Does generating electricity count as 'processing' under Connecticut's Manufacturing Recovery Act, so that machinery and equipment used to generate electricity qualify for the partial sales and use tax exemption?

Plain-English summary

Connecticut's Manufacturing Recovery Act of 1992 (MRA) (Conn. Gen. Stat. § 12-412i) gives a partial sales and use tax exemption for machinery and equipment used primarily in manufacturing, fabricating, or processing tangible personal property. In an earlier Ruling (2000-5), DRS had concluded that generating electricity counts as "processing" and so qualified for that partial exemption. After a thorough reexamination, DRS reversed course in this ruling.

DRS held that generating electricity is not "processing" under the MRA, so purchases of machinery and equipment used primarily to generate electricity do not qualify for the partial exemption. This ruling revokes the portion of Ruling 2000-5 that had held otherwise; the rest of Ruling 2000-5 remains in effect.

Two reasons drove the result:

1. Creation, not modification. The MRA defines "processing" as "the physical application of the materials and labor necessary to modify or change the characteristics of tangible personal property" (§ 12-412i(b)(3)). Generating electricity doesn't modify existing property — walking through the physics (a turbine spins a generator's rotor, whose electromagnets knock electrons loose in copper conductors, producing an electric current), DRS concluded the process creates brand-new tangible property (the electricity), rather than changing the characteristics of property that already existed. Creating new property is characteristic of manufacturing, and the Connecticut Supreme Court had already held electricity generation is not manufacturing for sales-tax purposes (United Illuminating Co. v. Groppo, 220 Conn. 749 (1992)).

2. Legislative history. When it enacted the MRA in 1992, the General Assembly knew of United Illuminating and took no step to extend the benefit to electric utilities. The Act's purpose was to "modernize our definition of manufacturing" and relieve an "anticompetitive tax burden" on manufacturers — and it was passed years before electric-industry deregulation. Nothing shows an intent to reach electric utilities (which the Standard Industrial Classification Manual places in a different division from manufacturing).

Crucially, DRS preserved a separate, broader exemption: the generation of electricity is part of the "furnishing of electricity … delivered to consumers through mains, lines or pipes" under Conn. Gen. Stat. § 12-412(18), so purchases of materials, tools, and fuel used directly in generating electricity remain fully exempt from sales and use taxes. So the ruling narrows the machinery-and-equipment partial exemption for generators while leaving the materials/tools/fuel full exemption intact.

What this means for you

Electric utilities and power generators

Don't claim the MRA's partial machinery-and-equipment exemption for equipment whose primary use is generating electricity — DRS says generation isn't "processing," so that equipment doesn't qualify. But you may still rely on the full exemption under § 12-412(18) for materials, tools, and fuel used directly in generating the electricity you furnish to consumers. The key is which exemption and which category of purchase you're claiming.

Manufacturers and businesses claiming the MRA exemption

The MRA's "processing" branch requires applying materials and labor to existing tangible personal property to modify or change its characteristics (§ 12-412i(b)(3)). An activity that creates new property rather than modifying existing property may fall outside "processing" — as electricity generation does here. Map each activity to the statutory definition before claiming the partial exemption.

Tax professionals and accountants

This ruling is a clean example of an agency reexamining and revoking its own prior position (part of Ruling 2000-5) on further analysis. Note the doctrinal split: creation of new property is manufacturing, and United Illuminating holds electricity generation isn't manufacturing for sales-tax purposes — so it fits neither the manufacturing nor the processing branch of the MRA. The § 12-412(18) full exemption for materials/tools/fuel used in furnishing electricity is a distinct provision that survives.

Common questions

Q: Can an electricity generator claim the MRA partial exemption on its generating equipment?
A: No. DRS ruled that generating electricity is not "processing" under the MRA, so machinery and equipment used primarily to generate electricity do not qualify for the partial exemption.

Q: Did this ruling change earlier DRS guidance?
A: Yes. It revoked the portion of Ruling 2000-5 that had treated electricity generation as "processing." The remainder of Ruling 2000-5 stays in effect.

Q: Is anything about electricity generation still exempt?
A: Yes. Under § 12-412(18), materials, tools, and fuel used directly in generating electricity delivered to consumers remain fully exempt from sales and use taxes. Only the MRA partial exemption for generating machinery and equipment is denied.

Q: Why isn't generating electricity "processing"?
A: Because it doesn't apply materials and labor to existing property to change its characteristics — it creates new tangible property (the electricity). Creating new property is a hallmark of manufacturing, and the Connecticut Supreme Court has held electricity generation isn't manufacturing for sales-tax purposes.

