A custom CD-ROM manufacturer buys computer hardware to process the 3-D animations/graphics it sells on the discs. Does that hardware qualify for the manufacturing exemption, and what happens if it's later used for something else?

Plain-English summary

A business that manufactures custom CD-ROMs — producing custom 3-D animations and graphics sold to customers — asked the Comptroller about the tax status of the computer hardware it buys to process the information needed to create those CDs.

The Comptroller confirmed that some of the equipment qualifies for the manufacturing exemption under Tax Code § 151.318, which exempts tangible personal property used directly in manufacturing if the property is necessary or essential to the operation and directly causes a physical or chemical change to the product being manufactured for ultimate sale. The exemption also reaches property necessary and essential to a quality control process during manufacturing. Qualifying equipment, repair/replacement parts, and accessories can all be purchased tax-free with an exemption certificate.

The letter also explains an important consequence of using an exemption certificate: if you buy equipment tax-free under the certificate and then use it for a different, nonqualifying purpose ("divergent use"), you become liable for sales tax on the equipment's fair market rental value for the period of that divergent use — the amount you'd pay to rent or lease the same item on the open market. You can stop that rental-value tax calculation at any time by switching to paying tax on the item's original purchase price instead — but no credit is given for any tax you already paid on the fair market rental value up to that point.

What this means for you

CD-ROM and digital media manufacturers

Computer hardware and processing equipment used directly in producing your manufactured product (and hardware essential to quality control) can be bought tax-free with an exemption certificate. But if you later repurpose that equipment for something outside manufacturing/QC — say, general office computing — you owe tax on the fair market rental value for that period of divergent use, not just a one-time penalty.

Accountants and tax professionals

The "fair market rental value vs. original purchase price" mechanism described here is a useful, precisely worded explanation of how Texas handles divergent use of exemption-certificate equipment — worth having on hand any time a manufacturing client's equipment use shifts over time. Note there's no retroactive credit for rental-value tax already paid if you later switch to the purchase-price method.

Common questions

Q: Does computer hardware used to produce our manufactured product qualify for the manufacturing exemption?
A: Yes, if it's necessary/essential to the manufacturing process and directly causes a physical or chemical change to the product (or is essential to quality control) — you can buy it tax-free with an exemption certificate.

Q: What happens if I later use exemption-certificate equipment for something else?
A: You owe sales tax on the fair market rental value of the item for the period it's used in that divergent, nonqualifying manner.

Q: Can I switch to paying tax on the original purchase price instead of the ongoing rental value?
A: Yes, at any time — but you won't get credit for any tax already paid on the fair market rental value.

Citations and references

Statute:

• Tex. Tax Code § 151.318 (manufacturing exemption)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9910930L

Original ruling text

October 4, 1999

Dear **:

Thank you for your letter concerning the manufacture of custom CD-ROM's.
Please accept my most sincere apology for the delay in responding to your
inquiry. You state that most the computer hardware you purchase is necessary
to process information so that you are able to manufacture the custom 3-D
animations and graphics that you sell to your customers.

Some of the equipment that you use in manufacturing the CD's will qualify for
exemption. Tax Code, Section 151.318 exempts tangible personal property used
directly in or during the manufacturing of tangible personal property for sale
if the use of the property is necessary or essential to the manufacturing,
processing, or fabrication operation and directly makes or causes a chemical or
physical change to the product being manufactured, processed, or fabricated for
ultimate sale. You may issue an exemption certificate in lieu of the tax on
qualifying equipment, repair and replacement parts, and accessories. The
exemption also applies to tangible personal property used or consumed during
the actual manufacturing, processing, or fabrication of tangible personal
property for sale if the use or consumption of the property is necessary and
essential to a quality control process.

When you issue an exemption certificate to purchase qualifying equipment
tax-free and make a use of the item in some other manner or for some other
purpose, you are liable for payment of the sales tax on the fair market rental
value for any period during which the item is used in a divergent manner or for
a divergent purpose. The fair market rental value is the amount that you would
pay on the open market to rent or lease the item. At any time, you may cease
paying sales tax on the fair market rental value and pay sales tax on the
original purchase price of the item. No credit will be given for taxes
previously paid on the fair market rental value.

This opinion is based on the facts presented. If there are any additional or
different facts, the opinion may change.

You may call me toll free at 1-800-531-5441, ext. 3-4675. The direct line is
(512) 463-4675. You also may write to Tax Policy Division, Comptroller of
Public Accounts, Capitol Station, Austin, TX 78774. You can view tax
publications and tax rules on our website at as well
as electronic edited letter rulings on our STAR (State Tax Automated
Research) system. You may also e-mail our tax help section at
.

Sincerely,

Tom Soto
Tax Policy Division