N.C. Business Court Grants (Partial) Victory to Scrap Metal ‘Manufacturers’

In N.C. Dep’t of Revenue v. Tri-State Scrap Metal, Inc. et al., 2019 NCBC 41 (N.C. Super. Ct. July 8, 2019), the Business Court addressed whether the respondent “recyclers” qualified as “manufacturers” for purposes of the privilege tax under G.S. § 105-187.51 (now repealed). If so, the respondents were entitled to apply the lower (1%) privilege tax rate—as opposed to the generally applicable state and local tax rates—on certain business purchases. Judge Robinson concluded that yes, the respondents were manufacturers generally entitled to the privilege tax rate, but that remand was required to determine application of the privilege tax on a purchase-by-purchase basis.

Take-Aways:

• To qualify for the privilege tax: (1) the taxpayer must be a “manufacturer”; and (2) the items in question must be used in the “production phase” of manufacturing.
• The process of converting scrap metals into “new and different” products qualifies as “manufacturing” for privilege tax purposes.
• Whether a manufacturer’s purchases are subject to the privilege tax must be determined on a purchase-by-purchase basis.

Though North Carolina’s 1% “privilege tax” sounds like something that might apply to wealthy individuals or entities, it is actually something quite different. This sales and use tax of 1% is a “privilege” reserved for businesses qualifying as “manufacturers” under the governing statute; and it is a “privilege” because it applies in lieu of the generally applicable (and much higher) state sales tax rate. As such, this tax is actually one that taxpayers hope to qualify for.

Tri-State Scrap Metal involved three “secondary metal recyclers” (collectively, the “respondents”) in the business of purchasing and “processing” scrap metals into products for use by their customers in their own manufacturing businesses. Id. ¶ 2. The respondents’ operations essentially consisted of recycling scrap metals by buying, altering, and then selling them – a business model that one might expect to receive “favorable” tax treatment. (Recycling is a good thing, right?)

The respondents took the position that as “secondary metal recyclers,” they qualified as “manufacturers” entitled to the 1% privilege tax rate described under G.S. § 105-187.51 (the “privilege tax”) on their purchases of “certain machinery, parts, and accessories used in their operations at their respective facilities.” Id. The respondents thus made payments to the NC Department of Revenue (the “Department”) based on the privilege tax rate—instead of the generally applicable sales and use tax rate—with respect to these purchases. Id. ¶ 3.

Upon audit, the Department determined that the respondents’ operations—i.e., its purchasing and processing of scrap metals—did not qualify as “manufacturing” for purposes of the privilege tax. Id. ¶ 3. The Department therefore assessed tax deficiencies against the respondents representing essentially the difference between the generally applicable sales tax and the privilege tax that respondents had paid on their purchases, plus interest and penalties. Id.

The respondents appealed to the Office of Administrative Hearings (“OAH”), which disagreed with the Department and ruled that the respondents were, in fact, “manufacturers” entitled to the privilege tax rate on their business purchases. Id. ¶¶ 4, 13.

The Department thereafter appealed the OAH’s decision to the North Carolina Business Court. (Yes, the Business Court hears tax cases, too.) See G.S. § 7A-454(b)(1) (providing that “[a]n action involving a material issue relating to tax law that has been the subject of a contested tax case for which judicial review is requested under G.S. 105-241.16…shall be designated as a mandatory complex business case”).

On appeal, the Business Court addressed two issues: (1) whether the respondents’ operations qualified as “manufacturing” under G.S. § 105-187.51; and (2) whether the OAH should have conducted a “purchase-by-purchase analysis” in determining whether the respondents’ purchases were subject to the privilege tax. Id. ¶ 5.

1. What is “Manufacturing?”

The Business Court first considered whether the nature of the respondents’ business operations entitled them to the 1% privilege tax rate.

As the Court observed, the privilege tax “is a partial exemption from State and local sales and use tax on tangible personal property.” Id. ¶ 19. The then-governing statute provided, in relevant part, as follows:

A privilege tax is imposed on the following persons: …. A manufacturing industry or plant that purchases mill machinery or mill machinery parts or accessories for storage, use, or consumption in this State. . . . The tax is one percent (1%) of the purchase price of the machinery, part, or accessory purchased.

