In re Appeal of Water Dist. No. 1 of Johnson County

Citation26 Kan. App.2d 371,988 P.2d 267
Decision Date13 August 1999
Docket NumberNo. 79,842.,79,842.
PartiesIn the Matter of the Appeal of Water District No. 1 of Johnson County From an Order of the Director of Taxation On Assessment of Additional Retailer's Sales Tax.
CourtCourt of Appeals of Kansas

Marty T. Jackson, of Speer, Austin, Holliday & Zimmerman, of Olathe, for appellant Water District No. 1 of Johnson County.

Joan E. Adam and Richard Cram, of Kansas Department of Revenue, for appellee. Gary Rebenstorf, city attorney, Joe Allen Lang, assistant city attorney, and Brian K. McLeod, Richard D. Greene, and Michael Lennen, of Morris Laing Evans Brock & Kennedy, Chartered, of Wichita, for amicus curiae City of Wichita.



Water District No. 1 of Johnson County (Taxpayer) appeals the ruling of the Board of Tax Appeals (BOTA) affirming the finding that Taxpayer is not entitled to a tax exemption under K.S.A. 79-3606(n).

We affirm in part, reverse in part, and remand.

Taxpayer is a quasi-municipal corporation which sells water to commercial, residential, and municipal customers in Johnson County, obtaining most of its water from the Kansas and Missouri rivers. The water is then treated at the Hansen Treatment plant in Wyandotte County. From the treatment plant, the water is pumped through pipes to various pumping stations and then on to the customers. Taxpayer purchases electricity to power the pumping stations which pressurize the water. Taxpayer then sells the pressurized water.

The Kansas Department of Revenue (KDOR) issued an assessment of additional retailer's sales tax against Taxpayer for its purchases of electricity and also levied a penalty against Taxpayer.

Taxpayer paid the tax and penalty under protest and appealed the assessment to the Director of Taxation. The Director denied the appeal, finding Taxpayer was not entitled to an exemption because the electricity was used in the "distribution" rather than the "production" of Taxpayer's water. Taxpayer appealed to BOTA, seeking an exemption and a refund of taxes. BOTA denied both requests.

BOTA's orders are subject to review pursuant to K.S.A. 77-601 et seq. and Taxpayer has the burden to show that the action taken by BOTA was erroneous. K.S.A. 77-621(a). Tax statutes are not to be extended by implication beyond the clear meaning of statutory language. In re Tax Exemption Application of Kaul, 261 Kan. 755, Syl. ¶ 3, 933 P.2d 717 (1997).

Further, tax exemption statutes, such as K.S.A. 79-3606, are to be construed in favor of imposing the tax and against allowing an exemption. In re Tax Appeal of Harbour Bros. Constr. Co., 256 Kan. 216, 223, 883 P.2d 1194 (1994). On the other hand, tax statutes will be construed favorably to the taxpayer where there is a reasonable doubt as to its meaning. In re Appeal of Topeka SMSA Ltd. Partnership, 260 Kan. 154, 164, 917 P.2d 827 (1996).

BOTA, in agreeing with the administrative law judge and the KDOR that the pressurization of Taxpayer's water was part of the distribution (rather than the manufacturing) process, relied on a 50-year-old Iowa case: Peoples Gas & Elec. Co. v. State Tax Comm, 238 Iowa 1369, 28 N.W.2d 799 (1947). BOTA also ruled inapplicable our Supreme Court case of In re Tax Appeal of Collingwood Grain, Inc., 257 Kan. 237, 891 P.2d 422 (1995). As we read Collingwood Grain, our Supreme Court has rejected the reasoning of Peoples Gas. In any event, BOTA reasoned the pressurization of Taxpayer's water did not enhance its "intrinsic value," rendering Collingwood Grain unpersuasive and inapplicable.

BOTA also relied on K.A.R. 92-19-53 for the proposition that distribution does not qualify for an exemption from sales and use tax because once "the water is processed at the treatment facility, it is fit for human consumption and in its final form." We conclude this ruling is contrary to the language and policy of Collingwood Grain and the language of K.A.R. 28-15-18.

