You asked for a (1) summary of Department of Revenue Services (DRS) ruling 2004-2 on the sales and use tax status of electricity generation equipment and (2) a discussion of the ruling’s implications.

SUMMARY

The ruling removes a partial exemption from the sales and use tax for machinery and equipment used to generate electricity, thereby increasing the tax rate to 6%. It reverses, in part, an earlier DRS ruling on the subject.

The new ruling will likely have a minimal impact on retail consumers, at least in the next few years. But it will increase costs for electricity generators in the state, which may be reflected in electric rates in the longer run. It may also place generators in the state at a slight disadvantage compared to out of state generators in the regional wholesale market. Finally, it will make it more expensive to build new power plants in the state and renovate existing plants.

RULING

On June 18, 2004 DRS issued Ruling 2004-2. The ruling addresses whether the generation of electricity meets the statutory definition of “processing” under the Manufacturing and Recovery Act of 1992, (CGS §12-412i(b)(3)), thus partially exempting purchases of machinery and equipment used to generate electricity from sales and use taxes.

The ruling holds that these purchases do not qualify for the partial exemption because the generation, or creation, of electricity does not meet the statutory definition of “processing”. Under this definition, processing is “the physical application of the materials and labor necessary to modify or change the characteristics of tangible personal property. ” The ruling revokes the part of an earlier ruling (number 2000-5) that held that generation constituted “processing” under the act.

The new ruling holds that generation does not qualify as “processing” under the act for two reasons. First, generation does not involve applying materials and labor to existing tangible personal property to modify or change the property’s characteristics; instead, it creates new tangible personal property in the form of electricity.

Second, the ruling finds that the act’s legislative history does not indicate that the legislature intended to include generation as processing. It notes that before the act was adopted, the state Supreme Court had held that generation was not manufacturing for purposes of the sales and use tax (United Illuminating Co. v. Groppo, 220 Conn. 749, 601 A. 2d 1005 (1992)). The Court has held that the legislature is assumed to be aware of its interpretation of the law, and “that its [the legislature’s] subsequent nonaction may be understood as a validation of that interpretation,” Phelps Dodge Copper Products Co. v. Groppo, 204 Conn. 122, 134, 527 A. 2d 672 (1987). According to the ruling, the legislation’s title strongly suggests that it was intended to address the manufacturing industry, which excludes electric utility companies (the ruling notes that manufacturing and electricity utilities have separate Standard Industrial Classification codes). According to the ruling, nothing in the act’s legislative history demonstrates any intention to expand the scope of industries deemed to be engaged in manufacturing, fabricating or processing activities to include electric utilities.

The ruling does not explain how the earlier ruling was mistaken or how changes in fact or law have made it passé. Ruling 2004-2 notes that other provisions of ruling 2000-5 remain in effect. As a result, purchases of materials, tools, and fuel used directly in generating electricity are fully exempt from sales and use taxes.

IMPLICATIONS

Short Run

The ruling is likely to have little if any effect on retail consumers in the next few years. This is because the overwhelming majority of consumers (more than 98%) served by distribution companies (Connecticut Light & Power and United Illuminating) receive transitional standard offer service. The companies have entered into wholesale contracts to provide this service, and it does not appear that the ruling will affect these contracts. The ruling is also unlikely to affect the companies themselves, which do not own generation facilities.

The ruling does impose additional costs on electricity generators, which sell power on the wholesale market. The cost increase varies by company, depending on the extent to which it will buy generation equipment and machinery. In some cases, such as for Connecticut Light & Power’s generation affiliate (Select Energy), company staff believe that the ruling will likely have a minimal effect. For other companies, the impact will be greater. Paddi LeShane, who represents NRG, believes that the ruling could cost the company several hundred thousand dollars in connection with the new Middletown plant.

The added taxes would also make Connecticut generators somewhat less competitive in the regional wholesale market. On the other hand, the ruling is unlikely to affect the competitive status of Connecticut manufacturers of generation machinery and equipment. This is because the ruling applies to the use tax, and thus to out of state machinery and equipment manufacturers who sell to Connecticut generators.

Longer Run

In the longer run, the ruling may increase consumer rates, to the extent that generators pay additional taxes and are able to pass these costs to distribution companies and competitive suppliers. It appears that the added sales and use tax would constitute a relatively minor share of the generator’s cost of business, although the proportion varies

by generator. The extent to which the generators will be able to pass these costs on will depend on the balance of supply and demand in the wholesale market.

The ruling will make it more expensive to build new power plants in the state, as generation equipment and machinery constitute a significant share of the plant’s total cost. It will also make it more expensive to renovate (“repower”) existing plants by replacing old generation equipment with new, more efficient, equipment. This may be a particular concern with regard to the southwestern third of the state, where electricity demand outstrips local supply and most of the existing power plants are old and inefficient.

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