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A Split Decision – One for Revenue and One for the Taxpayer

By Erica Horn and Maddie Schueler

In Kentucky Department of Revenue, v. Progress Metal Reclamation Company, Kentucky Court of Appeals, Case Nos. 2013-CA-1765-MR and 2013-CA-1776-MR (consolidated) (March 13, 2015), the Kentucky Court of Appeals addresses the tension arising in one of Kentucky’s sales and use tax statutes related to a manufacturing exemption. While KRS 139.470(11) allows an exemption for industrial tools “directly used in manufacturing or industrial processing” and having a “useful life of less than one (1) year”, the same statute excludes from the scope of the exemption “repair, replacement, or spare parts”. Controversies frequently arise as a result of the exclusion of repair parts and the requirement that industrial tools have a useful life of less than one year.

“Industrial tools” are defined as: “[H]and tools such as jigs, dies, drills, cutters, rolls, reamers, chucks, saws, spray guns, etc., and to tools attached to a machine such as molds, grinding balls, grinding wheels, dies, bits, cutting blades, etc. Normally, for industrial tools to be considered directly used in manufacturing, they shall come into direct contact with the product being manufactured.” The term “repair, replacement, or spare parts” is defined by KRS 139.010(26) (previously KRS 139.170(4)) to mean “any tangible personal property used to maintain, restore, mend, or repair machinery or equipment.”

Progress Metal Reclamation Company (“Progress Metal” or “Taxpayer”) argued hammer pins used in its business of recycling and manufacturing scrap metal for steel mills were exempt as industrial tools, and also claimed liquid oxygen used in its cutting torch was exempt as an industrial supply. The Kentucky Department of Revenue (“KDOR”) issued a final ruling holding the hammer pins were not industrial tools and the liquid oxygen was an energy producing fuel, not an industrial supply, so neither was exempt from sales tax.

Progress Metal appealed the KDOR’s determinations to the Kentucky Board of Tax Appeals (“KBTA”) wherein the testimony established the hammer pins hold hammers in place on rotors that break up metal. Progress Metal argued the hammer pins qualify for the exemption from tax because they function as chucks or tool holders, which are expressly listed in the statute. Furthermore, Progress Metal argued the hammer pins have a useful life of less than one year. The KDOR, by contrast, argued the hammer pins did not qualify for the exemption because they were repair, replacement or spare parts. The KBTA agreed with the KDOR and held the hammer pins were not industrial tools but repair or replacement parts.

Progress Metal also argued liquid oxygen used in an oxy-fuel torch cutting process to cut large pieces of metal into smaller pieces was exempt from tax as an industrial supply. KRS 139.470(11)(a)2.b. defines this exemption to include “supplies such as lubricating and compounding oils, grease, machine waste, abrasives, chemicals, solvents, fluxes, anodes,

filtering materials, fire brick, catalysts, dyes, refrigerants, explosives, etc.” The company also claimed the KDOR previously had exempted liquid oxygen from 1965 to 2004 but changed its position in 2004, despite no change in the law, thus violating the doctrine of contemporaneous construction. The KBTA noted the KDOR failed to address Progress Metal’s argument regarding the doctrine of contemporaneous construction, and the KDOR did not argue liquid oxygen was not an industrial supply. The KBTA, therefore, reversed the KDOR’s final ruling as to the liquid oxygen.

Both parties appealed to the Franklin Circuit Court. The circuit court affirmed, finding the KBTA’s decision was based on substantial evidence and a reasonable interpretation of the law. Both the KDOR and Taxpayer filed appeals, which were consolidated in the Court of Appeals.

On March 13, 2015, the Court of Appeals issued an opinion affirming the Franklin Circuit Court’s decision in full. The Court first addressed the KDOR’s classification of liquid oxygen, and agreed with the circuit court and the KBTA that the doctrine of contemporaneous construction applied. Thus the Court held the KDOR to its longstanding treatment (“four-decade long pattern of exemption”) of liquid oxygen as an industrial supply. The Court noted that it need not resort to the doctrine of contemporaneous construction in the absence of an ambiguity, but found an ambiguity existed.

With respect to Progress Metal’s use of hammer pins, the Court agreed with the KBTA and the circuit court that the hammer pins were not “industrial tools” but instead were “replacement parts” not exempt from taxation. Like the circuit court, the Court noted that, at best, the hammer pins came into only incidental contact with the metal the mechanical hammer was destroying, and the hammer pins simply “wore out” and were not intended to be “used up” in the manufacturing process.

The parties have 30 days from the Court’s decision to file a motion for discretionary review with the Supreme Court of Kentucky.