Sales and compensating use taxes are consumption taxes representing the largest single source of tax revenue for state governments. Hager, Kansas' Sales and Use Tax Law: Exemptions for Manufacturing Machinery and Equipment and the Integrated Plant Theory, 37 Washburn L.J. 543, 546 (1998). In Kansas, sales and use tax revenues account for 39.8% of the total general fund receipts. 37 Washburn L.J. at 546. The legislative amendments to K.S.A. 79-3602(m) require exemption from sales and use tax to be decided on a case-by-case basis as to items not specifically listed as exempt. In re Tax Appeal of Derby Refining Co., 17 Kan. App. 2d 377, Syl. ¶ 5, 838 P.2d 354 (1992).

Obviously, the central question we must decide is whether Taxpayer's purchase of electricity is exempt from the compensating use tax. Electricity, of course, is tangible personal property. K.S.A. 79-3602(m). The question is whether the electricity is "consumed in the production, manufacture, ... of tangible personal property,.... for ultimate sale at retail within or without the state of Kansas." K.S.A. 79-3606(n). There is a split of authority as to how the question is to be answered.

The more restrictive way to answer the question is referred to as the Ohio-Georgia or physical change rule. Under this rule, exemption is limited to items which physically change or transform the object of the manufacturing process. 37 Washburn L.J. at 561-62. We read Collingwood Grain as rejecting this restrictive rule and instead, as adopting impliedly if not expressly, the integrated plant theory.

The integrated plant theory allows exemption from sales and use taxes where equipment and machinery perform an essential or indispensable function in the manufacturing process regardless of whether a physical change is actually caused in raw materials. 37 Washburn L.J. at 563-65. In other words, the integrated plant theory asserts that the legislative purpose of manufacturing exemptions is inconsistent with an impractical or restrictive construction of those exemptions.

The current version of K.S.A. 79-3606(n) was enacted in 1988, L. 1988, ch. 386, § 3. Legislative history leaves little doubt that the legislature intended to promote economic development; to avoid pyramiding taxation on successive buyers and sellers; and to strike a balance between the longstanding policy of avoiding multiple taxation; and the need to raise revenue for the state's coffers. Then Governor Hayden placed a high priority on an extension of the manufacturing tax exemption in order to promote increased manufacturing activity and to make Kansas more competitive with other states. In an effort to achieve this goal, the legislature left the language of K.S.A. 79-3606(n) broad, omitting the restrictive "transformation" language existing in other states' statutes. See generally, 37 Washburn L.J. at 571-78.

The legislative desire to promote capital investment, to be more competitive with other states, and to make Kansas a more attractive choice for business expansion and location is patently inconsistent with a restrictive, impractical interpretation of this exemption. An analysis of Collingwood Grain

We are convinced our Supreme Court adopted the integrated plant theory in Collingwood Grain. That case involved an appeal by KDOR from a BOTA ruling, holding the sale of electricity consumed in grain elevator operations was exempt under K.S.A. 79-3606(n). After ruling electricity is tangible personal property subject to exemption, the court detailed the process by which the grain was blended, turned, fumigated, and aerated. 257 Kan. at 238-40.

The Collingwood Grain court then discussed the history of K.S.A. 79-3606(n), and how best to define "property used in processing" as applied to the statute. 257 Kan. at 245-46. In doing so, the court rejected KDOR's argument that the blending and cleaning of the grain did not transform or physically change the grain into a different product, thus making it ineligible for exemption. The court stated KDOR placed too much reliance on its assertion that the blending and cleaning of the grain simply produced an unchanged product. 257 Kan. at 250-51.

While the Collingwood Grain court acknowledged the grain would not be "transformed" or "physically changed" (thus, failing an application of the Ohio-Georgia physical change rule), it held that the grain was of a different quality than before the processes were performed. 257 Kan. at 251. Broadly stated, the court ruled that KDOR's construction of the term "production, manufacture [and] processing" was too...

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