Citations and references

Statutes:

• Conn. Gen. Stat. § 12-412i (Manufacturing Recovery Act of 1992 — partial sales/use tax exemption for machinery and equipment used primarily in manufacturing, fabricating, or processing); § 12-412i(a) (the operative partial-exemption language)
• Conn. Gen. Stat. § 12-412i(b)(3) (statutory definition of "processing" applied by the ruling)
• Conn. Gen. Stat. § 12-412(18) (full exemption for materials, tools, and fuel used directly in furnishing electricity delivered to consumers through mains, lines, or pipes)

Cases:

• United Illuminating Co. v. Groppo, 220 Conn. 749, 601 A.2d 1005 (1992) (electricity generation is not "manufacturing" for sales and use tax purposes)
• Phelps Dodge Copper Products Co. v. Groppo, 204 Conn. 122, 527 A.2d 672 (1987) (legislative non-action as validation of a prior statutory interpretation)

Legislative history:

• Office of Legislative Research, Summary of 1992 Public Acts; 35 H.R. Proc., Pt. 19, 1992 Sess. (Remarks of Reps. Luby and Arthur); OLR Amended Bill Analysis, 1992 H.B. 5708

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 2004-2

Original ruling text

Ruling 2004-2, Sales and Use Taxes / Manufacturing Recovery Act / Electricity Generation

BACKGROUND:

In Ruling 2000-5, the Department concluded that the generation of electricity qualified as “processing” for purposes of the Manufacturing Recovery Act of 1992, Conn. Gen. Stat. §12-412i (the “MRA”) and qualified for partial exemption from sales and use taxes. After conducting a thorough reexamination of this position, the Department has concluded that electricity generation is not “processing” as defined in Conn. Gen. Stat. §12-412i(b)(3).

The foundation of this reexamination of Ruling 2000-5 and the conclusion that electricity generation is not “processing” under the MRA, is a careful and detailed review of the nature of electricity itself, and the elements of electricity generation. All tangible personal property, including electricity, is made up of atoms. See Electricity – Electronics , at http://inventors.about.com/library/inventors/blelectric.htm . Each atom has a nucleus that contains protons, which are positively charged particles, electrons, which are negatively charged particles, and uncharged particles called neutrons. Electrons surround the nucleus. The number of protons and electrons is equal when an atom is in a neutral state. When the balancing force between protons and electrons is upset by an outside force, an atom may gain or lose an electron. When this occurs, the atom becomes “ionized” and electricity, or “electric current,” is created Navy Electricity and Electronics Training Series, Module 1 – Introduction to Matter, Energy, and Direct Current , NAVEDTRA 14173, pp. 1-8, 1-36 .

Consistent with the discussion above, the generation of electricity “has been defined as the directed movement of electrons.” Navy Electricity and Electronics Training Series, Module 1 – Introduction to Matter, Energy, and Direct Current , NAVEDTRA 14173, p. 1-36. The purposeful generation of massive amounts of electricity understandably requires fine-tuning of this ionization event using the right techniques and materials:

The number of free electrons resulting from ionization is dependent upon the quantity of energy applied to a material, as well as the atomic structure of the material.  At room temperature some materials, classified as conductors, have an abundance of free electrons. . . . Conductors are made up of atoms that contain loosely bound electrons in their outer orbits.  Due to the effects of increased energy, these outermost electrons frequently break away from their atoms and freely drift throughout the material.  If a conductor has a difference in potential impressed across it . . . a direction is imparted to the random drift.  This causes a general migration of electrons from one end of the conductor to the other.

Navy Electricity and Electronics Training Series, Module 1 – Introduction to Matter, Energy, and Direct Current , NAVEDTRA 14173, p. 1-34. This  directed movement of electrons constitutes the generation of electricity.

This movement of the electrons, and thus the generation of electricity, can be initiated in several ways: by moving a conductive material through a magnetic field; by friction, such as by rubbing a glass rod with silk; or by chemical means, such as in a battery. Charles W. Ryan, Basic Electricity , 2d Ed., p.4 (1986). The commercial generation of electricity involves moving a conductive material through a magnetic field, thereby upsetting the balance between protons and electrons in the atoms of a conductor that is located inside a generator.

See Navy Electricity and Electronics Training Series, Module 1 – Introduction to Matter, Energy, and Direct Current , NAVEDTRA 14173, p. 1-33. The elements involved in the commercial generation of electricity are turbines, generators and copper wire. Power Source – How Electricity Is Produced , at www.northlandutilities.nt.ca/power_source/21_production.htm.

A turbine is employed to generate mechanical energy, which is used to turn a generator that generates electricity.  “A turbine is a rotary engine that uses a continuous stream of fluid (gas or liquid) to turn a shaft that can drive machinery. . . . [Steam] turbines [are] the principal power sources used to drive most large electric generators. . . .” Columbia Encyclopedia, 6th Ed. (2004), at www.encyclopedia.com/html/t1/turbine.asp

A generator uses the motion imparted to it by a turbine to create electricity by rotating a rotor, which is an outer shell composed of a series of electromagnets, around a stator composed of coils of copper wire. The magnetic force from the electromagnets disturbs the stable relationship of negatively charged electrons and positively charged protons within the copper atoms, “knocking” electrons out of orbit. As electrons from neighboring atoms are attracted to the now-positively charged atoms, the movement of the electrons from negative to positive atoms forms an electric current until the magnetic force is removed, allowing the atoms to return to a neutrally charged state. This electric current is the electricity that is distributed over power distribution grids to consumers.

