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STATE OF ARKANSAS DEPARTMENT OF FINANCE & ADMINISTRATION

OFFICE OF HEARINGS & APPEALS

ADMINISTRATIVE DECISION

IN THE MATTER OF GROSS RECEIPTS TAX AND COMPENSATING USE

(ACCT. NO.: ) TAX ASSESSMENT AUDIT NO.: DOCKET NO.: 16-044 06/01/09 – 05/31/12 ( )1

RAY HOWARD, ADMINISTRATIVE LAW JUDGE

APPEARANCES This case is before the Office of Hearings and Appeals upon a written

protest dated June 3, 2015, signed by , Attorney at Law,

, on behalf of , the Taxpayer. The Taxpayer

protested the assessment of Gross Receipts Tax (“sales tax”) and Compensating

Use Tax (“use tax”) as a result of an audit conducted by Richard McDonald, Tax

Auditor – Northeast Audit District of the Office of Field Audit, for the

Department of Finance and Administration (“Department”).

A hearing was held on November 4, 2015, at 10:00 a.m., in Jonesboro,

Arkansas. The Department was represented by Lisa Ables and Todd Cockrill,

Attorneys at Law, Office of Revenue Legal Counsel. Present for the Department

were the Tax Auditor, Jeri Rogers - Audit Supervisor, and Cathy Coker – Audit

District Manager. The Taxpayer was represented by . Present for

1 The parties reached an agreement regarding some items in the audit and the amount of the assessment was not adjusted prior to the hearing. This Administrative Decision will not address any items or issues conceded by the Taxpayer or the Department.

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the Taxpayer were ,

, and .

The record remained open until December 3, 2015, for the submission and

review of additional evidence.

ISSUE

Whether the assessment issued against the Taxpayer should be sustained?

Yes, in part.

FINDINGS OF FACT/CONTENTIONS OF THE PARTIES

The Taxpayer operates a processing plant in , Arkansas. The

Taxpayer manufactures and .

The Assistant Plant Manager described the Taxpayer’s operations and processes,

as illustrated in Taxpayer Exhibit 3, and testified that: (1) he has worked at the

plant for more than 35 years; (2) he is familiar with the contested items picked up

in the audit; (3) for the , the Taxpayer has 5 production lines

[4 lines, with 72 positions, are for and 1 line, with 7 positions, is

for ]; (4) the Taxpayer also has a converting process where a

production line is used to convert the product into a product used by

; (5) the Taxpayer’s process begins with which is

taken through a series of chemical changes and converted into a liquid called

; (6) the is aged for a number of days then taken to an

[the process takes 60 hours ]; (7)

even though the process is the same, used on the lines is prepared

differently than used on the line; (8) Taxpayer Exhibit 3 – P. 8

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depicts a flow chart of the process;2 and (9) is further processed

by , See Taxpayer Exhibit 3 – P. 9, or , See

Taxpayer Exhibit 3 – P. 11.

With respect to , the Assistant Plant Manager stated that:

(1) is injected into an aquarium, a PVC pipe, which contain a

which coagulates the and turns it back into a

solid; (2) a in the center of aquarium determines the size of the

[the slides around the to establish the correct diameter]; (3) the

then goes over a [designated as on Taxpayer Exhibit 3 – P.

9] which allows further solidification as well as moving through a series of

to allow the to properly set; (4) next the goes

through a series of in order to regenerate the

[further solidify], then the goes into a [70% moisture is reduced

to 15%] See Taxpayer Exhibit 3 – P. 10; (5) a continuous

is involved in the Taxpayer’s manufacturing process from the point of extrusion

through the stage; (6) then the is wound into a roll on a ; and

(7) a roll of [which can be over 200 feet long] is shirred over a to

produce compressed pieces of on sticks which are 18” to 24” long.

2 is soaked in a to start breaking down the , then the product moves into a shredder (a vat with blades in it) where is it is ground up to create more surface area for the chemicals to react on, next the product moves into a heated aging can (at this stage, the product is quality-checked periodically to assure it is ready for further processing), then the product is dropped into a and is introduced into the process which causes the product to become a liquid, next the product is moved into a

and the is liquefied, then the product moves through a series of to get the correct

, next the product is subjected to filtration, and then .

