The Reconstruction of Morton Buildings

When states begin to lose money, there are several solutions they can propose. They can increase the tax rates, increase the tax base, or perhaps even propose new taxes on payroll, headcounts, or other basis. Closing doors to many tax saving opportunities is also a favored method of raising revenues. The Morton Buildings issue is one such opportunity that has been litigated in many states.

Morton Buildings, Inc. ("Morton") was in the business of manufacturing, selling, and installing prefabricated buildings primarily used in farming and industry. Morton would allow its customers to customize the building by allowing choices such as window and door placement. Morton's primary place of business was in Illinois. Orders placed in a given state would then be sent to outside of the given state, where all assembly of the building parts took place. Morton's building components were fabricated from lumber, steel, doors, rafters, plywood, and other items outside of the state from which the order was placed. Morton would cut the lumber, corrugate metal panels, and generally fabricate the building components from the raw materials. Morton purchased these raw materials also outside of the state. Once the building components were built, they would next be sent to the building site within the state from which they were ordered. Morton's employees in such state would then assemble and install the pre-manufactured parts into the customer's building.

Morton generally claimed that the raw materials from which the building components were made were not subject to use tax in the state where the building was constructed. Morton would also typically claim that the building components themselves were also not subject to use tax. The Morton Buildings issue is not new in itself. However, many states have changed their rules on the basis of this issue following litigation that was ruled in favor of the taxpayer. The following is an updated discussion of the status of the savings opportunity presented by the issue, argued by Morton and other taxpayers.

Alabama imposes a use tax upon the storage, use or other consumption in the state of tangible personal property. ¹ In the case Commissioner of Revenue v. Radio Corporation of America, 287 Ala 395, 252 So 2d 55, 03/18/1971, ("Commissioner v. RCA"), RCA manufactured electronic data processing systems in Florida. RCA subsequently leased the systems to =Southern Bell for use in Alabama.

The Commissioner contended that where a manufacturer rents or leases to others for use in Alabama, use tax should be due from the manufacturer measured by the purchase price of the materials becoming parts or components of such equipment. The Commissioner claimed that the taxable event in the instant case was the use by the taxpayer of manufactured products produced in its shops outside the state and leased to customers for use in the state. The tax should be based on the retail sales price of tangible personal property purchased outside the State of Alabama. The Commissioner viewed RCA as the ultimate consumer of the tangible personal property that it purchased to manufacture the data processing systems that it built for lease in Alabama.

RCA claimed that there was no taxable event under the Alabama use tax statute ² because: (a) Rentals may not be taxed; (b) Only the use of tangible personal property "purchased at retail" may be taxed; (c) These systems were not purchased at retail by RCA, but were manufactured; (d) The many thousands of ingredients which went into the manufacturing system were purchased by RCA, but were not subsequently used in Alabama, because what RCA rented to Southern Bell was a completed system, not the thousands of ingredient parts.

For purposes of this discussion, only the last contention is relevant. The court agreed with the Commissioner in the following judgment:

We conclude that RCA did purchase at retail the materials out of which RCA manufactured the leased machine; that the lease of the materials in the finished form is a use of those materials in Alabama by RCA subject to use tax; and that the basis upon which use tax is to be computed is the cost or sales price to RCA for those materials. 

Western Contracting Corporation v. State Board of Equalization, 265 Cal. App. 2d 568, 71 Cal Rptr 472 (1968) ("Western v. State Board") was a court case discussing the same type of contention asserted by Morton. Western Contracting Corporation ("Western") constructed dredges. Western constructed a dredge, the Western Eagle, for use anywhere in the world. The Western Eagle was constructed in Kansas City, Missouri in 1958. The Western Eagle arrived in San Diego in 1959. Cal. Rev. & Tax Code Ann.   6204 provides as follows:

An excise tax is hereby imposed on the storage, use, or other consumption in this State of tangible personal property purchased from any retailer.for storage, use, or other consumption in this State.

Western contended that the tangible personal property used to construct Western Eagle was not purchased for the purpose of use, storage, or other consumption in California. Western argued that it had not yet decided to use Western Eagle in California until after the Western Eagle's construction.

