Construction Accounting Article -
Could Semantics be Costing Your Company?
Target Audience: Any Construction, Manufacturing, or Distribution Company Conducting Business in Massachusetts
As the state of Massachusetts increases the number of sales tax agents on its payroll the logical expectation is that sales tax audit activity will also be on the rise. Exposure to double taxation should be a concern for any construction, manufacturing, or distributing company that conducts business in Massachusetts and also purchases materials and products outside of the state. If your company falls underneath this umbrella it is important to carefully consider Directive 01-2 and the case of Morton Buildings, Inc. v. Commissioner of Revenue, 43 Mass. App. Ct. 441 (1997). Sales tax exposure must be identified in order to determine whether your company is in compliance, and if not, what steps can be taken to mitigate the issue. The issue may be as simple (and yet as complicated) as determining the difference between “manufacturing” and “fabrication.”
Directive 01-2 provides an explanation for the application of the Morton Buildings, Inc. v. Commissioner of Revenue. This case and the ensuing directive delve into the realm of semantics and can affect any company purchasing material or products outside of Massachusetts for future use within the state. In order to avoid double taxation through sales and use tax, as well as ensuring compliance, it is important that a company and its auditors carefully consider the many different variables involved. Tax and audit specialists at Feeley & Driscoll are well equipped for this task and ready to help your company overcome this issue.
The Massachusetts Department of Revenue has provided some illustrations based on the Morton Buildings case. They are:
1. Company A installs and services heating and cooling systems. Company A purchases furnaces and air conditioner parts, for no particular job, from various out of state vendors. Parts are stored in inventory in its out of state facilities. Company A programs thermostats in its out of state facility according to customer specifications. Company A, acting as a building contractor, installs the modified thermostats into new or existing heating and cooling systems in MA. The thermostats are taxable, as are all of the purchased products Company A uses in MA. If after a part has been modified according to a customer’s specifications the original part still retains, its name, nature, or use, Morton Buildings does not prevent use tax from being imposed.
2. Company B manufactures, installs, and services heating and cooling systems. The company purchases, outside MA, raw materials in bulk for no particular customer or job and places the raw materials in inventory at its plant. The company manufacturing plant is located outside of MA. At the plant, it takes raw materials out of inventory and assembles and fabricates materials, supplies, and parts into finished units ready for installation. This process requires, fabrication, such as molding plastic, or shaping metal parts as part of a multi-step production process such that (1) the character of the inputs is changed from their purchased condition or (2) the parts are permanently attached and cannot be disassembled without being destroyed. When Company B, acting as a contractor, takes a heating system that it has manufactured and installs it to MA real estate, Morton Buildings prevents the application of use tax to the manufactured parts.
3. Taxpayer C has a facility in NH where it stores, manufactures, and refurbishes computer parts and components. C manufactures some components and purchases other (all purchases are made in bulk for no particular customer or job outside MA). C sells computer systems nationwide, and also uses its computers in its own business. Business C has its payroll office in MA, which it equips with computers taken from inventory in its NH facility. The modifications described in the scenarios below are all performed entirely in C’s NH facility. Use tax treatment of any previously untaxed item for the below-indicated modifications to the computers that C uses in its MA office would be as follows:
(a) Customization of a computer: C customizes a computer purchased in NH from another manufacturer by installing a new hard drive to provide faster computing capacity. C purchased the hard drive in NH and installed it in the same condition in which it was purchased. Use of the computer and of the hard drive in MA are both taxable. The character of neither one has changed.
(b) Installation of new canned software: C loads new canned software purchased in NH into a computer also purchased in NH from another manufacturer. Use of the computer and software in the MA office are taxable. Their character has not changed.
(c) Attachment of peripheral devices: C attaches peripheral devices, purchased in NH from another manufacturer, to computers also purchased from another manufacturer. Its use in MA of each of the components is taxable. The components are not altered from their purchased condition. They are merely attached to a person computer. Connecting or assembling components together, without materially changing the components, does not change their character and is not manufacturing.
(d) Replacing a damaged component: C sends a damaged computer from its MA payroll office to its NH facility where a damaged hard drive is removed and replaced with another hard drive purchased outside MA and kept in the parts and components inventory at C’s NH facility. The new hard drive is taxable when used in MA.
(e) Manufacturing a computer: C manufactures and ships to C’s MA office a new mainframe computer produced in its NH facility from raw materials purchased in bulk out of state and stored in its warehouse inventory. Assembly of this computer requires fabrication, such as molding plastic, shaping metal parts, and stamping silicon chips, as part of a multi-step production process such that (i) the character of the inputs is changed from their purchased condition, or (ii) the parts are permanently attached and could not be disassembled without being destroyed. Use in MA of the resulting product is not taxable under the Morton Building rule. Purchased components that are used unchanged in the new computer would, however, not be excluded from use tax.
4. Company D is an air carrier whose operation in MA includes both scheduled and unscheduled replacement of aircrafts parts on company aircraft. Parts are purchased out of state for use, storage or other consumption in several markets, including Logan International Airport in Boston. A malfunctioning fuel pump, which has been used in MA, is removed from a jet at Logan and shipped to the carrier’s central repair facility in NH for diagnostics and repair. Diagnostics indicate that the pressure relief valve in the fuel pump is broken. The broken part is replaced with a new pressure relief valve that was purchased in NH. The repaired fuel pump is returned to stock at Logan Airport and the new pressure relief valve is subject to use tax when it is used in MA.
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