Manufacturers are allowed a sales tax exemption for all equipment, machinery, parts, and supplies used directly in the manufacturing process. The theory behind the exemption is for sales tax to be charged to the end user or consumer who pays sales tax on the full retail price of the product. To have manufacturers pay sales tax on products they purchase which are later sold to retailers would cause an unnecessary burden as the price of the product would increase for each step in the process until the product reached the end-user.

While equipment, machinery, and supplies used in the manufacturing process are widely known to be sales tax exempt, an overlooked benefit is the sales tax exemption for utilities used in the manufacturing process (most notably natural gas and electricity). A large amount of a manufacturer’s utility bills could be considered sales tax exempt if the vast majority of the building is used for the manufacturing process. In a jurisdiction with a high sales tax rate (7% for Allegheny County, Pennsylvania), the savings could be quite substantial.

The qualifications for utility exemptions require more rigorous criteria be met than other purchases used in the manufacturing process. Qualifications vary from state to state however many require a utility or predominant use study in order to qualify for the exemption. The utility or predominant use study would indicate which portion of the utilities are manufacturing vs non-manufacturing and determine an overall amount of the utility bill which could ultimately qualify for an exemption (i.e. 80% of a building is considered manufacturing, thus 80% of the utility bill would be sales tax exempt).

The typical process in performing a utility or predominant use study would include the following steps:

• Review utility bills and amount of utility usage.
• Review fixed assets from asset listings and depreciation schedules.
• Take a facility tour to review each piece of equipment that is supplied by electricity or gas and note their energy consumption.
• Prepare an inventory list of all equipment that is using utilities.
• Determine taxability of equipment based on state law and exemptions.
• Calculate each equipment’s consumption based on utilization.
• Calculate percentage exempt vs taxable use of utilities.
• Prepare a deliverable based on the state’s specific guidelines.
• Communicate with utility vendors on refund request for prior periods, if applicable.
• File a refund request for prior periods, if applicable.

The final deliverable would be a formal report required by the state that documents the study procedures and calculations. This report will be required to be shown upon a sales tax audit and a tax exempt certificate would be given to the utility provider. Furthermore, the report will support the exemption amount until a significant change is made to or in the manufacturing process.

Pennsylvania Requirements

PA Code § 32.25 states that apportionment may be required between taxable and exempt use if a portion of the purchase is used directly in one or more of manufacturing business operations. To apportion the usage, an analysis of exempt usage shall be made. Any reasonable method of apportionment may be used. For example, the purchaser may estimate the exempt use of electricity through each meter by analyzing the electrical consumption of each item of equipment used directly by the purchaser in its manufacturing operation. This analysis should be annualized to reflect consumption during the entire calendar year. The resulting percentage of exempt use may be claimed by the purchaser upon the total monthly purchase of electricity through that meter. The exemption upon the purchase of electricity, expressed as a percentage, would be claimed through the use of an exemption certificate tendered to the vendor.

See PA Code § 32.32 for a listing of assets that qualify for the exemption vs taxable.

Conclusion:

Manufacturing companies may be able to claim the exemption with proper documentation of utility bills and invoices along with a formal utility or predominant use study. There is no time limit on how long the study will last, however, any substantial changes in the manufacturing process would warrant an updated study. Once complete, the formal utility or predominant use study will be required in the event of a sales tax audit. An exemption certificate will be provided to the utility provider and sales tax will no longer be charged on the exempt portion of consumption in the manufacturing process.

Jurisdictions with high sales tax rates, such as previously mentioned Allegheny County at 7%, could see substantial tax savings. Furthermore, manufacturers who use substantial electricity and natural gas in the manufacturing process (working multiple shifts or extended hours) could also see significant savings. Additionally, Pennsylvania allows companies to claim a refund of up to 3 years for sales tax exemptions not claimed but paid from the beginning of the reporting period in which the refund request is dated. This would provide an additional upfront cash inflow for companies failing to take the sales tax exemption in prior years. In conclusion, manufacturing companies failing to take an exemption on sales taxes for utility consumption are not only paying too much each month for utility bills but also are not taking advantage of the initial cash refund for prior period sales tax paid.