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Maryland Court Upholds Processing Exemption From Sales Tax for Utility

A Maryland court confirmed certain equipment qualifies for the processing exemption from sales tax.
  • Maryland Court of Appeals confirmed that certain transmission and distribution systems equipment qualifies for the processing exemption from sales tax. 
  • The case is notable for the Comptroller of the Treasury’s attempts to repudiate the waivers of the statute of limitations it had agreed to with the taxpayer during the audit cycle.

Background

In the latest round of litigation between the Potomac Edison Company (Potomac Edison) and the Comptroller of Maryland (Comptroller), the taxpayer was successful in claiming that certain of its transmission and distribution systems (T&D) qualified for the processing exemption from sales tax in Maryland. The court also agreed with Potomac Edison’s arguments that the statute of limitations did not bar its claim for a refund. The case had initially been heard, appealed, and then remanded back to the Maryland Tax Court for further findings. The instant case results from the appeal arising out of the remand.

The Processing Exemption

The Circuit Court of Anne Arundel County affirmed the tax court’s decision as to the taxability of the T&D opinion, which the Comptroller appealed. The critical issue was the so-called “production activity” exemption from sales tax contained in Section 11-210(b) of the Tax-General Article of the Maryland Code. Tangible personal property that is used “directly and predominantly” in a “production activity” is exempt from sales tax. Section 11-101 of the Tax-General Article of the Maryland Code defines the generation of electricity for sale or use in another production activity as a production activity, as well as processing or refining tangible personal property for resale. The court noted there was no dispute that some of the equipment (specifically those pieces of equipment changing the voltage of the electricity for further use) was involved in some degree of processing. In addition, the same section of the Maryland Code defines electricity as tangible personal property.

Electricity leaving Potomac Edison’s plants is stepped up to higher voltage as it moves through the T&D system, and then is stepped down to a lower voltage for customer use. Therefore, Potomac Edison argued that—under the plain language of the statute—stepping up and stepping down the voltage constituted processing, consistent with the initial finding of the court of appeals in an earlier round of the litigation. The Comptroller countered by arguing that the T&D equipment was not “directly and predominantly” used in a production activity; rather, its direct and predominant use was delivery of power. Further, the Comptroller argued that Potomac Edison was not entitled to the exemption as the T&D system was annexed to real estate.

The court of appeals reviewed the findings of the tax court and the evidence presented there and agreed with Potomac Edison’s argument that the tax court’s findings should be affirmed under the applicable standard for appellate review. It concurred with the tax court’s finding that the conductor, substation, and transformer equipment was essential to a production activity and served that purpose a preponderance of the time such that this equipment was predominantly used in a production activity. 

Insight From Forvis Mazars: This decision highlights the importance of “out of the box” thinking in applying exemptions to activities that facially do not seem to meet the definition of exemption based upon common conception.

The Comptroller Attempts to Repudiate Statutory Waivers

During the second round of litigation in tax court, the Comptroller, for the first time, asserted that the earliest parts of Potomac Edison’s claims were time barred by the statute of limitations found in §13-1104(g) of the Tax-General Article of the Maryland Code. The Comptroller argued that its failure to raise the issue earlier did not constitute a waiver of the claim as it was a condition precedent to Potomac Edison’s claims.

Potomac Edison and the Comptroller had agreed to extend the statute several times, and the full claim was filed before the expiration of the last extension. In fact, the Comptroller had initiated the extension as the audit dragged on; it helped mitigate the risk that the Comptroller’s claims against Potomac Edison would be barred. The audit manager for the Comptroller had, in fact, admitted in writing the extensions applied to the refund claims as well. Further, the Comptroller’s own witness, who testified that the extension agreement did not mention refund claims and, therefore, did not apply to the refund claims, admitted under oath that it was the Comptroller’s standard practice to permit such extensions to cover refund claims as a matter of fairness.

The court of appeals ruled in favor of Potomac Edison, based upon its construction of the statute that §13-1104 did not apply in the instant case; rather, it noted that §13-508(a) of the Tax General Article of the Maryland Code provides for a 30-day period from the date of a notice of assessment to request a refund and that Potomac Edison had met this time frame.

Insight From Forvis Mazars: This aggressive approach by the Comptroller highlights the importance of careful review of all contracts entered into with state taxing authorities, including—but not limited to—statutory extensions and closing agreements, and the need to make sure that taxpayers are explicitly protected to their satisfaction in the agreements.

How Forvis Mazars Can Help

Forvis Mazars can assist in reviewing purchases for potential refund opportunities related to unclaimed sales tax exemptions. In addition, we can work with inside or outside counsel to help you have adequate protection in any contracts that you have agreed to with state and local taxing authorities.

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