Timken Co. v. Lindley

Citations: 504 N.E.2d 455; 29 Ohio App. 3d 181; 29 Ohio B. 211; 1985 Ohio App. LEXIS 10400Docket: No. CA-6621

Court: Ohio Court of Appeals; October 21, 1985; Ohio; State Appellate Court

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The Timken Company, the appellant, is appealing a decision from the Ohio Board of Tax Appeals regarding a sales and use tax assessment resulting from an audit covering January 1, 1975, to December 31, 1977. The board modified the Tax Commissioner's final order dated May 11, 1982, leading to five specific assignments of error by the appellant:

1. The board incorrectly concluded that certain tangible personal property items were not purchased for direct use in the production of goods for sale, thus not exempt from sales tax under Section 5739.01(E)(2) of the Revised Code.
2. The board dismissed the probative value of testimony from a Timken witness regarding the intended use of certain items, which was relevant to the exemption from sales tax.
3. Payments made by Timken for labor related to the installation of tangible personal property were wrongly deemed subject to sales tax as part of the "price" of the property under Section 5739.01(H).
4. Items purchased for the repair or maintenance of machinery used directly in production were incorrectly subjected to sales tax, contrary to Section 5739.01(E)(2), and the board did not consider Rule 5703-9-21(M) from the Department of Taxation.
5. Transactions involving engineering services for which Timken paid were misclassified as purchases of tangible property instead of personal services, where any transfer of property was a minor aspect under Section 5739.01(B).

The court found the board’s decision unreasonable and unlawful, thereby sustaining the appellant's assignments of error and reversing the board's decision. The Timken Company manufactures steel products, including mechanical tubing and bearings, utilizing various processes such as continuous casting, ingot production, and finishing operations, alongside rigorous quality control methods.

Timken pays sales and use taxes in Ohio via a direct payment permit issued by the Tax Commissioner. On April 19, 1979, the Tax Commissioner issued an original assessment for additional sales and use taxes on several hundred items, prompting Timken to file a petition for reassessment under R.C. 5739.13, contesting approximately four hundred items. After a hearing, the assessment was reduced, but Timken appealed to the Board of Tax Appeals, contesting specific items. During the appeal, Timken withdrew some items and presented evidence for others. The Board partially upheld the Tax Commissioner's determination, ordering a recomputation of the assessment and penalties for the items it found favorable to Timken. Timken is now appealing the Board's decision, primarily focusing on the Board's interpretation of the law regarding the emergency ladle system and heat recuperators. The Board incorrectly determined that these items were not purchased for direct use in production, thus not qualifying for a tax exemption under R.C. 5739.01(E)(2). The emergency ladle system, which captures molten steel, was mischaracterized by the Board, leading to a flawed conclusion about its tax-exempt status. This misinterpretation contradicts the undisputed facts regarding the use of the steel from the emergency ladle, which is integral to Timken's manufacturing process.

The emergency ladle system utilized in Timken's steel manufacturing is employed after steel production begins and before it is completed, placing it directly in the manufacturing process. R.C. 5739.01(E)(2) exempts from taxation items used directly in the production of tangible personal property for sale. Established legal principles dictate that for an item to qualify for this exemption, it must be directly involved in manufacturing, which is defined as transforming materials into a different state or form. The Ohio Supreme Court has ruled that the interpretation of "directly" should align with past decisions to reduce ambiguity, even if it leads to seemingly artificial distinctions. Equipment or materials are considered "used directly" if consumed during the manufacturing process. The court does not break down machines or systems into parts to determine their contribution to production. However, if an intermediary intervenes between the equipment and the manufacturing process, the exemption may not apply. This is known as the "physical" test, differing from an analysis based on the function of the item in manufacturing. The Tax Commissioner has formalized these principles in Ohio Adm. Code 5703-9-21, clarifying that those engaged in manufacturing can claim exemptions when purchasing qualifying items.

Production machinery refers to any machinery, equipment, or personal property involved in the conversion or assembly of materials into finished products for sale. This includes items that transport or temporarily store materials during production but excludes those that transport materials to the production site, handle finished products post-packaging, or dispose of waste. Machinery used for the repair or maintenance of production machinery is also classified under this category. Items not classified within these definitions are presumed taxable under Section 5739.02 of the Revised Code.

The emergency ladle system is identified as an exception to Ohio's sales and use taxes. The law defines "manufacturing" and "processing" as the transformation of materials into a different state, including necessary adjuncts used during production. For an item to be exempt from taxation, it must be an adjunct, used at the same location, and utilized after transformation begins. Additionally, it must be adjunct to direct use or consumption. The emergency ladle system meets these criteria.

