State Ex Rel. Department of Revenue v. Capitol Castings, Inc.

SUPREME COURT OF ARIZONA
En Banc

STATE OF ARIZONA ex rel. THE ) Arizona Supreme Court
ARIZONA DEPARTMENT OF REVENUE, ) No. CV-03-0250-PR
)
Plaintiff-Appellant, ) Court of Appeals
) Division One
v. ) Nos. 1 CA-TX 01-0007
) 1 CA-TX 02-0014
CAPITOL CASTINGS, INC., ) (Consolidated)
)
Defendant-Appellee. ) Arizona Tax Court
__________________________________) Nos. TX 1996-00028
) TX 1996-00028-3
STATE OF ARIZONA ex rel. THE )
ARIZONA DEPARTMENT OF REVENUE, )
)
Plaintiff-Appellee, ) O P I N I O N
)
v. )
)
CAPITOL CASTINGS, INC., )
)
Defendant-Appellant. )
__________________________________)

Appeal from the Arizona Tax Court
The Honorable Jeffrey S. Cates, Judge
The Honorable Paul A. Katz, Judge

REVERSED AND REMANDED

Opinion of the Court of Appeals, Division One
205 Ariz. 258, 69 P.3d 29 (App. 2003)

VACATED

TERRY GODDARD, ARIZONA ATTORNEY GENERAL Phoenix
by Sara D. Branscum, Assistant Attorney General
Attorneys for Plaintiff Arizona Department of Revenue
SNELL & WILMER, L.L.P. Phoenix
by Charles A. Pulaski, Jr.
and Barbara J. Dawson
and Martha E. Gibbs
Attorneys for Defendant Capitol Castings, Inc.

FENNEMORE CRAIG, P.C. Phoenix
by Steven R. Partridge
Attorneys for Amicus Curiae
Arizona Tax Research Association

B E R C H, Justice

¶1 Arizona law exempts from use tax any “[m]achinery[] or

equipment[] used directly in manufacturing, processing,

fabricating, . . . or metallurgical operations.” Ariz. Rev.

Stat. (“A.R.S.”) § 42-5159(B)(1) (Supp. 2003).1 Capitol Castings

claimed that several items purchased for use in its foundry

facilities qualified for the use tax exemption. The court of

appeals, however, concluded that the items did not qualify for

the exemption because they were not “machinery or equipment.”

See State ex rel. Ariz. Dep’t of Revenue v. Capitol Castings,

Inc., 205 Ariz. 258, 266, ¶¶ 34, 36, 69 P.3d 29, 37 (2003)

(“Capitol II”). We granted Capitol Castings’ petition for

review and, for the reasons set forth, vacate the opinion of the

court of appeals, resolve the exemption status of several items,

and remand the case for further proceedings.

1
The legislature renumbered § 42-1409(B)(1) as § 42-
5159(B)(1) in 1997, see 1997 Ariz. Sess. Laws, ch. 150, §§ 107,
110, but made no substantive change to its language. Because
there was no substantive change, this opinion refers to the
current citation.

2
 BACKGROUND AND PROCEDURAL HISTORY

¶2 Capitol Castings manufactured grinding balls and

custom-cast items used in mining and other industries.2

Manufacturing these items entailed pouring molten metals and

alloys into molds to form the desired shapes. Capitol

constructed its molds using metal, silica sand, chemical

binders, exothermic sleeves, mold cores, mold wash, and hot

topping.

¶3 The molds for custom castings consisted almost

entirely of sand. For some of the custom molds, Capitol would

ram the sand for each half of the mold into a steel flat

containing a wood pattern of the desired shape. For other

custom molds, Capitol would pour sand treated with chemical

binders over wood patterns. The binders helped the sand retain

its form. Capitol would then insert into one of the custom

casting mold’s halves an exothermic sleeve, a round tube that

protruded from the mold like an exhaust pipe and retained excess

molten metal that became part of the casting as the metal inside

cooled and contracted. Capitol used “hot topping,” a powder, to

cover the end of the exothermic sleeve to keep the molten metal

in the sleeve from cooling. After removing the wood patterns

from the molds, Capitol sprayed the cavity left by the pattern

2
Capitol no longer owns the foundry facilities discussed in
this opinion.

3
in the mold with a mold wash to prevent the sand from sticking

to the casting. Capitol sometimes used mold cores, also made of

sand, to form cavities in the molds. Once the halves of each

custom casting mold were complete, Capitol put the halves

together to form a single mold.

¶4 Capitol’s molds were destroyed during the

manufacturing process. The chemical binder and mold wash were

completely consumed and the exothermic sleeves and hot topping

were rendered unusable each time Capitol used a mold, but

Capitol was able to salvage the metal and sand for use in future

molds.

