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Do Faulty Sales Tax Rules Waste Time and Money?

author photo of Annette Nellen

It seems that a lot of time is lost (wasted) in states writing statutes to exempt certain business purchases from sales tax. Time is also lost by tax agencies and courts trying to interpret the statutes. The uncertainty puts sellers in a risky position of owing sales tax if they interpret the statute incorrectly or losing customers if they insist on charging the tax due to uncertainty. Litigation can result, as recently was the case in Missouri.

Union Electric Co. v. Director of Revenue, No. SC93083 (Mo S Ct, 3/11/14) – Union Electric (UE) sought a refund of sales tax it charged Schnucks (S) grocery stores. S used electricity to operate ovens and other equipment in its bakery departments. Schnucks bakes items starting with frozen dough it acquires. UE argued that these energy costs qualified for a sales tax exemption for energy used in processing products.  The Missouri Department of Revenue denied the claim and the Administrative Hearing Commission (AHC) agreed with the state.

The Missouri Supreme Court upheld the holding, supported by a 2012 ruling (Aquila, 362 S.W.3d 1) that “’processing’ as used in section 144.054.2, does not include in-store preparation of cooked goods for retail sale. The relevant statute “exempts from sales tax “electrical energy and gas … used or consumed in the manufacturing, processing, compounding, mining, or producing of any product.”

The AHC concluded that S’s activities to thaw, fry and perform other activities to prepare the baked goods for sale was not “processing” but instead “was part of cooking or preparing the baked goods for retail sale and, therefore, did not fall within the exemption.” UE also argued that this fact pattern was similar to one in the related regulations that involved a bakery. The AHC found that the example did not support the statute and was, thus, not binding.

Section 144.054.1(1) defines “processing” as  “any mode of treatment, act, or series of acts performed upon materials to transform or reduce them to a different state or thing.” Per UE, because S converts frozen dough to edible baked goods – a different form or state, it processes. The AHC found it to be mere cooking.

The court used rules of statutory interpretation to determine the meaning of the "processing" exemption. Per the court: "because the word at issue appears in the statute within a list of words, the Court will apply the principle of statutory construction known as noscitur a sociis − a word is known by the company it keeps." ... "If the meaning of a word is unclear from consideration of the statute alone, a court will interpret the meaning of the statute in pari materia with other statutes dealing with the same or similar subject matter." As the court had ruled in Aquila, it found that "processing" used along with manufacturing and producing was an industrial context and did not serve the same intent as food preparation for retail sale. Per the court, Aquila was engaged in activities similar to “preparing,” “furnishing,” or “serving.”

An example in the regulations for the statute includes a bakery. Per Example (O): "A bakery creates baked goods for sale directly to the public or through retailers. The energy sources, chemicals, machinery, equipment, and materials used by the bakery are exempt from state sales and use tax and local use tax, but not local sales tax."

The court put no weight in the example stating that the food prep by Schnucks was not processing as required by the statue and the question of whether Schnucks was a bakery was not an issue. So, the court did not have to rule on whether the example is valid (footnote 7). And, UE's argument that it can rely on the example, even if incorrect, because the tax agency has not removed it was incorrect and moot since the court found that type of activity Schnucks engaged in was not processing. And, the court is not required to rely on a regulation that is inconsistent with the statute - "a statute prevails over a regulation and ... a regulation cannot expand or modify a statute."

Also relevant in interpreting the statute and its terminology and noted by the court: "Tax exemptions will be strictly construed against the taxpayer, and doubts as to the taxpayer’s eligibility will be resolved in favor of taxation."

The issue of how broad sales tax exemptions for equipment used in manufacturing or processing are not new. You can find these types of ruling in most states that have a sales tax exemption for manufacturing equipment or services. For example, Colorado GIL12-015 discusses whether bakery equipment qualifies for the manufacturing equipment exemption. It doesn't reach a specific conclusion but notes that other states have interpreted manufacturing as meaning the industrial context.

Maryland explains its manufacturing exemption in the context of bakeries as follows: " Generally, food processed for sale by grocery stores, bakeries and other food retailers does not qualify for exemption. However, there is a specific exemption for the sale of equipment to be used by a retail food vendor to manufacture or process bread or bakery goods for resale. To qualify for the exemption, the vendor must operate a substantial grocery or market business (as defined in Section 11-206(a) of the Tax-General Article) at the same location where the food is sold. The taxable price of each piece of exempt equipment must be at least $2,000."

