Sales & Use Tax Exemption For Utilities

Date: February 22, 2011

Written By: Jeff Gillesse

Businesses in Michigan are generally sales and use tax-exempt for purchases of goods and services used or consumed in industrial processing activities. This includes year-round purchases for water, electricity, natural gas, propane, and other forms of energy used in industrial processing. Qualifying activities include:

• production
• patent, experimentation, development, engineering inspection and quality control
• planning, scheduling and production control
• design, construction and maintenance of factory machinery, equipment and tooling
• disposal of production scrap and waste
• production supervision
• production material handling

These tax-exempt energy resources that are consumed may be a component of the product being manufactured, used directly to operate certain machinery and equipment, or used for incidental activities such as heating or lighting the facility space in which the industrial processing activities take place.

When a consumer of these commodities desires to claim an industrial processing exemption, the consumption must be separately metered or else have a clearly drawn up plan that adequately separates the exempt from the non-exempt usage. Claims for any such exemption are subject to audit by the State of Michigan Department of Treasury and must be in an acceptable form. A claimant generally provides an exemption certificate to the supplier of the utility showing the amount that is
exempt, however they may alternatively submit a request to the Department of Treasury for a private letter ruling on the chosen methodology. These regulations are highlighted in Revenue Administrative Bulletin RAB-2002-15.

Our experience in becoming involved with a client having liquidity challenges commonly reveals that this particular area is one that is often not given adequate consideration. The company may already be involved in an audit by the Department of Treasury; this may be one area of significant exposure to taxation if an excessive exemption has been claimed that is unrealistic or without adequate support for the calculation.

Other times when we have been engaged to optimize financial performance in an industrial setting, we may find that more sales tax is being paid than what is required under the law. Two common mistakes frequently seen are: 1) Lack of understanding of how the law defines what is exempt for industrial processing; and 2) Lack of an acceptable basis for calculating the exemption amount, or no supporting calculation at all.

We rarely see meaningful separate metering of utilities, as this is usually costly, complicated, or incomplete. For example, a common natural gas distribution line through a factory may operate air makeup units that service industrial processing areas (exempt) as well as units in shipping and receiving areas (non-exempt). Electrical power buses likewise may provide power for exempt machinery as well as building systems that are non-exempt; unless meters are installed in each zone according to tax
status or on individual machines or HVAC units, metering is an ineffective option.

While Level Ten does not actively provide accounting or tax services, our experience in the area of developing allocation studies and models that are useful in calculating accurate allocations is significant. Our involvement in this area can help shield a company from unnecessary exposure to a significant adverse tax adjustment, or perhaps reduce an unnecessary cost of paying sales or use tax on an otherwise exempt utility purchase. We generally try to collaborate with the company’s CPA firm in
undertaking this activity.

When no separate metering of utilities exists or no acceptable support is made available to a Department auditor, the Department may consider the entire amount to be non-exempt, and therefore taxable at 6%, or else develop a simplistic allocation method based upon square footage or some other statistic. That calculation is then applied on a retroactive basis for up to five years, comparing the calculated tax liability to what tax may have been paid during that period. We have found that these simple allocations often do not take specific circumstances into effect that may minimize the tax burden, such as disproportional consumption occurring in the production processes or in the facility space occupied by those processes. The result of this is a higher assessment of sales or use taxes than necessary under the law.

Some examples of variables that may be incorporated into a calculation model that minimize the impact of taxation where utilities are not separately metered include:

• Heating or lighting of non-exempt facility space to a lesser degree than the industrial space occupied. For example: storage, shipping, or receiving area having a lower ceiling height and heated or lighted to a lesser degree. In this case we may incorporate heating degree day statistics (i.e., temperature rise from ambient to a standard) and cubic footage into the equations to realistically allocate the lower consumption of energy into these spaces;
• Weighting the allocation of electrical peak demand costs toward industrial processing where the higher draw of exempt machinery and equipment are causal;
• Office space, which is usually heated or cooled in a more energy efficient manner than the production facilities;
• Water purchased from a municipal utility that may be consumed or employed in industrial processing as distinguished from bathrooms, sprinkling systems, or other similar non-exempt utilization.

Engineering studies and other such supportive methodologies need not necessarily follow a specific prescribed format, as the Department of Treasury does not publish such specific guidance. However, what is developed and utilized must be logical and realistic in order to pass the scrutiny of the Department. A reasonable and logical allocation calculation is generally accepted; while the lack of any such support is never acceptable. While it is never guaranteed that these allocation studies would go unchallenged or unadjusted, we have not encountered an instance where they were rejected or significantly changed.

If you would like more information about our allocation models, please contact us at info@leveltengroup.com or call Jeff Gillesse at 616-893-0366.