With the 2018 changes to Kentucky’s tax code, there are a few particularly noteworthy for manufacturers: (1) for income tax: conformity with the federal tax changes, and adoption of single sales factor apportionment for multi-state corporations; (2) for sales tax: the taxation of some repair and installation labor, and a narrowing of the exemption for energy in excess of three percent of cost of production; and (3) for property tax: the phase-in of a credit for taxes paid on inventories, and the exemption of custom software.
Kentucky conforms to a majority of the changes to the federal tax code set forth in the Tax Cuts and Jobs Act. This means that the domestic production activities deduction is no longer available. The primary exception to Kentucky’s conformity is the decoupling from the federal depreciation and expensing provisions. Additionally, Kentucky’s income tax rate was changed to a flat 5% rate, and the state adopted single sales factor apportionment.
Single sales factor apportionment applies to multi-state corporations doing business in Kentucky. Previously, multi-state corporations apportioned income to Kentucky using a three-factor (sales, property, and payroll) apportionment formula. Effective for the 2018 tax year, only the sales factor will be used for apportionment purposes. The three-factor formula was retained for providers of communications and multichannel video programming services (cable and satellite TV) and certain financial organizations.
Sales and Use Tax
Kentucky joined 21 states and the District of Columbia in taxing installation and repair labor. This change was made by adding installation and repair labor to the definition of “gross receipts”, which is the tax base for sales and use tax. Specifically, gross receipts includes: “the amount charged for labor or services rendered in installing or applying the tangible personal property, digital property, or service sold.” Three general rules can be drawn from the statutory change.
- There is no sales tax on installation or repair labor, unless there is a transfer of tangible property or digital property.
- If a manufacturer is involved, there is no sales tax on installation or repair labor if the machinery or equipment is (a) directly used in manufacturing, (b) the labor is separately stated on the invoice, and (c) the customer provides the installer/repairer with a resale certificate.
- There is no sales tax on installation or repair labor if the customer is exempt from tax under Section 501(c)(3) of the Internal Revenue Code and the exempt entity gives the installer/repairer an exemption certificate.
The exemption for machinery and equipment directly used in manufacturing described in Rule 2 is critical to manufacturers. Machinery or equipment that is “directly used” in manufacturing is located at and between (i) the place where the raw materials start into a “continuous, unbroken, integrated process”, and (ii) the place at which the finished product is packaged and ready for sale. The manufacturer should provide the installer/repairer with a resale certificate. In the absence of a resale certificate, the installer/repairer should collect and remit sales tax at the 6% rate.
Historically, Kentucky has permitted manufacturers to exempt from sales tax energy purchases in excess of three percent (3%) of their cost of production. Some entities bifurcated the purchase of their raw materials from their other cost of production to maximize the energy exemption. The change to Kentucky’s statute forecloses this planning opportunity by requiring raw materials to be included in the calculation of cost of production, regardless of what entity purchases the raw materials.
The General Assembly also adopted an inventory tax credit to be phased-in over the next four years. The credit is a non-refundable income tax or limited liability entity tax credit allowed for ad valorem taxes timely paid on business inventory. The phase-in is as follows: 2018 – 25% of tax paid; 2019 – 50% of tax paid; 2020 – 75% of tax paid; and 2021 and forward – 100% of tax paid. Additionally, the legislature enacted an exemption from property tax for custom software.