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With respect to , the Assistant Plant Manager stated that:

(1) a different product is produced by the ; (2) a

machine, off to the side, supplies the with a

; (3) the is a separate machine from

the production line; (4) the injects the into the

process at the aquarium; (5) the from the is

necessary to coagulate the ; (6) the aquarium contains

; (7) the consists of

; (8) is solidified in the aquarium so it

can be ; (9) the goes through a series of washes to remove

chemicals and continue the solidification process; and (10) then the

is dried by a .

During the audit period, the Taxpayer purchased items of tangible

personal property (i.e. machinery or equipment). The Taxpayer’s Answers to

Information Request stated that, “[Taxpayer] performed numerous capital

projects to improve efficiency and increase production, and several of these

projects had items assessed in the audit as taxable. [P. 1].” The Department’s

Answers to Information Request stated, in part:

Tax had not been accrued on most of the capital invoices reviewed by the auditor. For example, was an entire new line that was added during the audit period which the auditor determined to be exempt. A few other projects were also determined to be exempt. The remaining items however were determined to be taxable based on the description contained within the capital request forms provided by the Taxpayer. [P. 2-3].

Subject to the applicability of an exemption, deduction, or credit, use tax is

imposed on sales of tangible personal property made by out-of-state

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vendors/sellers to in-state purchasers for storage, use, or consumption in this

state,3 and sales tax is imposed on sales of tangible personal property made by in-

state vendors/sellers to in-state purchasers.4 The items the Taxpayer contends

were exempt from tax are set forth below with the arguments presented by the

Taxpayer, the arguments presented by the Department, and a legal analysis.

CONCLUSIONS OF LAW

Standard of Proof

Ark. Code Ann. § 26-18-313 (Supp. 2015) provides, in pertinent part, as

follows:

(a) When the state seeks to impose a tax under the terms of a state tax law, then the statute imposing the tax shall be strictly construed in limitation of the imposition of the tax.

(b) When a taxpayer claims to be entitled to a tax exemption, deduction, or credit under the terms of a state tax law, then the statute providing the tax exemption, deduction, or credit shall be strictly construed in limitation of the exemption, deduction, or credit.

(c) The burden of proof applied to matters of fact and evidence, whether placed on the taxpayer or the state, in controversies regarding the application of a state tax law shall be by preponderance of the evidence.

(d) When the meaning of a state tax law is in controversy, the burden of establishing the proper construction of the statute shall be on the party claiming application of the tax or benefit of the tax exemption, deduction, or credit.

(e) Words used in statutes imposing a tax and in statutes providing for a tax exemption, deduction, or credit shall be given their plain and ordinary meaning, not their narrowest possible meaning.

(f)(1) Statutes imposing a tax and statutes providing a tax exemption, deduction, or credit shall be fairly and reasonably construed, taking into consideration the purpose and spirit of the tax, exemption, deduction, or credit and the public policy at the time the statute was passed.

(2) If after taking this section and other applicable rules of statutory construction into account, a well-founded doubt

3 See Ark. Code Ann. § 26-53-101 et seq. (Repl. 2014 & Supp. 2015). 4 See Ark. Code Ann. § 26-52-101 et seq. (Repl. 2014 & Supp. 2015).

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exists with respect to the meaning of a statute imposing a tax or providing a tax exemption, deduction, or credit, the rule of strict construction shall require that the doubt be resolved against the tax, exemption, deduction, or credit. [Emphasis added]. A preponderance of the evidence means the greater weight of the evidence.

See Chandler v. Baker, 16 Ark. App. 253, 700 S.W.2d 378 (1985). In Edmisten v.

Bull Shoals Landing, 2014 Ark. 89, at 12-13, 432 S.W.3d 25, 33, the Arkansas

Supreme Court explained that:

[a] preponderance of the evidence is not necessarily established by the greater number of witnesses testifying to a fact but by evidence that has the most convincing force; superior evidentiary weight that, though not sufficient to free the mind wholly from all reasonable doubt, is still sufficient to incline a fair and impartial mind to one side of the issue rather than the other.