See Harold D. Wallace, Jr., Throw the Switch: The Technology of Electric Power , and Electricity – Electronics .

Copper wire is the preferred conductor, or conductive material.

Some metals are better conductors of electricity than others.  Silver, copper, gold, and aluminum are materials with many free electrons and make good conductors.  Silver is the best conductor, followed by copper, gold, and aluminum.  Copper is used more often than silver because of cost.  Aluminum is used where weight is a major consideration, such as in high-tension power lines, with long spans between supports.  Gold is used where oxidation or corrosion is a consideration and a good conductivity is required.

Navy Electricity and Electronics Training Series, Module 1 – Introduction to Matter, Energy, and Direct Current , NAVEDTRA 14173, p. 1-8.

ISSUE:

Whether the generation of electricity meets the statutory definition of “processing” under the Manufacturing and Recovery Act of 1992, (the “MRA”) Conn. Gen. Stat. §12-412i(b)(3), thus partially exempting purchases of machinery and equipment used for generating electricity from sales and use taxes.

RULING:

Purchases of machinery and equipment for use primarily in generating electricity do not qualify for the partial exemption because the generation, or creation, of electricity does not meet the statutory definition of “processing” under Conn. Gen. Stat. §12-412i(b)(3), which defines “processing” to mean “the physical application of the materials and labor necessary to modify or change the characteristics of tangible personal property.” The generation of electricity does not qualify as “processing” under the MRA for two reasons. First, electricity generation does not involve applying materials and labor to existing tangible personal property to modify or change the characteristics of tangible personal property; instead, it results in the creation of new tangible personal property. Secondarily, the legislative history of the MRA does not support a legislative intent to include the generation of electricity as processing.

This ruling revokes the portion of Ruling 2000-5 that held that the generation of electricity is “processing” for purposes of the MRA.  The remainder of Ruling 2000-5 remains in effect. The generation of electricity is part of the “furnishing of electricity when delivered to consumers through mains, lines or pipes” under Conn. Gen. Stat. §12-412(18), and purchases of materials, tools and fuel used directly in generating electricity are fully exempt from sales and use taxes.

DISCUSSION:

The MRA was adopted by the General Assembly in order to expand the sales tax exemptions available to the manufacturing sector.  According to the General Assembly’s Office of Legislative Research,

[t]his act adds an exemption for equipment defining this term … separate from machinery but essential to a manufacturing, processing or fabricating process. It also extends the exemption to machinery and equipment used “primarily”(rather than directly) in manufacturing and in fabrication or processing under any of the following circumstances:

at any stage of those processes from the time raw materials are received to the time the product is ready for delivery;

for research and development, measuring or testing related to furthering any of these processes;

to maintain or repair items used in (1) or (2);

or for metal refinishing.

Office of Legislative Research, Summary of 1992 Public Acts , p. 96.

Manufacturing, processing and fabricating represent different degrees of change to a product.  On one end of the scale is manufacturing where the form, composition, quality or character of the property is changed. See Conn. Gen. Stat. §12-412i(b)(1). On the other end is processing where the characteristics of the property are modified or changed.  Conn. Gen. Stat. §12-412i(b)(2). In the middle is fabricating, a process that allows the property to work in a new or different manner.  Conn. Gen. Stat. §12-412i(b)(3).

In light of the above, the MRA provides in relevant part:

“The taxes imposed by this chapter shall not apply to the percentage set forth in subsection (c) of this section of the gross receipts from the sale of and the storage, use and consumption of the following items; . . . (2) machinery and equipment which will be used primarily in the process of . . . processing . . . tangible personal property. . . . if . . . (B) the machinery or equipment is used at any stage of . . .  processing . . .  from the time any raw materials are received to the time the product is ready for delivery or storage. . . . (Emphasis added.)" Conn. Gen. Stat. §12-412i(a).

The MRA goes on to define “processing” as “the physical application of the materials and labor necessary to modify or change the characteristics of tangible personal property.” Conn. Gen. Stat. §12-412i(b)(3).

To qualify as processing under the MRA, the above-quoted statutory language clearly shows that, not only must processing occur, but also that processing requires that labor and materials be applied to the product that is delivered to the consumer.