G.S. § 105-187.51 (repealed effective July 1, 2018) (emphasis added). The threshold question, then, was whether the respondents’ business of purchasing and processing scrap metals qualified as “manufacturing” within the meaning of G.S. § 105-187.51.

Finding no statutory definition of “manufacturing” on point, the court turned to the case law, and specifically Duke Power v. Clayton, 274 N.C. 505, 164 S.E.2d 289 (1968). There, the North Carolina Supreme Court defined “manufacturing” as “the producing of a new article or use or ornament by application of skill and labor to raw materials.” Id. at 514, 164 S.E.2d at 295. An item is considered manufactured, in other words, where “the labor . . . result[s] in a new and different article with a distinctive name, character or use.” Id. at 513, 164 S.E.2d at 295.

The Business Court applied this “new and different” concept in analyzing the respondents’ “secondary metal recycling” operations. The court found that the respondents’ operations “transform[ed]” scrap metal that was “no longer usable into new products that have distinct names, characteristics, and uses.” Id. ¶ 22. For instance, the respondents took “post-consumer aluminum beverage cans”—which otherwise would be “discarded as trash”—and through their processes of drying, cleaning, flattening, and baling the used cans, converted them into a new product (“Baled Aluminum Used Beverage Can Scrap”) that could be used by the respondents’ customers. The respondents’ “transformation processes” thus converted otherwise useless items into products that had value for their customers and that their customers were willing to purchase. Id. ¶ 23. Indeed, as the court summed up (rather eloquently): “Respondents create new life and new purpose for products that have been discarded and have lost their intended value—[and] this is entirely consistent with the Duke Power definition of manufacturing.” Id. ¶ 23.

Accordingly, the respondents qualified as “manufacturers” for privilege tax purposes.

2. Which Items Get the Privilege Tax Rate?

The Business Court’s analysis did not end with its holding that the respondents were manufacturers, however. The question remained as to which items purchased by the respondents were subject to the lower privilege tax rate.

The OAH had concluded that all items purchased by the respondents were subject to the privilege tax. It did so, however, without assessing application of the privilege tax on a purchase-by-purchase basis. Instead, it had “assumed, without proof, that all claimed purchases were entitled to the lower Privilege Tax because the ALJ concluded as a matter of law that the Respondents were manufacturers.” Id. ¶ 35. This blanket assumption, according to the Business Court, was error (although, as the court was quick to point out, the OAH did not have before it the evidence needed to undertake a purchase-by-purchase analysis).

The Business Court reasoned that not all items purchased by a manufacturer necessarily qualified for the privilege tax because, under the plain language of the statute, the tax applied only to certain types of business purchases – namely, “mill machinery or mill machinery parts or accessories for storage, use, or consumption in this State.” G.S. § 105-187.51(a)(1). Further, the statute applied the tax to “the purchase price of the machinery, part, or accessory purchased.” G.S. § 105-187.51(b) (emphasis added). As this language suggests, and as the court concluded, “a purchase-by-purchase analysis must be done” to determine whether each item purchased qualifies for the lower privilege tax rate. Id. ¶ 31.

In short, “[w]hile being a manufacturer is a prerequisite to being eligible for the Privilege Tax, not all items purchased by a manufacturer are entitled to the lower rate of taxation.” Id. ¶ 31. And since the OAH had applied the privilege tax to all purchases without assessing whether each individual purchase was subject to the tax, remand was required.

As for which items actually qualify for the privilege tax, the Business Court did offer some guidance to the OAH on remand. In particular, the court instructed that “only those items used in the production phase of manufacturing are subject to the Privilege Tax.” Id. ¶¶ 33-36 (citing 17 N.C. Admin. Code 07D.0102(a)(1)) (emphasis added). The court cited “computer equipment and printer ink cartridges” as examples of items bought by the respondents that were “seemingly used for purposes other than manufacturing,” and therefore would not qualify for the privilege tax. Similarly, items used merely “for the movement of raw materials into inventory are not subject to the Privilege Tax.” Id. ¶¶ 34-35.

Accordingly, the ball now returns to the OAH, where the respondents must scrap together evidence sufficient to show that the privilege tax should apply to each (or as many as possible) of their purchases.