The Indiana Tax Court recently examined in Aztec Partners, LLC v. Ind. Dep’t of State Revenue, No. 49T10-1210-SC-00067, 2015 Ind. Tax LEXIS 29 (Ind. Tax Ct. June 23, 2015), whether electricity that Aztec Partners, LLC (“Aztec”), who operates nineteen Qdoba Mexican Restaurants in Indiana, used to power electrical equipment was subject to Indiana sales tax. The Court found it was not and reversed the Department of State Revenue’s (the “Department”) final determination and remanded the case.
At Aztec’s Qdoba Restaurants, employees prepare food items that are ultimately combined and served as entrées. Those food items are held and preserved in electrical equipment, such as food warmers and cooling systems, until they are combined into entrées and sold. The electrical equipment is not used to cook the food. In June 2011, Aztec filed twelve refund claims with the Department for the refund of sales tax paid on the electricity used to power electrical equipment. The Department denied the refunds finding that the electricity was taxable. Aztec protested the refund denial. Thereafter, the Department held a hearing and issued a Memorandum of Decision on August 24, 2012 denying that protest. Aztec initiated an original tax appeal.
On appeal, Aztec argued that the electricity it used to power its electric equipment was exempt from sales tax under Indiana Code section 6-2.5-5-5.1 (the “consumption exemption”). The Department argued that the Court lacked subject matter jurisdiction over the claim or alternatively that Aztec did not qualify for the consumption exemption.
Addressing the Department’s argument that the Court lacked subject matter jurisdiction, the Court noted “[t]he Tax Court has subject matter jurisdiction over cases that arise under the tax laws of Indiana and are initial appeals of final determinations made by the Department regarding the listed taxes.” Ind. Code §§ 33-26-3-1(1), -3 (2015).
After determining subject matter jurisdiction existed, the Court went on to address the consumption exemption. The consumption exemption statutes are “strictly construed against the taxpayer” and the taxpayer bears the burden of establishing the exemption. Indianapolis Fruit Co. v. Ind. Dep’t of State Revenue, 691 N.E.2d 1379, 1383 (Ind. Tax Ct. 1998). To qualify for the consumption exemption, Aztec was required to show: (1) it is engaged in production, (2) it has an integrated production process, and (3) the electricity is essential and integral to its integrated production process. Indianapolis Fruit, 691 N.E.2d at 1383-84.
A taxpayer is not exempt unless there is production. Id. at 1384. “Production requires a “‘substantial change or transformation resulting from an integrated series of operations [that] places tangible personal property in a form, composition, or character different from that in which it was acquired.'” 45 IND. ADMIN. CODE 2.2-5-8(k) (2010) (see http://www.in.gov/legislature/iac/). Production “focuses on the creation of a marketable good.” Indianapolis Fruit, 691 N.E.2d at 1383-84. Aztec argued that it engaged in production by creating entrées, a marketable product. The Department argued that combining the food items did not amount to production because these actions did not “substantially transform the food items either physically or chemically.” Aztec Partners LLC, 2015 Ind. Tax LEXIS 29, *6.
The Court addressed these arguments noting that the exemption applies when “equipment is directly used to induce a substantial chemical change” resulting in a “new, marketable product.” Trump Indiana, Inc. v. Ind. Dep’t of State Revenue, 790 N.E.2d 192, 196 (Ind. Tax Ct. 2003). However, production also occurs when a supplier of fruits and vegetables “cleans, cuts, and packages” the items for resale, although no chemical change occurs. Indianapolis Fruit, 691 N.E.2d at 1381-83. The Court found that Aztec engaged in production because it prepared and combined the food items in a way that changed them from individual foods and into entrées. The entrées, according to the Court, were new, marketable items with a different character and form from the original food items.
The Court went on to address whether Aztec had an integrated production process. Production “begins at the point of the first operation or activity constituting part of the integrated production process and ends at the point that the production has altered the item to its completed from, including packaging, if required.” 45 I.A.C. 2.2-5-8(d). In General Motors Corp. v. Ind. Dep’t of State Revenue, 578 N.E.2d 399, 404 (Ind. Tax Ct. 1991), aff’d, 599 N.E.2d 588 (Ind. 1992), this Court noted that the integrated production process “terminates upon the production of the most marketable finished product, e.g., the product actually marketed.
Aztec argued that the electricity used to power the electrical equipment was consumed within an integrated production process and thus eligible for the consumption exemption. Specifically, the process began when food items were prepared and ended when the items were combined into entrées and then sold. The Department argued that Aztec provided a service and its production process ended when the food items were cooked. Specifically, the electrical equipment held the food before it was combined in an entrée, which was post-production. The Court held that Aztec had an integrated production process and the electricity was consumed in that process as demonstrated by the several steps before an entrée is competed and ready for sale. Moreover, the Court noted that Aztec does not sell any of the prepared food items separately.
The Court then turned to whether the equipment used by Aztec in its integrated production process had an “immediate effect” on the property being produced. Ind. Dep’t of State Revenue v. Cave Stone, Inc., 457 N.E.2d 520, 525-27 (Ind. 1983). Equipment has an “immediate effect” if it is “essential and integral” to the production process. Id. To qualify for the exemption, the equipment must be essential and integral to the production process.
Aztec argued that that the electricity used by the equipment was essential and integral to the production process and therefore, exempt. The Department, however, argued that it was not essential and integral because it did not chemically change the food items, but merely kept the food at a constant temperature until combined into an entrée. The Department relied on Trump, where the court found that a hotdog bun warmer and microwave oven did not qualify for an equipment exemption because warmer and oven did not cause a substantial change in the items to create a new marketable product. Trump, 790 N.E.2d at 196. The Court was not persuaded by the Department’s argument for three reasons.
First, the Court indicated that Trump did not create a per se rule that warming or cooling food could not be essential and integral and that the Department misinterpreted the Court’s rationale. In the case, the Court held the warmer and oven did not qualify for the exemption because there was no evidence that merely warming the food created a substantial chemical transformation resulting in a new, marketable product. Trump, 790 N.E.2d at 196.
Second, the Court noted that equipment in a production process must be essential and integral, but need not be directly transformational. Cave Stone, 457 N.E.2d at 524. In Cave Stone, the Court found that no marketable product would have resulted without the equipment, making it essential and integral, although it did not transform the product. The Court noted similarly that Aztec needed only to show the electricity was essential and integral to the production process not that it had a transformational effect on the food items .
Third, the Court reiterated the ultimate question: “whether using electricity to preserve food items is essential and integral to combining them into Aztec’s entrées, i.e., its marketable products. Aztec Partners LLC, 2015 Ind. Tax LEXIS 29, *10. The Department argued that the purpose of the equipment was merely to preserve the food until combined into entrées. The Court notes that the Department’s argument “strains to distinguish the action of preserving from an action more directly transformative like cooking” and does not address the ultimate question. Id. The Court found that “the use of electricity to preserve the food items at certain temperatures is essential and integral to Aztec’s integrated production process because without it, Aztec could not produce the entrées.”
The Court concluded by reversing the Department’s final determination and remanding the matter to the Department.
Jeremy Fetty is a partner in the law firm of Parr Richey Frandsen Patterson Kruse with offices in Lebanon and Indianapolis. He often advises businesses and utilities (for profit, non-profit and cooperative) on organizational, human resources, and transactional matters and drafts and reviews commercial contracts.
The statements contained herein are matters of opinion and general information only and are not to be considered legal advice and should not be construed to form an attorney-client relationship. If you have any questions regarding this article, please contact an attorney.