The solution - sales tax should not apply to purchases by businesses; only to purchases by consumers. This is a challenge today though, because tax collections from businesses might represent 20 - 35% of a state's sales tax collections. These amounts could gradually be replaced with an expanded sales tax base to include more types of personal consumption. I think it would be a useful and appropriate effort by state legislatures to be working towards - exempting all business purchases from sales and use tax. It would make the sales tax simpler, more efficient and avoid pyramiding (imposing a tax on a tax). Perhaps not adding or renewing income tax breaks for businesses would help in finding the dollars - and that effort would also make the tax laws simpler.

What do you think?

Other recent “Sales Tax Policy - Tales & Trends” posts by Annette Nellen, CPA, ESQ:

NOTE: All blog content, comments, and participation subject to disclaimer at bottom of page.

Comments

5 Responses to Do Faulty Sales Tax Rules Waste Time and Money?

  • Posted by Eric on August 2, 2014 4:57pm:

    There are more than states to consider. There are multiple transaction taxes within each taxing jurisdiction.
    For example, NH and AK are in the supposed NOMAD states where many believe there are no sales taxes. However there are state and local transaction taxes. In the case of NH there are state level hotel/motel and telecom taxes. These transaction taxes adapt politically based upon the socioeconomic conditions of each jurisdiction.
    The freedom to adapt to your own political jurisdiction is driven by politics as it should be. Its not the law that is complicated its people that are. Taxes (who, what where how and when) are a reflection of the peoples wishes.
    Ask Florida in 1986 and then again in 1987. Broad Services taxes were pulled by the will of the people.
    Jurisdictions need the flexibility to respond to this will.

  • Posted by Author photo of Annette NellenAnnette Nellen on May 10, 2014 12:26pm:

    Bob,
    Good points. Design flaws in the income tax and sales tax make it challenging to propose solutions once the flaws become embedded in the system. While the income tax is likely borne a fair amount by workers (and per a recent Joint Committee on Taxation study), the sales tax is mostly passed onto the buyer.
    Thanks for the comments.

  • Posted by Bob on May 10, 2014 12:08pm:

    Professor Nellen,
    I am sorry, but I cannot buy what you selling with your theory/proposal. Fact is that state local sales taxes rates average 7%-10.5% across the US. And it's also a fact that businesses do NOT pay sales taxes on ALL of their purchases (e.g. product/services for resale or otherwise exempt by law), however, these same businesses DO pay income taxes on their ENTIRE NET INCOME (after allowable deductions). So in fact, your "fear" of pyramiding sales/use taxes most likely amounts to concerns about an "effective" average state/local sales tax rate of something less the 7%-10.5% US average. I am sorry, whatever a business' sales tax EFFECTIVE rate turns out to be, in my view is simply too small to consider your proposed revamping of our states' sales tax systems.
    And the fact is that the states would likely NEVER agree to exempt businesses from sales taxes. It is simply too PROFITABLE for the states to mine USE TAX from businesses. Especially when they "sample" a businesses' expenses, develop error rations thereon, and then extrapolate the results across the audit period. Indeed, the neglect of taxing/self-assessing a few hundred dollars via sampling indeed translates to THOUSANDS of dollars the state collects on the audit plus penalty/interest. I simply cannot see how the states would EVER agree to your proposal.
    However, since you acknowledge that businesses pass such costs such as taxes into the pricing of their goods/services, I would strongly suggest instead that you shift your focus on "pyramiding of taxes" towards the abolishment of Federal/state INCOME TAXES on businesses!!
    Rather than attempt to play around with LESS than 7-10.5% on the sales/use tax side, why not vigorously consider ELIMINATION of US income tax rates that in fact average 35%-45% on businesses NET INCOME?? And for a starting point, I would refer you to the study: "Simulating the Elimination of the U.S. Corporate Income Tax" by Messrs Hans Fehr, Sabine Jokisch, Ashwin Kambhampati and Laurence J. Kotlikoff. This study is linked in "To Help US Workers Find Jobs, Eliminate or Slash Corporate Income Tax" as printed on CNN News.com on 4/15/13 by Susan Hollingsorth.
    Quoting from the study:
    "The U.S. Corporate Income Tax is a controversial element of the U.S. tax system. The tax produces remarkably little revenue- only 1.8 percent of GDP in 2013, but entails major compliance and collection costs... But many economists, going back to the writings of David Bradford (1978) and Arnold Har-berger (1982), have suggested that the tax may actually fall on workers, not capitalists ... Of central issue is the effect of eliminating the U.S. corporate income tax in its entirety while using either wage or consumption taxation to make up lost revenue."
    Bob Parker, indeed, portions of the above-cited quotes from the study amplify upon your pyramiding concerns., it's just that the study is focusing on Federal/state INCOME taxes. Moreover, I would argue that implementation of the STUDY's recommendations would be far SIMPLER than your proposal with economic benefit that by far outweighs your proposal in terms of ECONOMIC BENEFIT to the US economy as a whole!!
    Note that with the study's proposals, there is no radical changes to states' sales tax schemes. Instead, there is the outright ELIMINATION of business INCOME TAXES and likely a shrinkage of Federal/state government via REDUCTION to the size of Federal and state auditors.
    Yes, there is the same protests from the states with the Feds added to the protestors. However, with the income tax percentages significantly higher than the sales tax rates, it should be far easier to build the case for corresponding INCREASES in sales taxes due to jobs returning to the US from overseas, businesses being allowed to RETAIN more of the income that they make which, in and of itself should result in the overall lowering of their prices that you seek.