Tax Assessment

Project. Taxpayer Exhibit 4 is a copy of Capital Order Request #

367020 and an Estimate of Cost. Page 2 of Taxpayer Exhibit 4 states that, “[t]he

new system would utilize 3000 lb. super sacks by using a

hoist and screw conveyor to automatically add to the system as

needed to maintain the . The delivery system eliminates the

current operator handling where 50 [lb.] sacks are physically picked up and

poured into the .” The Assistant Plant Manager presented the following

testimony regarding the project: (1) the system was composed

of a tank with a mixer and an operator was required to monitor chemical

concentrations and manually dump 50 lb. bags of into the

system on an hourly basis; (2) the project automated the process by installing

equipment to use 3000 lb. bags of the chemical and allow the concentration of

the chemical to be automatically maintained; (3) the mixed chemicals

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for the process; (4) the chemicals are mixed in the solution

house as well as chemicals used for other processes; (5) the project

allows the appropriate amount of to be automatically added to

the solution; (6) after mixing, the solution is injected into an aquarium

for use in the process; (7) programming was added to automatically

monitor chemical concentrations and density as well as engaging the auger to add

; (8) an operator can adjust a setting to increase the input of

after testing is performed; (9) the chemicals mixed in the

are necessary to make the finished product; (10) the project

resulted in an increase in production; (11) the project resulted in the

Taxpayer having better control over the chemical concentration in the ;

(12) all of the machinery and equipment purchased for project are part

of an integrated unit operated by one control panel; (13) all of the components of

the are interconnected and operate as an integrated machine5; and (14)

the original was completely replaced by the new .

The Tax Auditor stated the Department’s original position was that the

items purchased for the project were taxable because the project

involved a non-substantial modification of existing machinery and equipment.

The Audit District Manager stated that, after hearing the testimony of the

Assistant Plant Manager, the project did not involve a modification of

existing machinery but rather a new system. The Department’s current position

is that the machine is not used directly in manufacturing because the

mixing of the solution is one-step removed from the manufacturing 5 The majority of the expenditures related to the project were made prior to this audit period.

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process. The Taxpayer contended that the items of machinery and equipment

installed for the project are used directly in manufacturing pursuant to

GR-55(F)(3)(Example 2).6

Replacement machinery. As a general rule, in order for replacement

machinery to be exempt from taxation, the machinery must be used directly in

manufacturing and substantially replace existing machinery. See Ark. Code Ann.

§ 26-52-402(a)(2) (Supp. 2015), Ark. Code Ann. § 26-53-114(a)(2) (Repl. 2014),

and GR-55(D). Based upon the credible and competent testimony of the

Assistant Plant Manager, the evidence established that the items of machinery

and equipment purchased for the project were component parts of a

unitized automated machine which substantially or completely replaced an

existing manual machine.

Used Directly. GR-55(F)(3) provides the following example of machinery

and equipment which is used directly in manufacturing:

Example 2: Machinery and equipment “used directly” in the manufacturing process shall include, but shall not be limited to the following: . . .; machinery and equipment that produce . . . electricity, or chemical catalysts and solutions that are essential to the manufacturing process but which are consumed during the course of the manufacturing process and do not become necessary and integral parts of the finished product. [Emphasis added].

In light of the Assistant Plant Manager’s experience and knowledge of the

Taxpayer’s manufacturing operation, the credible and competent testimony of

the Assistant Plant Manager is sufficient evidence to support a finding that the

injection of the solution into the manufacturing process is essential to

6 All citations to “GR” are referring to the Arkansas Gross Receipts Tax Rules.

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the manufacturing process. Consequently, the Taxpayer proved that the

machine, which mixes and produces the essential solution (i.e. chemical

solution), is used directly in manufacturing. The Department incorrectly

assessed tax on items of machinery and equipment purchased by the Taxpayer

for the project.

Heat Exchangers. The Taxpayer replaced which supplied

hot water for the manufacturing process. The hot water is used in the

throughout the production lines to remove from . The

Assistant Plant Manager testified that: (1) the Taxpayer increased the number of

[from 16 positions to 20 positions on each line] and the old

were operating at capacity before the increased number of positions;

(2) the old were completely replaced but the piping to the

from the old was retained; (3) the new produced

more hot water than the old ; (4) the are located

in the powerhouse with the boilers; (5) water is chemically treated and heated in

the ; and (6) the steam used to heat the water in the

is generated by the boilers.

The Department contended that the are not used directly

in manufacturing because the heating of the water in the is one-

step removed from the manufacturing process. The Taxpayer contended that:

water is a chemical; the heated water is a chemical solution used in the

production process; the produce the chemical solution for the

production process; and the heating of the water in the is not

one-step removed from the manufacturing process. (GR-55(F)(3) (Example 2)).

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GR-55.1 addresses the tax exemption for chemicals used in manufacturing.

