News and Insights

Court of Appeals Narrows the “Temporary Storage” Exclusion from Texas Use Tax

Tax Development Dec 27, 2011

In Combs v. Chapal Zenray, Inc., No. 03-10-00646-CV (Tex. App. – Austin, November 18, 2011, no writ history), the Third Court of Appeals in Austin (“Court”) determined that certain packaging materials were subject to use tax in Texas.

Chapal Zenray is a wholesale jeweler that purchased jewelry and packaging supplies (display cards, jewelry boxes, labels, elastic strings, twist ties, and foam ring pads) from vendors outside Texas. In Texas, Chapal Zenray attached the packaging supplies to the jewelry. For example, earring posts would be punched through display cards and then fastened, and rings would be inserted into foam pads that were then placed inside ring boxes. Chapal Zenray then shipped the packaged jewelry to retailers outside Texas via common carrier. In an audit, the Texas Comptroller of Public Accounts (“Comptroller”) assessed Texas use tax on Chapal Zenray’s purchases of packaging supplies.

Chapal Zenray contended that the packaging supplies were not subject to use tax. Tex. Tax Code § 151.101(a) imposes use tax on “the storage, use, or other consumption in this state of a taxable item purchased from a retailer for storage, use, or other consumption in this state.” However, Tex. Tax Code § 151.011(f) excludes from the definition of taxable “use” and “storage” the following activities: “processing, fabricating, or manufacturing the property into other property or attaching the property to or incorporating the property into other property to be transported outside the state for use solely outside the state.” Chapal Zenray argued that the packaging supplies were “attached” to the jewelry, after which they were transported outside the state for use by Chapal Zenray’s customers outside Texas. Therefore, the “use” of the packaging materials in Texas was not taxable.

Although the packaging supplies were undeniably attached to the jewelry, the Court determined that the Texas Legislature intended for the exclusion to apply to items that are more permanently joined. The Court wrote that this narrow construction made the exclusion internally consistent because it also applies to items that are “processed,” “fabricated,” “manufactured,” or “incorporated into” one another. Furthermore, the Court held that the “attachment of the materials” must “result in a finished product that has functionality, aesthetic appeal, or usefulness to the ultimate consumer throughout the product’s useful life…” Because many of the packaging materials were intended to be discarded by the consumer when the jewelry was ultimately sold, they were not “attached” for purposes of the exclusion.

The decision is troubling for several reasons. First, the Court failed to construe the temporary storage exclusion broadly in favor of the taxpayer, as required by Bullock v. Statistical Tabulating Corp., 549 S.W.2d 166, 169 (Tex. 1977). Instead, the Court adopted the Comptroller’s extremely narrow construction of the statute. In addition, the Court did not follow the “plain meaning” of the word “attached,” as required by Fleming Foods of Tex., Inc. v. Rylander, 6 S.W.3d 278 (Tex. 1999). Instead, the Court adopted the Comptroller’s narrow definition requiring that such items be relatively permanently attached, and the attachment must result in a functional and useful finished product to the ultimate consumer. Finally, none of these requirements appears in the text of the statute, any legislative history underlying the law, any rule of the Comptroller, or any other administrative precedent other than Chapal Zenray’s own administrative hearing. Under these circumstances, the Court should not have deferred to the Comptroller’s narrow construction of the statute, let alone adopted it.

The case may be appealed to the Texas Supreme Court.