business of manufacturing if more of their total annual revenues are derived from the sales of products they manufacture and sell as tangible property than from any other commercial activity. “Annual revenues” for purposes of this test are based on the taxpayer’s most recent 12 month period including the month in which the machinery or equipment was placed into service.
Problems with this definition of a “manufacturer” include:
a. The Department’s definition would cause two companies who are performing the exact same business activity to be taxed differently. Consider a scenario where two manufacturing facilities are producing identical products – widgets. The first facility is owned by a company which is solely engaged in producing widgets. The second facility is owned by a conglomerate, which also owns a number of service businesses and those service businesses account for over 50% of the company’s revenue. Under the Department’s regulation, the first facility may qualify for the exemption; the second would not qualify because over 50% of its revenues were derived from its services businesses.
b. Under the Department’s proposed definition, the sales tax results for a company would vary depending on the relative amounts of revenue which an entity generated in a given year. For example, if in 2011 Conglomerate, Inc. were to earn 60% of its revenue from its manufacturing facility and 40% of its revenue from its service business, it could claim the manufacturing machinery and equipment exemption (at least for December 2011). However, if in 2012 Conglomerate, Inc. earned 55% of its revenue from its service business and 45% of its revenue from its manufacturing facility, then Conglomerate, Inc. could not claim the manufacturing machinery and equipment exemption in December 2012 – even though it was engaged in the same business activity in each year.
c. Because the Department would base qualification as a “manufacturer” on the 12 month period which includes the period in which the equipment is placed in service, a taxpayer may not know if it is eligible for the exemption until after it purchased its equipment. A business which could not be sure of its ability to claim an exemption will likely not include the value of that exemption when deciding where to locate its new or expanded businesses facilities. This would mean that the State would lose the value of that exemption for attracting new or expanding businesses – which is the very point of the exemption in the first place.
d. Because the Department would base qualification as a “manufacturer” on a rolling 12 month period, eligibility for the exemption may vary between months. We see no statutory basis for these results, particularly because the statutes themselves never use the term “manufacturer,” but instead allow all companies who are simply “engaged in the business of manufacturing” to qualify for the exemption.
2. The regulation states that “manufacturing” requires a “physical change” to property and does not include an increase in the value of a product without a physical change. We see no statutory basis for this rule by the Department.
3. The regulation unilaterally adds certain activities to the list of activities which do not constitute “manufacturing.” The Nebraska statutes which govern the exemption contain a list of activities which expressly do not qualify for the exemption. Within Reg. 1-107, the Department unilaterally added certain additional activities to this list, including: a) the growing or caring for crops or animal life; b) mining, quarrying, and any other activity performed in severing raw materials or other property from the ground; c) sorting, cleaning, or repackaging property; and d) breaking bulk quantities of property into smaller units or packages. In practice, these additional exclusions will likely be used by the Department to attempt to deny the exemption to certain businesses which would otherwise qualify as doing “manufacturing” within the statute.
4. The regulation would require that manufactured property be produced “for sale.” Many service providers provide property to their customers or clients as a part of providing that service. Such property is often treated for tax purposes as passing incident to the service. If that service business opened a facility to manufacture the property that was transferred incident to the service, the service business may not qualify for the manufacturing machinery and equipment exemption under the Department’s regulation. This is because the manufactured property itself was not “for sale.” This restriction does not appear in the relevant statutes.