GR-55.1(C)(2)(e) provides that, “[w]ater used during the manufacturing process

is not exempt.” With respect to the heating of water, the Taxpayer’s reliance on

GR-55(F)(3)(Example 2) is misplaced. The do not produce a

chemical solution for use in the production process. The are

merely used to heat water. The act directly on water and not on

the product being manufactured by the Taxpayer. The are one-

step removed from the manufacturing process and are not used directly in

manufacturing under the provisions of Ark. Code Ann. § 26-52-402 (Supp. 2015),

Ark. Code Ann. § 26-53-114 (Repl. 2014), or GR-55. The Department correctly

assessed tax on the purchased by the Taxpayer.

Modification Project for Machine. After completion of the

project (See Pages 6 - 9 of this Administrative Decision), the Taxpayer

purchased machinery and equipment to “modify our current

.” See Taxpayer Exhibit 6. An invoice related to this project reflects that,

“Technician on Site to Repair System.” See Taxpayer Exhibit 2 –

P. 7. The Assistant Plant Manager stated that after completion of the

project, the machine did not perform as intended or meet expectations

so this modification project involved an addition of devices to improve control.

The Taxpayer’s representative argued that the pertinent project was merely a

continuation of the original project to maximize the operation of the

machine.

The original project was completed and the machine

was operational for approximately ten (10) months before the modification

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project. Since the machinery and equipment purchased for the

modification replaced some existing machinery and equipment, it must be

determined if the purchased items were exempt replacement machinery under

Ark. Code Ann. § 26-52-402(a)(2) (Supp. 2015)7 which provides, as follows:

(2)(A) Machinery purchased to replace existing machinery and used directly in producing, manufacturing, fabricating, assembling, processing, finishing, or packaging of articles of commerce at manufacturing or processing plants or facilities in this state will be exempt under this subdivision (a)(2). (B)(i) As used in subdivision (a)(2)(A) of this section, “machinery purchased to replace existing machinery” means that substantially all of the machinery and equipment required to perform an essential function is physically replaced with new machinery. (ii) As used in subdivision (a)(2)(B)(i) of this section, “substantially” is intended to exclude routine repairs and maintenance and partial replacements that do not improve efficiency or extend the useful life of the entire machine, but it is not intended to mean that foundations and minor components that can be economically adapted, rebuilt, or refurbished must be completely replaced when replacement would be more expensive or impracticable than adapting, rebuilding, or refurbishing the old foundation or minor components. With respect to manufacturing machinery, GR-9.18(C) provides that,

“[l]abor performed in connection with the replacement of exempt manufacturing

machinery is exempt from tax only if the machinery being replaced meets all of

the requirements for exemption required by Ark. Code Ann. §§ 26-52-402 and

26-53-114, including the requirement that substantially all of the machinery

required to perform an essential function is replaced.” In the instant case, a

preponderance of the evidence does not support a finding that the modification

of the machine amounted to a replacement of “substantially all” of the

machine as required by Ark. Code Ann. § 26-52-402(a)(2)(B)(i) (Supp.

7 The exemption from use tax is codified at Ark. Code Ann. § 26-53-114(a)(2) (Repl. 2014).

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2015) or Ark. Code Ann. § 26-53-114(a)(2)(B)(i) (Repl. 2014). The Taxpayer

failed to prove that the purchases of the machinery and equipment for the

modification were exempt from tax as a substantial replacement of existing

machinery rather than a taxable partial replacement or taxable repair parts.

Consequently, the Department correctly assessed tax on the Taxpayer’s purchases

of the machinery and equipment, and associated labor charges, for the

modification.8

Project. Taxpayer Exhibit 7 is a Capital Order Request for

new device (including a motor, drives, and a computer system

and programming) for controlling as is rolled up to improve the

lay-flat9 of the . The Assistant Plant Manager stated that: (1) an existing

device was completely replaced with a new device

with improved technology; (2) the device is basically a photo-eye that

gauges the and relaxes the as the gets closer to the

; (3) the is part of the machine at the very end; (4) the

function of the is to work with a to control the of the

when it is being ; (5) a motor pulls the onto the and

the controls the motor; (6) a total of seven [7] positions on the

are regulated by the device; (7) the drives on each of the

seven [7] positions were replaced; (8) the device is part of the

8 If as part of the modification project, the Taxpayer added machinery or equipment to which did not exist, or the Taxpayer did not have, before the modification project, at this stage of the administrative review, the Taxpayer failed to prove that the new machinery or equipment resulted in an economic expansion of the Taxpayer’s plant or facility. 9 Described as “the way as it is rolled up.”

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but it is really a stand-alone operation; and (9) the and

device were additions to the .