Heat recuperators, situated atop furnaces used for heating ingots, improve efficiency by reusing heat that would otherwise be lost. As they are integral to the production process, helping to reheat products of prior operations, they also satisfy the definitions and requirements for tax exemption similar to the emergency ladle system. The adoption of the "adjuncts" concept clarifies that recuperators are necessary for ongoing production at the same location after conversion has commenced.

An analogy is drawn between heat recuperators and other equipment that has been exempt from sales tax, as established in several Ohio cases. The board failed to reconcile its decision with these precedents, violating legal requirements regarding sales tax. Additionally, the board improperly segmented a single machine into components, which contradicts the established rule for direct use analysis. The second assignment of error asserts that the board incorrectly deemed the testimony of Timken's tax manager, Mr. Perry, as lacking probative value for demonstrating that certain purchases were made for direct use in production. The board's ruling, which cited a prior case, is viewed as an attempt to circumvent established law. The burden of proof rests on the taxpayer to demonstrate that items were transferred to manufacturing to qualify for tax exemption. Perry's testimony, which interpreted Timken's business records to support the existence of such a transfer, was found to have probative value and relevance, contrary to the board's determination. The board's view that Perry's testimony was hearsay and thus irrelevant is challenged, as hearsay can possess significant probative value, especially when supported by admissible business records.

Perry served as an expert witness, interpreting Timken's business records, making his testimony relevant and admissible as hearsay. His testimony indicated that specific items were purchased by Timken for direct use in producing tangible personal property for sale, thus qualifying for a sales tax exemption. The court upheld this point in the second assignment of error. 

In the third assignment of error, the appellant argued that the board incorrectly deemed certain labor and installation payments as taxable under R.C. 5739.01(H). The board stated that to exclude labor from sales tax calculations, charges must be specifically identified on the initial bill from the vendor to the consumer. However, the court found the board's determination unreasonable and unlawful. R.C. 5739.01(H) defines "price" as the total value paid in a retail sale, excluding separately stated labor or service charges for installation. Timken often contracts for the installation of equipment, with varying arrangements regarding labor and materials. In this case, the contractor provided a partial un-itemized bill followed by a detailed final bill. The court addressed the statutory requirement for labor charges to be separately stated on the vendor's initial billing, emphasizing that this should occur contemporaneously with the work performed, ensuring the authenticity of the charges. The statute does not explicitly address partial billings for extended projects, but it aims to impose sales tax on tangible personal property rather than on labor and services.

Similarities exist between the transactions in question and construction contracts, which receive special legal treatment regarding the incorporation of tangible personal property into real property improvements. Contractors are viewed as consumers who pay tax only on materials, with labor exempt from taxation. The board erred by not recognizing that the documentation for these transactions met statutory requirements for separately stating labor charges, leading to the sustenance of the appellant's third assignment of error.

In the fourth assignment of error, the appellant contends that the Board of Tax Appeals incorrectly ruled that items purchased by Timken for repairing or maintaining machinery used in production were subject to sales tax. The appellant argues that these items are exempt under Ohio Adm. Code 5703-9-21(M). Timken provided extensive evidence regarding the use of these items, but the board failed to consider this evidence and neglected the relevant administrative rule, thus not adhering to the Ohio Supreme Court's directives regarding the legal effect of agency rules. As a result, the board's decision is deemed unreasonable and unlawful.

In the fifth assignment of error, the appellant asserts that the board inaccurately classified engineering services paid for by Timken as the purchase of tangible personal property, rather than recognizing the services as the primary transaction with any tangible property transfer being incidental. The board disregarded substantial evidence related to these engineering transactions and did not differentiate among various projects. The appellant argues that this decision adversely affects state welfare by discouraging plant construction and improvements. The appellant's argument is accepted, resulting in the sustenance of this assignment of error as well.

Timken operates its own engineering division and also utilizes outside engineering firms to manage workload demands or acquire specific expertise. Evidence indicates that Timken's primary goal in hiring outside engineers was to leverage their skills and knowledge rather than to receive physical deliverables. The work performed by external engineers was intellectual, involving data analysis and recommendations, with any produced documents serving merely as communication tools rather than the essence of the service. The argument for taxing these services based on the creation of documents is rejected, as it would unfairly differentiate architects and engineers from other professionals like accountants and attorneys, who also produce documents without incurring sales tax on their services. The court asserts that the documents are secondary to the professional services rendered and that imposing a tax would improperly convert a tax on tangible goods into one on services. The board's reliance on precedent cases is deemed misplaced, leading to an unreasonable interpretation of tax applicability. Consequently, the Board of Tax Appeals' decision is reversed and remanded for actions consistent with this ruling.