¶5 The Arizona Department of Revenue (“ADOR”) did not

contest the exemption for the metal molds, thus impliedly

conceding that the metal molds are exempt from use tax, but it

contends that the other materials — silica sand, chemical

binders, hot topping, mold wash, mold cores, and exothermic

sleeves — are not exempt.

¶6 ADOR also contests the exemption for the cement and

lime Capitol used at its Chandler facility to detoxify dust

created by the arc furnaces used in the casting process. Like

the chemical binders and hot topping, the cement and lime could

not be reused after they were injected into the toxic dust.

¶7 Finally, ADOR contests the exemption for refractory

materials, such as coxy sand and cerwool blankets, used to

4
protect Capitol’s machinery and equipment from the extreme heat

generated by its manufacturing processes. The manufacturing

process destroyed the refractory materials, requiring Capitol to

replace them periodically.

¶8 This case has an extensive procedural history,

including two tax court proceedings, two published court of

appeals opinions, and a legislative amendment to the exclusions

from the exemptions afforded by A.R.S. § 42-5159(B). We will

explain the history as it becomes pertinent to the analysis.

DISCUSSION

A. Standard of Review

¶9 This case involves the interpretation of statutory

provisions, matters that we review de novo. See Bilke v. State,

___ Ariz. , , ¶ 11, 80 P.3d 269, 271 (2003) (citing Canon

Sch. Dist. No. 50 v. W.E.S. Constr. Co., 177 Ariz. 526, 529, 869

P.2d 500, 503 (1994)). When interpreting statutes, we strive to

“discern and give effect to legislative intent.” People’s

Choice TV Corp. v. City of Tucson, 202 Ariz. 401, 403, ¶ 7, 46

P.3d 412, 414 (2002). We “construe the statute as a whole, and

consider its context, language, subject matter, historical

background, effects and consequences, [as well as] its spirit

and purpose.” Id. (quoting State ex rel. Ariz. Dep’t of Revenue

v. Phoenix Lodge No. 708, Loyal Order of Moose, Inc., 187 Ariz.

242, 247, 928 P.2d 666, 671 (App. 1996)).

5
¶10 In the tax field, we liberally construe statutes

imposing taxes in favor of taxpayers and against the government,

Ariz. Tax Comm’n v. Dairy & Consumers Co-op Ass’n, 70 Ariz. 7,

18, 215 P.2d 235, 242-43 (1950), but strictly construe tax

exemptions because they violate the policy that all taxpayers

should share the common burden of taxation. See Tucson Transit

Auth., Inc. v. Nelson, 107 Ariz. 246, 252, 485 P.2d 816, 822

(1971); 71 Am. Jur. 2d State and Local Taxation §§ 232, 233

(2001). Nevertheless, an exemption should “not be so strictly

construed as to defeat or destroy the [legislative] intent and

purpose.”3 W.E. Shipley, Annotation, Items or Materials Exempt

from Use Tax as Used in Manufacturing, Processing, or the Like,

30 A.L.R.2d 1439, 1442 (1953). Bearing these principles in

mind, we turn to the issue raised by the parties.

B. Machinery or Equipment

¶11 Our analysis begins with the text of A.R.S. § 42-

5159(B)(1), which exempts “[m]achinery, or equipment, used

directly in manufacturing, processing, fabricating, job

printing, refining or metallurgical operations.” The statute

3
Citing People’s Choice TV Corp., 202 Ariz. at 403, ¶ 7, 46
P.3d at 414, Capitol argues that we should construe the
exemption at issue in this case liberally. As the court of
appeals below correctly pointed out, People’s Choice TV Corp.
interpreted a statute prohibiting the imposition of a tax, not a
provision exempting an otherwise taxable item. See Capitol II,
205 Ariz. at 263-64, ¶ 23, 69 P.3d at 34-35. Capitol’s reliance
on People’s Choice TV Corp. is therefore misplaced.

6
requires that the “terms ‘manufacturing,’ ‘processing,’

‘fabricating,’ ‘job printing,’ ‘refining’ and ‘metallurgical’”

be interpreted to include “those operations commonly understood

within their ordinary meaning.” Id. No one disputes that

Capitol’s casting processes were of the type contemplated by the

statute.

¶12 The statute does not define the terms “machinery or

equipment.” Generally accepted definitions of “machinery”

indicate that it may be “an assemblage of machines,” “the parts

of a machine collectively,” or “a system by which action is

maintained or by which some result is obtained.” Webster’s

College Dictionary 788 (2d ed. 1997). The definition includes

“an apparatus consisting of interrelated parts with separate

functions, used in the performance of some kind of work,” or “a

device that transmits or modifies force or motion.” Id. at 787.