The Taxpayer’s position is that the device substantially

replaced existing machinery and equipment. The Department’s position is that

the device is a taxable partial replacement of existing machinery

and equipment. In Southern Steel & Wire Co. v. Wooten, 276 Ark. 37, 631 S.W.2d

835 (1982), the Arkansas Supreme Court stated, as follows:

The control panels are designed from scratch and plugged into a welding machine to control the welding process. Appellant urges that each is a separate piece of machinery and that since these control panels can be utilized with different welding machine and are physically plugged into a welder to achieve the desired results, they are distinguishable from the component parts of a drilling rig which we considered in S. H. & J. Drilling Corp. v. Qualls, supra. There we held that where the appellant purchased certain items to replace existing items of a drilling rig, even if the individual item was considered a machine within the definition of Heath v. Research-Cottrell, Inc., 258 Ark. 813, 529 S.W.2d 336 (1975), once they were assembled into a rig and are designed to accomplish a single purpose, they become a single unit and are not exempt from taxation. We find that reasoning controlling here. It appears undisputed that the control panels, air cylinders and transformers are physically combined with other existing components in order to construct a welding machine which has a single purpose and function. The control panels and welding machines are interconnected or component parts of welding machines and designed to accomplish a single purpose - welding wire to form shelves. They must function simultaneously as a single unit.

Id. at 40-41, 631 S.W.2d at 837.

Taxpayer Exhibit 2 contains invoices related to the pertinent project. The

“job description” on the invoice from was “[l]abor to

work on , service work done 11/9, 11/10 & 11/13/10 . . ..” Id. at 26. The

product descriptions on the invoice from were for a “[c]orrosion-

resistant Enclosure ( ) Fiberglass . . .” and a “21” Height X 21” Width

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Enclosure Panel.” Id. at 27. On November 13, 2015, the Taxpayer’s

representative submitted photographs depicting a , a ,

and a . See Taxpayer Exhibit 19.

Similar to the control panels in Southern Steel & Wire Co. v. Wooten,

supra, which were physically combined with other components in order to

construct a machine that had a “single purpose and function,”10 the

device would not have any function absent the connection to the .

Consequently, the was a component part of the .11 Since the

replaced existing machinery, it must be determined if the

was exempt replacement machinery under Ark. Code Ann. § 26-52-

402(a)(2) (Supp. 2015) or Ark. Code Ann. § 26-53-114(a)(2) (Repl. 2014).

In light of the significant number of component parts of the

(depicted in Taxpayer Exhibit 19) that were not replaced during the

project, a preponderance of the evidence does not support a finding that

“substantially all” of the was physically replaced with new machinery as

required by Ark. Code Ann. § 26-52-402(a)(2)(B)(i) (Supp. 2015) or Ark. Code

Ann. § 26-53-114(a)(2)(B)(i) (Repl. 2014). Consequently, the Department

correctly assessed tax on the Taxpayer’s purchases of machinery and equipment,

and associated labor,12 for the project (the machinery and

equipment were taxable as partial replacements or taxable repair parts).

10 Id. at 41, 631 S.W.2d at 837. 11 See Arkansas Gross Receipts Tax Rule GR-55(D)(3). 12 With respect to a taxable service, the entire gross receipts derived from the performance of the taxable service, including the sale or transfer of title or possession of any materials or supplies used or consumed in performing the taxable service, are subject to tax. See Ark. Code Ann. § 26-52-103(13)(A) (Repl. 2014) and Ark. Code Ann. § 26-52-307(b) (Repl. 2014).

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System. Taxpayer Exhibit 8 is a Capital Order

Request for an upgrade of a system. The Taxpayer

purchased a , pipes, pumps, and other tangible personal property

for this capital project. See Taxpayer Exhibit 2 – P. 28 - 48. The Assistant Plant

Manager stated that: (1) the project involved the addition of a mechanical filter

for the system and putting in a to control

the temperature of the ; (2) the solution used in the

process13 is taken through a filtration process to remove any

remaining from the manufacturing process; (3) the and

mechanical filter did not exist before the project, pumps and piping were

replacement machinery; (4) the project was necessary to increase the filtration of

the because of the expansion of a production line from sixteen

[16] to twenty [20] positions; (5) the is recovered after it is used

in the manufacturing process and it is filtered, reconcentrated, and reused; and

(6) the is an ingredient of the .

