Read the appeals court decision [PDF 46 KB]
In the court’s view, although distribution activities generally do not constitute industrial processing, the electricity continued to be processed while en route to customers because:
- Changes were constantly being made to the quality, current, and voltage of the electricity
- The electricity could not be used by customers until it left the final transformer at the customer’s location
In addition, various items of machinery and equipment outside the generating facility were used to produce, process, monitor, test, and maintain the electricity, as well as to protect, test, inspect, and control other equipment in the system. The testing and monitoring activities are also a component of the industrial processing exemption.
Under Michigan law for the tax years at issue, tangible personal property used in industrial processing was exempt from sales and use tax. “Industrial processing” was defined as
...the activity of converting or conditioning tangible personal property by changing the form, composition, quality, combination, or character of the property for ultimate sale at retail or for use in the manufacturing of a product to be ultimately sold at retail.
Excluded from the definition of “industrial processing” were distribution activities. There was no dispute that the taxpayer engaged in industrial processing when it used machinery and equipment to convert natural resources into electricity at its plants.
The dispute was whether the machinery and equipment used outside the plant (consisting of a network of substations, transformers, high-voltage towers, cables and poles among other components) to transmit and deliver the electricity to customers were likewise exempt under the industrial processing exemption. Specifically, the key issue was whether the machinery and equipment were merely used to distribute the electricity (the Michigan Department of Treasury’s view) or whether the machinery and equipment were used to change (i.e., process) the electricity while en route to customers, thereby making it exempt from use tax (the taxpayer’s view). After a court of claims found that the taxpayer qualified for the exemption, the Department appealed.
The taxpayer’s expert witnesses presented detailed scientific evidence that the electricity continued to be processed while en route to customers. In particular, the machinery in question was used to alter the voltage and the “volt amp reactive levels” (current) of the electricity flowing through the system, and in the end, converted it to a voltage that could be used by a residential customer.
In contrast, the Department submitted the affidavit of one expert witness who summarily concluded that the nature and character of the electricity did not change during the transmission and delivery process. The court did not find the Department’s expert witness testimony to be compelling, observing that he struggled during his deposition to testify in line with the Department’s position.
After weighing the evidence presented by both sides, the appeals court concluded that the taxpayer’s machinery and equipment was used to covert and condition electricity by changing the quality, form, character, and/or composition of the electricity for ultimate sale at retail up until the time the electricity reached its customers’ meters, at which point it became a finished good. The Department also failed to rebut the taxpayer’s position that the machinery and equipment were used to inspect, test, and control the quality of electricity as it flowed through the transmission and distribution system—also an exempt use.
Although the machinery and equipment were also used to distribute the electricity, which was a non-exempt use, the appeals court concluded that based on prior Michigan case law, the taxpayer was entitled to the “industrial processing” exemption in full. Finally, the court concluded that a departmental rule providing that tangible personal property used in distributing electricity as taxable was invalid and unenforceable.
The holding in this case may provide refund opportunities for Michigan taxpayers engaged in the distribution and transmission of electricity. In addition, the court’s rationale may be persuasive in other jurisdictions that have similar laws exempting machinery and equipment used in processing. The case is still subject to potential appeal to the Michigan Supreme Court by the Department of Treasury.
For more information, contact a KPMG State and Local Tax professional:
+1 213 593 6769