“Equipment” includes “the articles, implements, etc., used or

needed for a specific purpose or activity.” Id. at 442.

¶13 Despite the lack of definitional specificity in the

statute, there is no dispute about its underlying purpose. The

legislature enacted A.R.S. § 42-5159(B)(1) to stimulate business

investment in Arizona in order to improve the state’s economy

and increase revenue from other taxes, such as income and

property taxes. See Ariz. Dep’t of Revenue v. Blue Line

Distrib., Inc., 202 Ariz. 266, 268, ¶ 11, 43 P.3d 214, 216 (App.

7
2002) (describing the policy supporting the “machinery or

equipment” exemption from the transaction privilege tax and

citing 71 Am. Jur. 2d State and Local Taxation § 288 (2001));

Duval Sierrita Corp. v. Ariz. Dep’t of Revenue, 116 Ariz. 200,

204, 568 P.2d 1098, 2002 (App. 1977) (same). Our interpretation

of the statute therefore should further, not frustrate, the

policy of encouraging investment and spurring economic

development.

¶14 Although the text of the statute may not clearly

reveal the legislature’s intent, the procedural history of this

case provides significant evidence of the legislature’s intended

definition and its purpose in exempting machinery and equipment

used in industrial processes from the use tax. In Arizona

Department of Revenue v. Capitol Castings, Inc., 193 Ariz. 89,

970 P.2d 443 (App. 1998) (“Capitol I”), which addressed the

issue presented in this case before the legislature amended §

41-5159(C)(1), the court of appeals held that the items at issue

did not qualify for the use tax exemption afforded by § 42-

5159(B)(1) because they were expended or consumed in the

production process. Id. at 95, ¶ 26, 970 P.2d at 449. The

court also found that the items at issue did not qualify as

machinery or equipment, but determined that this conclusion was

“moot” in light of its holding that the items fell within § 42-

5159(C)(1), which excluded “expendable materials” from the use

8
tax exemption contained in § 42-5159(B)(1). Id. at 93-95, ¶¶

14-26, 970 P.2d at 447-49.

¶15 In the course of its “machinery or equipment”

discussion, the court overruled the tax court’s opinion in

Arizona Department of Revenue v. Cyprus Sierrita Corp., 177

Ariz. 301, 303, 867 P.2d 871, 873 (Tax 1994) (“Cyprus

Sierrita”), which had held that chemicals expended during the

ore leaching process nonetheless qualified as “machinery or

equipment” for purposes of the exemption because they functioned

as machinery might in an ore leaching process and they were “an

integral part of a complicated process.” The court of appeals

also distinguished its own opinion in Duval Sierrita Corp. v.

Arizona Department of Revenue, 116 Ariz. 200, 568 P.2d 1098

(App. 1977), which had adopted two tests — the ultimate function

and integrated rule tests — for determining whether items were

machinery or equipment “used directly” in qualifying operations

under § 42-5159(B)(1).

¶16 In response to Capitol I, the legislature amended §

42-5159(C)(1), which excludes expendable materials from the

(B)(1) use tax exemption, to provide that “expendable materials

do not include any of the categories of tangible personal

property specified in subsection B of [§ 42-5159] regardless of

the cost or useful life of that property.” See 1999 Ariz. Sess.

Laws, ch. 153, § 2 (emphasis added). The amendment plainly was

9
designed to avoid the interpretation given to the prior version

of subsection (C)(1) in Capitol I. As evidenced by the parties’

arguments, however, there remains a question whether the

amendment of the (C)(1) exclusion also affects the analysis in

Capitol I of § 42-5159(B)(1), the provision exempting certain

machinery or equipment from the use tax. In Capitol II, the

court of appeals held that the amendment did not affect the

machinery or equipment analysis under subsection (B)(1). 205

Ariz. at 266, ¶ 33, 69 P.3d at 37.

¶17 The court of appeals reasoned in Capitol II that its

opinion in Capitol I contained two parts: one that “rejected

the broad interpretation of ‘machinery or equipment,’” id. at

264, ¶ 24, 69 P.3d at 35, and a second that analyzed whether the

materials at issue were expendable. Id. ¶ 25. The court

concluded that the 1999 amendment affected only the expendable

materials discussion in Capitol I, but did not affect its

discussion of what constitutes machinery or equipment. Id. at

265-66, ¶¶ 29-34, 69 P.3d at 36-37. We disagree and conclude

that this narrow interpretation of the legislative amendment

fails to give full effect to the legislature’s intent.

