Editor: Anthony S. Bakale, CPA, M. Tax.
State & Local Taxes
Many states offer sales tax exemptions to companies that manufacture or are involved in the production or processing of oil and gas. The states examined here—Texas, Kansas, Missouri, Ohio, Pennsylvania, and West Virginia—account for considerable activity in the manufacturing and energy industries and offer generous sales tax exemptions.
Benefiting from those exemptions, though, can be complicated. Exemptions change over time. Claiming the exemptions also requires evaluating all vendor purchases and being aware of which purchases qualify as exempt from sales tax. Those complications are particularly relevant for a company that operates in multiple states.
Sales tax rules and regulations may also vary greatly from one manufacturing sector to another, and from one energy industry segment to another (i.e., upstream vs. downstream). The upstream segment of an energy business involves searching for and extracting raw materials, whereas the downstream segment usually refers to processing for use and distributing the finished product.
States may have general rules for mining operations that would apply to upstream businesses, or they may have specific rules for upstream activities. States’ manufacturing rules generally apply to downstream operations as well as supply companies. Depending on the state, midstream operations (i.e., transporting the product by pipeline, train, truck, or barge) may be treated as mining or manufacturing activities, or both.
Here is a brief review of sales tax exemptions for Texas, Kansas, Missouri, Ohio, Pennsylvania, and West Virginia.
Midstream, downstream, and manufacturing companies benefit from Texas’s manufacturing sales tax exemptions, which generally apply to equipment and supplies that directly cause a change to the item being produced for sale (Tex. Tax Code §151.318; 34 Tex. Admin. Code §3.300(a)(10)).
Under the Texas tax code, the manufacturing process begins with the first activity that changes a raw material or ingredient and ends with the packaging of that personal property as it will be sold (Tex. Tax Code §151.318(d); 34 Tex. Admin. Code §3.300(a)(9)). Available exemptions include repairs to qualifying items and necessary lubricants, chemicals, gases, and liquids used in manufacturing (34 Tex. Admin. Code §3.300(d)(7)).
Texas offers generous sales tax incentives to all energy industry segments, but the exemptions tend to be specific and can be tricky to apply. Upstream processes have a harder time qualifying for the manufacturing exemption because Texas takes the position that bringing oil to the surface does not qualify as manufacturing unless the extraction equipment directly causes a change to the material being extracted (see, e.g., Tex. Comptroller Tax Policy Letter 9612121L). The most beneficial exemption for upstream companies applies to downhole services, which start or stimulate production at a well. Texas also exempts oil-soluble chemicals as well as numerous lease services.
Kansas offers an array of sales tax exemptions related to manufacturers and energy industry companies.
As a general guideline, an item is exempt from sales tax if it is used as an integral or essential part of an integrated production operation by a manufacturing or processing facility (Kan. Stat. §79-3606(kk)). Consumable purchases are generally exempt if they are used in a manufacturing, mining, drilling, or refining process (Kan. Stat. §79-3606(n)). Qualifying purchases must be necessary and essential to the process. Purchased items must also be completely consumed within one year (Kan. Stat. 79-3602(dd)).
Manufacturers may purchase machinery and equipment tax free if those items are directly used in a manufacturing or refining process. Computers and related equipment used for research and development or product design qualify as exempt, as does pollution control equipment, if the pollution can be attributed to the manufacturing or processing operation (Kan. Stat. §§79-3606(kk)(3) and (4)).
Drill bits and explosives used for oil and gas exploration, as well as electricity or gas used to remove the oil or gas from the ground, are sales tax exempt (Kan. Stat. §§79-3606(pp) and 79-3602(dd)). Electricity or gas used for lighting or other nonextraction purposes is subject to sales tax.
Manufacturing and mining companies in Missouri may benefit from generous sales tax exemptions. Machinery, equipment, and related replacement parts used in manufacturing or mining typically qualify as tax exempt (Mo. Rev. Stat. §144.030(2)). Qualifying equipment must be used directly in mining or in manufacturing products to be sold.
Materials and chemicals used for manufacturing and mining are exempt, as are items used for research and development activities related to those two industries (Mo. Rev. Stat. §144.054).
Missouri also offers sales tax exemptions for parts, materials, and supplies related to machinery and equipment purchased to establish new manufacturing or mining operations in the state or to expand existing businesses in those industries (Mo. Rev. Stat. §144.030(5)).
Manufacturers in Ohio benefit from sales tax exemptions not only for machinery and equipment, but also for supplies and fuel used by manufacturing facilities to produce tangible personal property for sale (Ohio Rev. Code §5739.011). Warehouse machinery and equipment may qualify for sales tax exemption if inventory is primarily distributed outside Ohio (Ohio Rev. Code §5739.02(B)(42)(j)). The sales tax exemption may also be applied to machinery and equipment used for research and development purposes (Ohio Rev. Code §5739.02(B)(42)(i)).
Mining companies benefit from exemption on all supplies and equipment used directly in the exploration and production processes. Ohio extends that exemption to service companies within the mining industry (Ohio Rev. Code §5739.02(B)(42)). States rarely apply such exemptions to service companies.
Pennsylvania and West Virginia
Pennsylvania and West Virginia offer similar broad-based exemptions for supplies and equipment directly used for manufacturing or mining. For both states, sales tax exemption eligibility hinges on meeting that direct-use standard.
In Pennsylvania, parts and foundations directly related to manufacturing or processing are exempt from sales tax. Packaging, testing, and inspection, research and development, and other items used for manufacturing may also be exempt (61 Pa. Code §32.32). Fuel used to run a drilling unit and electricity and off-road fuel used to run a pump jack are also exempt from sales tax (61 Pa. Code §32.35; Pa. Dep’t of Rev. Q&A Answer ID 2869.)
West Virginia, likewise, offers an array of wide exemptions to mining companies as well as manufacturers. Machinery and materials used in the production of natural resources are exempt, including drilling rig units, drilling heads, pump rods, and casings (W. Va. Code §11-15-9).
Be Aware of States’ Various Offerings; Evaluate Available Exemptions
While Texas, Kansas, Missouri, Ohio, Pennsylvania, and West Virginia offer a range of sales tax exemptions for the manufacturing and energy industries, not all states with substantial business presences in those sectors offer such extensive benefits. Those considerable differences can influence where company operations may be located.
A three-step process is involved in taking advantage of exemptions offered to manufacturing and energy companies:
- Managers need to understand available exemptions in states where the company has operations.
- Vendors selling sales tax-exempt items must be identified. The company may have erroneously been charged sales tax in the past on those exempt purchases.
- Vendors must be informed of those tax exemptions and provide any required exemption certificates.
The company then needs to monitor future purchases, rather than assume that vendors will charge tax correctly. Continual review of all vendors who make a material amount of sales is the best way to improve sales tax compliance and reduce both overpayments and underpayments.
While identifying opportunities for sales tax exemption requires considerable work, the potential tax savings make that effort worthwhile.
Anthony Bakale is with Cohen & Co. Ltd., Baker Tilly International, Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.