The court in Western v. State Board was not swayed by the fact that Western did not decide until 1959 that it was going to use Western Eagle in California. The court states as follows:

The lesson of the California use tax cases is that parts and materials are purchased for use in California if at the time of purchase it is contemplated that they might be used in California or elsewhere as the needs of the purchaser might require. (Emphasis added.)

The court continued to state that the Western Eagle was not used to perform any contract outside of California before it was brought to California. Therefore, had Western used the Western Eagle elsewhere before bringing it to California, Western would not have owed use tax upon the materials used to construct Western Eagle. Further, if Western could prove that Western Eagle was never intended for use in California, then the materials would not have been subject to California use tax.

Connecticut approached the issue of imposing the use tax upon materials purchased out of the state in Morton Buildings, Inc. v. Bannon, 222 Conn 49, 607 A2d 424 (1992) ("Morton Buildings v. Bannon").

Connecticut General Statutes   12-411(1) (West 1990) imposes a use tax:

[O]n the storage, acceptance, consumption or any other use in this state of tangible personal property purchased from any retailer for storage, acceptance, consumption or any other use in this state of tangible personal property purchased from any retailer for storage, acceptance, consumption or any other use in this state.

Morton's case in Connecticut was on whether or not the use tax was due on raw materials that Morton converted into building components outside of the state for incorporation into prefabricated buildings that would be erected for customers in Connecticut.

The trial court decided that Morton was in the business of selling contracts for improvement to realty, rather than selling tangible personal property. Therefore, the court ruled that the taxpayer must pay tax on the materials that it used and consumed in fulfilling the contracts. Morton appealed to the Superior Court of Connecticut.

The court in Morton Buildings v. Bannon reviews a similar set of facts as are present in Sharp v. Morton. However, the facts in this case expand a bit to describe that some raw materials are shipped to the site in Connecticut without any out-of-state production processes. Other raw materials are constructed into building components outside of the state. Morton dutifully paid tax on the unaltered raw materials that were shipped to Connecticut without any pre-fabrication work done.

Morton claimed that it had no Connecticut use tax liability for raw materials once its out-of-state production process had transformed such materials into prefabricated building and hardware components, as the production process constituted a "use" of the raw materials outside of Connecticut. The court outlines three conditions for the imposition of the use tax by the State of Connecticut:

• the allegedly taxable item was "tangible personal property" that was used in this state;
• the "tangible personal property" was "purchased" from a "retailer"; and
• the "tangible personal property" was purchased for "use in this state."

The court begins its analysis by applying each of the requirements of the use tax to Morton's facts and circumstances. The court found that Conn. Gen. Stat. Ann. 12-411(13) provides that "it shall be presumed that tangible personal property shipped or brought to this state by the purchaser was purchased from a retailer for storage, use or other consumption in this state." As Morton clearly brought the building components into the state for the purpose of installing them, then the first condition is met.

Morton contended that it did not meet the second requirement because the transformation of raw materials into building components removed them from the definition of tangible personal property purchased from any retailer for use in the state. Morton stated that the raw materials are not identical to the resulting building components. The court found that indeed, the building components were fabricated by affixing materials, cutting lumber, and implementing all sorts of other changes to the raw materials outside of the state. Therefore, the court ruled that Morton's raw materials should not be subject to the Connecticut use tax when they are fabricated into building components outside of the state.

The court did not answer the third requirement, as Morton clearly met the second requirement. The question of whether the tangible personal property was purchased for use in the state was a question left for another day.

The Connecticut Legislature reacted quickly to the outcome of the court case. The legislature amended the use tax statute effective as of July 1, 1992 in order to quash the court's ruling and impose the use tax upon Morton and upon all other taxpayers with Morton's set of facts. The amended statute Gen. Stat. Ann.   12-411(1) currently states as follows:

An excise tax is hereby imposed on the storage, acceptance, consumption or any other use in this state of tangible personal property purchased from any retailer for storage, acceptance, consumption or any other use in this state, the acceptance or receipt of any services constituting a sale in accordance with subdivision (2) of subsection (a) of section 12-407, purchased from any retailer for consumption or use in this state, or the storage, acceptance, consumption or any other use in this state of tangible personal property which has been manufactured, fabricated, assembled or processed from materials by a person, either within or without this state, for storage, acceptance, consumption or any other use by such person in this state.(Emphasis added.)