Applying these statutory requirements to the generation of electricity shows that it does not qualify as processing under the MRA. Specifically, in order for the generation of electricity to be regarded as processing, the electricity, as tangible property, would have to undergo a process whereby the application of materials and labor resulted in modifying or changing the characteristics of the electricity.  In the case of electricity, this simply does not happen.  As discussed in detail above, the generation of electricity occurs when a turbine creates movement, which enables a generator to turn a rotor which causes electromagnets to disturb the stable relationship of electrons and protons in the atoms of the conductor, creating the electric current that is the electricity that is distributed to customers. This series of events does not result in a change or modification to the characteristics of electricity.  Rather, it results in the creation of electricity itself.

Moreover, electricity does not exist before the generation process begins.  Rather it only exists afterwards.  Thus the generation process results in the creation of new tangible property, the electricity.  As such, the creation of new tangible property is characteristic of a manufacturing process.  Ordinarily, the creation of tangible personal property would be considered manufacturing; however, the Connecticut Supreme Court has held that the generation of electricity is not manufacturing for purposes of the Sales and Use Taxes Act. United Illuminating Co. v. Groppo , 220 Conn. 749, 601 A.2d 1005 (1992) .  This holding does not conflict with the present analysis, indeed, as discussed below, it supports the Department’s analysis of the legislative intent of the MRA.

Examining generally accepted examples of processing supports the Department’s conclusion that, “processing,” requires the characteristics of the tangible personal property that is delivered to the consumer be changed or modified. Some relevant examples of activities considered to be processing include:

pipe threading (cutting an external screw thread into a pipe): input is a plain pipe that is processed by applying labor and materials to imprint a thread on the pipe; the output is threaded pipe;

making water potable (filtering and disinfecting water): input is undrinkable water that is processed by applying filters and disinfectant to remove impurities; the output is drinkable water; and

waterproofing fabric (coating fabric with a water-impervious substance): the input is fabric that is processed by applying a waterproof substance to the surface of the fabric; the output is waterproof fabric.

In all the examples above, tangible property exists before the process and emerges from the process changed or modified.  In contrast to these examples, electricity generation creates electricity, instead of modifying or changing electricity.

Although there is a temporary change in the charge of the copper atoms contained in the wire and in the stator that the electricity passes through, this change has nothing to do with the analysis as to whether the characteristics of the electricity are changed or modified.  As has been established, there is no change to the electricity, which is the focus of our analysis.

Finally, the legislative history of the MRA does not support the conclusion that the General Assembly intended to include electricity generation within the exemption. When it enacted the MRA, the General Assembly was aware of the Connecticut Supreme Court’s conclusion, that electricity generation did not meet the statutory definition of manufacturing, in United Illuminating Co., supra , but took no steps to extend the benefit of the MRA to purchases made by electric utilities. The Court has “made it clear that the legislature is presumed to be aware of the interpretation of a statute and ‘that its subsequent nonaction may be understood as a validation of that interpretation.’” Phelps Dodge Copper Products Co. v. Groppo , 204 Conn. 122, 134, 527 A.2d 672 (1987) (citations omitted). The intent of the legislature in enacting the MRA was to “modernize our definition of manufacturing” (35 H.R. Proc., Pt. 19, 1992 Sess., p. 6389, 6391 (Remarks of Rep. Luby) and p. 6405 (Remarks of Rep. Arthur)); see also OLR Amended Bill Analysis, 1992 H.B. 5708 (File 519, as amended by House “A,” “B,” and “C”). The MRA was enacted to “relieve some of the anticompetitive tax burden on our businesses.” 35 H.R. Proc., Pt. 19, 1992 Sess., p. 6389 (Remarks of Rep. Luby).  Since the MRA was enacted in 1992, long before deregulation of the electric industry legislation was passed in 1998, it is clear that the General Assembly was not addressing an “anticompetitive tax burden” on the electric industry in the MRA. The legislation creating the MRA expanded the definitions of “manufacturing” and “machinery” to cover a wider range of products and activities, added equipment to the partial exemption, modified the definition of “fabrication,” included measuring and testing as well as certain research and development, and added processing as a qualifying activity.  The very name of the legislation, “An Act Concerning the Manufacturing Recovery Act of 1992,” strongly suggests that it was intended to address the manufacturing industry, which excludes electric utility companies. [1] Nothing in the legislative history demonstrates any intention to expand the scope of industries deemed to be engaged in manufacturing, fabricating or processing activities beyond “true manufacturing” to include electric utilities.

In light of the foregoing, the Department concludes that the generation of electricity is not processing within the meaning of the MRA. Conn. Gen. Stat. § 12-412(i)(b)(3).

LEGAL DIVISION

June 18, 2004

[1] That manufacturing industries are distinct from electric utilities is borne out by the Standard Industrial Classification Manual (1987), which was in effect when the MRA was enacted. The two industry types are classified in discrete divisions: Manufacturing is in Division D, and Utilities are found in Division E.