The process of recycling, reconcentrating, and reintroducing the used

back into the manufacturing process is one-step removed from

the manufacturing process. The machinery and equipment utilized to

recycle a previously used chemical solution does not “produce”14 the chemical

solution for the purposes of GR-55(F)(3) (Example 2). The items of machinery

and equipment purchased for the upgrade of the system

are not used directly in manufacturing under the provisions of Ark. Code Ann. §

13 See Taxpayer Exhibit 3 – P. 8. 14 Black’s Law Dictionary, Fifth Edition, defines “produce” to mean “[t]o make, originate, or yield, as gasoline.”

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26-52-402 (Supp. 2015), Ark. Code Ann. § 26-53-114 (Repl. 2014), or GR-55. The

Department correctly assessed tax on the machinery and equipment purchased

by the Taxpayer to upgrade the system.

Piping Project. Taxpayer Exhibit 9 is a Capital Order Request

for an upgrade of the Piping. The project involved piping

between the and the . The Assistant Plant Manager testified

that: (1) the is a which removes water, and causes

to form in order to remove the , from the

solution; (2) after the stage of production, the next stage of

production is the ; (3) the Taxpayer replaced seventy-five percent (75%)

of the piping [150 feet of the existing 200 feet] between the and the

; and (4) the pertinent piping is handling work-in-progress.

The Taxpayer’s representative argued that the piping is conveyance

equipment between different stages of production. Stated differently, the

Taxpayer’s position is that the function is completely finished when

the product enters the piping so the piping is a stand-alone piece of equipment

(conveying work-in-progress between different stages of production) and the

Taxpayer substantially replaced the existing piping. The Department’s

representative contended that the piping is a component part of machinery since

the piping is interconnected to machinery and that the Taxpayer did not

substantially replace existing machinery or equipment.

The piping at issue connected items of production machinery (the

was connected to the by the piping). Although the piping

may be nonmechanical in nature, based on the definition of “machine” in Heath

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v. Research-Cottrell, Inc., 258 Ark. 813, 529 S.W.2d 336 (1975),15 the piping is a

component part of interconnected machinery.16 In the instant case, the pertinent

piping is a component part of the since the function of the

includes the delivery of the product to the next stage of processing (it is necessary

for the work-in-progress to be delivered from the to the in

order to continue the manufacturing process). A preponderance of the evidence

does not support a finding that “substantially all” of the was

physically replaced with new machinery or equipment as a result of the

piping project. See Ark. Code Ann. § 26-52-402(a)(2)(B)(i) (Supp.

2015) or Ark. Code Ann. § 26-53-114(a)(2)(B)(i) (Repl. 2014). The Taxpayer’s

contention that the interconnected piping, between the and the

, can be segregated or isolated as a stand-alone piece of equipment is not

persuasive.17 The Department correctly assessed tax on the items of tangible

personal property purchased by the Taxpayer to upgrade the piping.

Piping Project. Taxpayer Exhibit 10 is a Capital Order Request

for the replacement of piping associated with the system. The

pertinent piping connects the to the aquarium on the

production line. Based upon the same rationale used for resolution of the dispute

15 The Court defined machine as "any device consisting of two or more resistant, relatively constrained parts, which, by a certain pre-determined intermotion, may serve to transmit and modify force and motion so as to produce some given effect or to do some desired kind of work." 16 See also GR-3(I) and GR-55(D)(3). 17 Furthermore, the record is void of any evidence to establish that the piping possessed a sufficient degree of complexity. In Weiss v. Bryce Co., LLC, 2009 Ark. 412, 330 S.W.3d 756, the Arkansas Supreme Court held that items of tangible personal property may be exempt manufacturing equipment if the items: (1) possess some degree of complexity; (2) possess continuing utility; and (3) are used directly in the manufacturing process by causing “a recognizable and measurable mechanical, chemical, electrical, or electronic action to take place as a necessary and integral part of manufacturing, the absence of which would cause the manufacturing operation to cease.” Id. at 5-6, 330 S.W.3d at 758-759.

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regarding taxability of the piping, the pertinent piping is a component

part of the system since the function of the includes the

delivery of the chemical solution to the next stage of processing (it is necessary

for the chemical solution to be delivered from the to the aquarium for

the manufacturing process to continue). A preponderance of the evidence does

not support a finding that “substantially all” of the system was

physically replaced with new machinery or equipment as a result of the

piping project. See Ark. Code Ann. § 26-52-402(a)(2)(B)(i) (Supp. 2015) or Ark.