American Can Company v. The Department of Revenue, 47 Ill 2d 531, 267 NE2d 657 (1971) ("American Can v. DOR") is a different school of thought for the use tax application. The facts of American Can v. DOR are somewhat similar to that of Sharp v. Morton, however, the application of this case is much broader, encompassing more than just contractors, as Morton did.

American Can Company ("American Can") was a New Jersey corporation that was authorized to do business in Illinois. American Can was in the business of manufacturing and selling containers for packaging food and other items. American Can manufactured all of its own manufacturing equipment, as well as the repair and replacement parts inevitably needed. The machinery and repair and replacement parts were all manufactured outside of Illinois in California, Ohio, and New York. The machinery and repair and replacement parts were manufactured from raw materials purchased outside of Illinois.

American Can purchased many raw materials upon which it paid no sales tax in Illinois or in any other state. The materials were converted into the machinery and repair and replacement parts outside of Illinois and then sent into the manufacturing plants in Illinois to be incorporated into or replace the manufacturing machinery.

Illinois imposed a use tax upon the privilege of using within the state tangible personal property purchased at retail from a retailer. ³ The DOR assessed the use tax upon the value of the raw materials that had been purchased outside of Illinois and made into machinery and repair and replacement parts for use in Illinois. The DOR stated its contention as follows:

The tax herein sought to be imposed is on the components, and other materials which were purchased by Taxpayer. It is perhaps misleading that the term 'raw materials' is used herein. Taxpayer's machinery and replacement parts are made from steel or other alloy, bar metal and rough castings which taxpayer purchases at retail. These materials are cut, welded, shaped and machined in Taxpayer's machine shops and are then used for the fabrication of the machines and replacement and repair parts. ⁴

American Can Company v. The Department of Revenue, 47 Ill 2d 531, 267 NE2d 657 (1971) ("American Can v. DOR") is a different school of thought for the use tax application. The facts of American Can v. DOR are somewhat similar to that of Sharp v. Morton, however, the application of this case is much broader, encompassing more than just contractors, as Morton did.

The DOR essentially contended that because an Illinois manufacturer would be liable for the use tax on materials incorporated into machines and parts in Illinois, it would give an undue advantage to an out-of-state manufacturer who incorporates the materials into machinery out of the state for subsequent use in the state. American Can contended that in order for the use tax to apply, the following criteria must be met:

• the property must have been purchased at retail for the use tax to apply; and
• the property must have been used in Illinois.

The first contention was met. American Can did purchase the property at retail. However, the raw materials were not used in Illinois. American Can contends that the raw materials were converted into other materials before being used in Illinois, and therefore, the raw materials were no longer raw materials, as they changed identity once they were incorporated into machinery and repair and replacement parts.

The Illinois court investigated other state cases such as Chicago Bridge & Iron Co. v. Johnson, 19 Cal.2d 162 [119 P.2d 945] (1941) and considered the impact upon the ruling on future transactions. The court ultimately held that the materials were subject to the tax. The reasoning put forth by the court is as follows:

[A] holding that the materials here are used in Illinois and subject to the tax is consistent with the policy and intendment of the Use Tax Act to protect citizens of Illinois from having their business diverted to out-of-state sellers. To exempt American from the application of the use tax here would operate to discriminate against Illinois citizens who manufacture or assemble machinery or parts in this State.

As in the other Morton Buildings cases, Morton Buildings, Inc. v. Indiana Department of State Revenue, 819 NE2d 913 (2004) ("Morton Buildings v. Indiana Department of Revenue") deals with the question of whether the raw materials Morton purchased and used outside of the state to make building components, that were eventually assembled into prefabricated buildings in Indiana, are subject to Indiana use tax.

Ind. Code Ann.   6-2.5-3-2 establishes two conditions for the imposition of use tax on tangible personal property:

• The "tangible personal property" at issue must be "stor[ed], use[d], or consum[Ed] in Indiana;" and
• The "tangible personal property" at issue must have been "acquired in a retail transaction."