  • Posted by Author photo of Annette NellenAnnette Nellen on May 9, 2014 1:22pm:

    Bob - thank you for the comment. My suggestion for not imposing sales tax on businesses is to avoid pyramiding. When the business pays the sales tax, it is likely worked into the product price and sales tax is charged again. While not a perfect system in that service providers might not be subject to sales tax, we should work towards exempting businesses that do charge sales tax. This is how a credit invoice VAT works.
    I agree with you that fewer exemptions, such as bottled water depending on where you purchased it, just adds unnecessary complications. And, a broader base of what consumers pay sales tax should allow for a lower rate.
    Thank you.

  • Posted by Bob on May 9, 2014 11:24am:

    Professor Nellen,
    With all due respect, IMHO you have offered a GROSSLY oversimplified solution (exempting businesses from ALLsales tax) to an immensely complex problem (multi-state sales tax schemes). And in the process of presenting your conclusion, you actually contradicted yourself. by stating "...sales tax should not apply to purchases by businesses; only to purchases by consumers."
    You see businesses more often than not in fact are CONSUMERS every bit as much as you or I.
    Should business' non-production sites that consume heat/water/electric be exempted from sales taxes thereon while you or I as INDIVIDUAL CONSUMERS are fully taxed for consumption of those same utilities?
    Businesses frequently book hotels/restaurants for corporate functions & will frequently pay for food/beverages for their employees/customers/prospective customers. Should businesses be exempted from sales taxes thereon while you or I as INDIVIDUAL CONSUMERS are fully taxed for our direct purchase of those same food/beverages provided & served by those same hotels/restaurants?
    And finally, exactly what is there to stop those of us savvy INDIVIDUAL CONSUMERS to find the ways/means (e.g.CPA's/attorneys) to become recognized as BUSINESSES ourselves & thus individually attain the tax-exempt status on ALL of OUR purchases, hmmm???
    Professor, the problem lies within the states' complex sales tax schemes. With some digital goods, states fight like unsupervised spoiled brats seeking to tax transactions irrespective of where the goods are deemed delivered vs. actually downloaded/used. As a result, consumers can find themselves taxed by several different states on the exact same purchase!! This is something that needs to be corrected, however, the states apparently have yet to work out a solution.
    And while states attempt to set up goods (e.g. food/clothing) as tax exempt, they then develop the means to literally worm their way into such goods so that they can extract a tax revenue stream. For examples:
    Candies made with wheat-based flour = not taxable Candies made with nut-based flour = taxable
    Bagel and cream cheese sold separately = not taxable. Bagel sold with cream cheese spread on it by vendor = taxable as a prepared food.
    Bottled water sold in a store = not taxable. Bottled water sold by a restaurant or diner = taxable.
    No professor, simplifying sales taxes by exempting businesses will lead to discrimination and encourage savvy individuals to evade sales taxes by becoming businesses themselves. Such a solution will not simplify the monstrously complex/ridiculous sales tax schemes that the states have set up.
    And also keep in mind that it took the states DECADES to create this mess. An attempt at a simplified solution is unlikely to untangle the mess that it took the states decades to create.

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