Code Ann. § 26-53-114(a)(2)(B)(i) (Repl. 2014). The Department correctly

assessed tax on the items of tangible personal property purchased by the

Taxpayer to replace the piping.

Upgrade of . Taxpayer Exhibit 12 is a Capital

Order Request for a Upgrade. Taxpayer Exhibit 12

provides, in part:

The following capital is requested to fund multiple upgrades on the line to improve several aspects of its overall

operation. These upgrades include installing at the to reduce creases;

improving treatment drainage by installing new , installing a programmable audio-visual

system to more efficiently communicate process changes or upsets between the ; and making piping modifications around the to accommodate future instrument and controls additions that will improve density control of the

. The funds requested in this particular order will cover the costs of work for these upgrades that may only be performed during the while the line is down. [P. 1].

The Assistant Plant Manager testified that: (1) several projects were

involved with this capital request; (2) the was

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installed to prevent creases when the is being ; (3) pieces of

were overlapped and glued so the must be shifted back and forth,

like a bobbin, to prevent the from ; (4) the

was a new system to control the shifting action; (5) the

was an addition to existing machinery (the existing

is still operational) and did not replace existing machinery; (6) the

was added to existing machinery to fine tune the operation of

the ; (7) Taxpayer Exhibit 13 is a year-to-year performance summary which

reflects total product waste from 2009 through 2014; (8) product waste has been

reduced by a series of projects over the last several years; (9) the start-up date for

the upgrade of the line was estimated as February of 2012; (10)

Taxpayer Exhibit 13 reflects total waste for 2012, 2013, and 2014, as 7.3%, 6.3%,

and 5.2% respectively; (11) there was a steady decline of product waste after

completion of the upgrade of the ; (12) when waste is

reduced, output is increased since more product can be sold; (13) a lot of projects,

not just this one, contributed to the increase in production; (14) Taxpayer Exhibit

13 also reflects an increase in net pounds from 2012 to 2014 [net pounds was

actually less in 2014 than 2013 but that decrease was partially attributed to an

extended overhaul in 2014]; and (15) he could not point to a specific number or

amount of increased production, such as a specific amount of reduced waste,

attributable to the upgrade of the .

When a manufacturer purchases machinery and equipment that the

manufacturer did not have before, even if the new items are attached to existing

machinery or equipment, the new items qualify as new machinery or equipment

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rather than replacement machinery or equipment. In those situations, rather

than using the “substantially all” test or GR-55(D), the appropriate test to apply is

the “plant expansion” test in GR-55(C). GR-55(C) states, in part:

C. PLANT EXPANSION. The gross receipts or gross proceeds derived from the sale of machinery and equipment purchased and used to expand a manufacturing plant or facility in Arkansas are exempt from tax if: 1. The machinery and equipment satisfy the requirements of GR-55(B)(1), (B)(2), and (B)(3); and either 2. The purchase of the machinery results in an economic expansion of the taxpayer's plant or facility (regardless of whether there is a physical expansion) by: a. Increasing production, volume; or, b. Increasing employment; or, c. Increasing the number of different types or models of property that can be manufactured[.] The Assistant Plant Manager did not present testimony regarding a

specific number or amount of increased production attributable to the upgrade of

the . With respect to the new machinery or equipment

purchased by the Taxpayer for the upgrade of the , even

though the Taxpayer presented some evidence of increased production resulting

from multiple capital projects (by and through the reduction of product waste), at

this stage of the administrative review, the evidence fails to preponderate in favor

of a finding that the Taxpayer proved a direct or causal relationship between the

new machinery or equipment purchased for the upgrade of the

and the increased production. Consequently, the Department correctly

determined that the Taxpayer’s purchases of machinery and equipment for the

upgrade of the were subject to tax.

Upgrade . Taxpayer Exhibit 16 is a Capital Order

request for a project to upgrade the for the .

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The Assistant Plant Manager testified that this project (Number 367425) was

similar to the project relating to the new device for Project

Number 367040. See Taxpayer Exhibit 7. Based upon the same rationale

employed regarding the for the , which was

addressed in Taxpayer Exhibit 7, in light of the significant number of component

parts of the (depicted in Taxpayer Exhibit 19) that were not replaced

during the project, a preponderance of the evidence does not

support a finding that “substantially all” of the was physically replaced with

new machinery as required by Ark. Code Ann. § 26-52-402(a)(2)(B)(i) (Supp.

