In our latest NC Chamber Legal Institute Sidebar, we’re reviewing a case that involves a sales tax exemption for manufacturers who purchase equipment and machinery used to transform raw materials into finished goods.

Sometime early next year, the NC Supreme Court will hear a case involving the NC Department of Revenue’s interpretation of the sales tax exemption for purchases of “mill machinery.” The specific tax issue in dispute will be of interest primarily to tax specialists, but the case highlights important rule of law issues that should interest anyone subject to regulation by executive branch agencies.  The outcome of the case could tell us a lot about how the Court will view agency action in the coming years.

The case, NC Department of Revenue v. FSC II, LLC, involves the sales tax exemption for manufacturers who purchase equipment and machinery used to transform raw materials into finished goods (known as “mill machinery”). The exemption statute, which has been on the books for decades, has only two requirements: the taxpayer must be a manufacturer, and the purchased equipment must be mill machinery. The Department conceded that FSC II used the equipment in question to transform raw materials into a new product – hot mix asphalt. This would seem to satisfy both statutory requirements and entitle the taxpayer to the exemption. However, the Department of Revenue (“DoR”) denied the exemption. DoR argued that the exemption was only available if the taxpayer sold most of its manufactured product to third parties. FSC II sold hundreds of thousands of dollars of its hot mix asphalt to third parties, but used even more in its own construction projects. Because FSC II’s “primary purpose” was not selling to third parties, it did not qualify for the exemption. DoR thus effectively added a third requirement to the exemption statute.

An amicus brief filed in the NC Supreme Court on behalf of the NC Chamber Legal Institute argues that DoR’s attempt to enforce its “primary purpose” test violates the NC Administrative Procedure Act (NC APA).  The NC APA prohibits agencies, including DoR, from enforcing a “rule” unless the rule has been promulgated in accordance with certain procedures. The DoR is exempt from some of these procedures, but not all. For instance, DoR rules must be submitted to the Rules Review Commission and published in the North Carolina Register before they can take effect. DoR makes no claim that they followed these rulemaking procedures with respect to the “primary purpose” test. Indeed, the briefs in the case show that DoR attempted to enforce the “primary purpose” test in individual cases over several decades without ever making the rule known.

The case thus may come down to whether the “primary purpose” test falls within the NC APA’s definition of a “rule.” The NC APA defines a rule, with limited exceptions, as “[a]ny agency regulation, standard, or statement of general applicability that implements or interprets an enactment of the General Assembly.”  The NC Chamber’s amicus brief makes the case that the “primary purpose” test squarely fits within the definition of “rule,” and qualifies for no exception to that definition because of its general applicability.

The Supreme Court’s decision in the case could therefore have implications for the regulated public far beyond the scope of the mill machinery exemption. The case raises the fundamental question of whether citizens can be bound by rules never reduced to writing or publicly announced. The NC Chamber’s brief argues that the enforcement of such rules is incompatible both with fundamental fairness and with a sound business climate. “Players need to know the rules of the game before they roll the dice. When government agencies can exact penalties for the transgression of secret rules, even the most daring entrepreneurs will be reluctant to commit their capital into the future.”

The DoR lost its case in both the Office of Administrative Hearings and the Business Court.  We hope the Supreme Court enunciates a clear and appropriate interpretation of agencies’ rulemaking obligation for the benefit of both the regulated community and regulatory agencies.