Morton contended that neither of these conditions were met with respect to the materials used to manufacture its buildings. The raw materials it acquired in a retail transaction were used in Morton's factories entirely outside of Indiana to fabricate building components. Further, the materials Morton did use in Indiana - the building components - were not acquired in a retail transaction; rather, they were fabricated by Morton and had an identity separate and distinct from the raw materials used to make them. Morton contended that raw materials were not taxable because they were not used in Indiana and the building components were not taxable because they were not purchased in a retail transaction.

The Court ruled in favor of Morton in this case. The Court found that the raw materials purchased at retail were consumed in the production process out-of-state and, therefore, were never used in Indiana. Furthermore, the building components were fabricated by Morton, and not acquired by Morton. Morton did not owe use tax on either the raw materials or the building components.

Morton's set of facts did not change in Kentucky, however, the Kentucky judicial system was not as sympathetic to its cause as other state courts. Morton purchased raw materials outside of Kentucky from which it manufactured building components. The building components were then shipped into Kentucky where they were assembled into buildings for Morton's Kentucky customers. Morton filed a refund request for the period November 1, 1985 through October 31, 1989 for use taxes that it contended were not due on its purchases of raw materials that it used to manufacture building components outside of the state.

Ky. Rev. Stat. Ann.   139.310 imposes an excise tax on the storage, use, or other consumption of tangible personal property in Kentucky. The first court case ruled on August 30, 2001, Morton Buildings, Inc. v. Revenue Cabinet, K-18239, K92-R-80, Kentucky Board of Tax Appeals (2001), stated that the word "or" is disjunctive in meaning, and that if Morton engaged in one of the three statutory actions, then Morton would be subject to use tax. Morton cited its many winnings in other states in order to support its claim, however, the court was not swayed by these decisions and denied the refund claim. Morton appealed the case, and was denied again by the Kentucky Circuit Court. The Kentucky Circuit Court found as follows:

The manufacture of raw materials into the building components out-of-state will not aid Morton in avoiding the use tax.raw materials are consumed in Kentucky when they are brought in the state for use whether or not they are first manufactured.

Therefore, Morton owed use tax on its purchases of raw materials that it used to manufacture building components outside of the state. The Kentucky Court of Appeals affirmed the Circuit Court decision denying the refund of use tax paid on materials purchased, stored, and transformed outside of Kentucky in a decision issued on July 25, 2003.

American Can, like Morton, made its case heard in several states. In this case, Comptroller of Treasury v. American Can Company, 208 Md 203, 117 A2d 550 (1955) ("Comptroller v. American Can"), American Can appealed the decision of the Comptroller of the Treasury that denied American Can a refund of use tax paid on raw materials purchased outside of the State of Maryland. The court reversed the Comptroller's denial in American Can's appeal. The Comptroller then appealed the decision.

Comptroller v. American Can questioned the application of the use tax provision presented in Md. Ann. Code art. 81,   369 (1951), which reads as follows:

[A]n excise tax is hereby levied and imposed on the use, storage or consumption n this State of tangible personal property purchased from a vendor within or without this State. for use, storage or consumption within the State.

American Can's situation in Maryland is identical to its set of facts and circumstances already discussed. However, the reasoning used by the Maryland court in deciding this case is noteworthy. The court considered that the finished product, the machinery and repair and replacement parts were shipped into Maryland, and not at all the raw materials upon which Maryland sought to impose a use tax. The court summarized its position as follows:

The raw materials would be utterly useless for the purpose of making containers. To interpret the use of the finished product as a use of the raw materials disregards the fact that before the use began the raw materials had been converted into tangible personal property of a different nature and utility. ⁵

The court based its decision upon the plain meaning of the statute language employed in 1951, in Maryland Code Art. 81,   369, which provided that the tax is imposed upon the use of tangible personal property. The court concluded that the raw materials were never actually used as raw materials in Maryland. The court further noted that the machinery and repair and replacement parts constructed from the raw materials were not actually purchased in Maryland or elsewhere.