2015) or Ark. Code Ann. § 26-53-114(a)(2)(B)(i) (Repl. 2014). Consequently, the

Department correctly assessed tax on the Taxpayer’s purchases of machinery and

equipment, and associated labor,18 for the project (the machinery

and equipment were taxable as partial replacements or taxable repair parts).

Upgrade of . Taxpayer Exhibit 17 is a Capital

Order Request for a project to modify and upgrade . Taxpayer

Exhibit 17 reflects that the project “will also allow us to put an additional tank

back into service. [P. 1].” The Assistant Plant Manager testified that: (1) due to

increasing our capacity on machines, our from the filters to our

wasn’t large enough so we increased the diameter of the piping

and replaced it with stainless steel; (2) the diameter of the piping was

increased from 4” to 6” so we could force more product through; (3) we had to

put in an additional holding tank to be able to manage the volume that we needed 18 With respect to a taxable service, the entire gross receipts derived from the performance of the taxable service, including the sale or transfer of title or possession of any materials or supplies used or consumed in performing the taxable service, are subject to tax. See Ark. Code Ann. § 26-52-103(13)(A) (Repl. 2014) and Ark. Code Ann. § 26-52-307(b) (Repl. 2014).

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as well; (4) work-in-process, , is in the additional holding tank; (5) the

project involved the replacement of piping which had an increased diameter for

the purpose of increasing production; (6) old piping was taken out and new

piping was put in; (7) the Taxpayer needed a new holding tank, there were 3

tanks holding the same thing, and we needed 1 more; and (8) the new tank is

holding increased volume.

The Audit District Manager stated that: (1) I think the tank is exempt but I

think the piping is taxable; (2) piping is not independent, this is replacement and

we are not talking about expansion; and (3) I think that by the mere fact that they

had to have a whole other tank, I agree it probably increased production but I

don’t think that is relevant because I don’t think it was an expansion.

The Taxpayer added a new holding tank to the

which the Taxpayer did not have before the upgrade of

. Even though the new holding tank was added to the existing production

line, the new holding tank qualifies as new machinery or equipment rather than

replacement machinery or equipment. As a result, the correct exemption test is

the “plant expansion” test in GR-55(C). The Department agreed that the addition

of the new holding tank satisfied the plant expansion test by increasing the

Taxpayer’s production. However, the Department contended that the new 6”

piping was taxable because it replaced 4” piping and failed to satisfy the

“substantially all” test of GR-55(D).

Under the facts and circumstances of this case, the new 6” stainless steel

piping is a component of the new holding tank (rather than a mere replacement

of the existing 4” piping) since the installation of the 6” piping was necessary to

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accommodate or handle the increased volume of the product generated by the

new holding tank. Stated differently, the interdependent relationship of the new

holding tank and the new 6” piping resulted in the economic expansion of the

Taxpayer’s manufacturing plant. Given the symbiotic relationship of the new

holding tank and the new 6” piping, the combination of the new items created a

new piece of machinery or equipment which increased the Taxpayer’s production.

Consequently, the Department incorrectly assessed tax on the Taxpayer’s

purchases of the new holding tank and the new 6” stainless steel piping.

To the extent that other matters not conceded by either party, were

discussed or presented at the Administrative Hearing and are not specifically

addressed by this Administrative Decision, the Taxpayer failed to establish

entitlement to a tax exemption by a preponderance of the evidence.

DECISION AND ORDER

The proposed assessment is sustained, in part. The file is to be returned to

the appropriate section of the Department for further proceedings in accordance

with this Administrative Decision and applicable law. Pursuant to Ark. Code

Ann. § 26-18-405 (Supp. 2015), unless the Taxpayer requests in writing within

twenty (20) days of the mailing of this decision that the Commissioner of

Revenues revise the decision of the Administrative Law Judge, this decision shall

be effective and become the action of the agency. The revision request may be

mailed to the Assistant Commissioner of Revenues - Policy & Legal, P.O. Box

1272, Rm. 2440, Little Rock, Arkansas 72203. The Commissioner of Revenues,

within twenty (20) days of the mailing of this Administrative Decision, may revise

the decision regardless of whether the Taxpayer has requested a revision. The

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Taxpayer may seek relief from the final decision of the Administrative Law Judge

or the Commissioner of Revenues on a final assessment of a tax deficiency by

following the procedure set forth in Ark. Code Ann. § 26-18-406 (Supp. 2015).

OFFICE OF HEARINGS & APPEALS

DATED: March 9, 2016