¶18 Several factors demonstrate that, in amending A.R.S. §

42-5159(C)(1), the legislature meant to alter the specific

result reached by the court of appeals in Capitol I, not just

the conclusion that the materials at issue were expendable and

10
therefore excluded from the exemption. First is the language of

the amendment itself. The conclusion in Capitol I that the

items at issue did not qualify as machinery or equipment was

ultimately grounded on the fact that the items were expended in

the casting process. 193 Ariz. at 95, ¶ 26, 970 P.2d at 449

(describing the question whether the items qualified as

machinery or equipment as “moot” in light of their

expendability). The legislature then promptly removed an item’s

expendability as an impediment to qualification for the use tax

exemption, thus making plain that expendable materials can

function as machinery or equipment.

¶19 Second, the legislative history of the amendment

reveals that the legislature meant to change the result of

Capitol I. Minutes of Senate Committee on Finance, 44th Leg.,

1st Reg. Sess. (Feb. 22, 1999) (discussing the case law

addressing the exemption for machinery or equipment and the

exclusion for expendable materials); Senate Fact Sheet for H.B.

2395, 44th Leg., 1st Reg. Sess. (Feb. 18, 1999) (same); Minutes

of House of Representatives Committee on Ways and Means, 44th

Leg., 1st Reg. Sess. (Jan. 26, 1999) (same); House of

Representatives Abstract for H.B. 2395, 44th Leg., 1st Reg.

Sess. (1999) (same). We are therefore reluctant to read the

amendment as leaving unaltered the ultimate result in Capitol I.

¶20 Finally, the legislature made the amendment

11
retroactive to May 19, 1977, see 1999 Ariz. Sess. Laws, ch. 153,

§ 3(A), the same day the court of appeals issued its opinion in

Duval Sierrita, which had applied broader, function-based tests

to determine whether items used in mining processes were exempt

from use tax – an opinion distinguished in Capitol I. See 193

Ariz. at 94-95, ¶¶ 21-25, 970 P.2d at 448-49. The unusual

retroactive effective date suggests three things. First, it

implies that the legislature intended to return the

interpretation of the statute to its pre-Capitol I status.

Second, because Duval Sierrita addressed only the § 42-

5159(B)(1) exemption, not the (C)(1) exclusion that was the

subject of the amendment, the retroactive date also shows the

legislature’s intent that the (C)(1) exclusion be construed to

act upon the definitions in subsection (B)(1) in a functional

way, exempting from the use tax items that would qualify under

(B)(1) even if they are expended in the manufacturing or

fabricating process. Finally, the effective date suggests the

legislature’s approval of the “ultimate function” and

“integrated rule” tests used in Duval Sierrita for determining

whether items should be exempt from use tax under § 42-

5159(B)(1).

¶21 Although the items for which exemption was sought in

Duval Sierrita differ from those at issue in this case, the

approaches developed in that case provide a useful framework for

12
analyzing whether an item is exempt under § 42-5159(B)(1). In

Duval Sierrita, the court addressed whether two types of

property qualified for the § 42-5159(B)(1) use tax exemption:

(1) spare or replacement parts for items conceded to be

machinery or equipment, 116 Ariz. at 203, 568 P.2d at 1101, and

(2) water booster pumps and steel water pipes used in Duval

Sierrita’s mining operations, id. at 202, 568 P.2d at 1100. The

answers to both questions turned on the statutory requirement

that the machinery or equipment be “used directly” in the

qualifying operations. Id. at 203, 568 P.2d at 1101. The court

concluded that rather than view each item at a fixed point in

time, without reference to its function, it should apply the

“ultimate function” test: that is, it should examine how the

item functions in the industrial process at issue to see whether

the item qualifies for the § 42-5159(B)(1) exemption. Id. at

204, 568 P.2d at 1102. For the specific items already in

service, the court adopted an “integrated approach” that

addresses how the item is used in the industrial processes

described in A.R.S. § 42-5159(B)(1) and considers the item’s

necessity to the process. Id. at 205, 568 P.2d at 1103. The

integrated approach exempts only those items that are “essential

to [the] operation and which make it an integrated system.” Id.

at 206, 568 P.2d at 1104. The Duval Sierrita approaches allow

some items that would not ordinarily be considered “machinery”

13
or “equipment” to qualify for the § 42-5159(B)(1) exemption if

they function as a necessary part of an integrated process.

Such a result furthers the legislative goal of encouraging

investment and spurring economic development.

¶22 While § 42-5159(B)(1), by its terms, applies only to

“machinery” or “equipment” that is “used directly in

manufacturing . . . operations,” Duval Sierrita clarifies that

whether an item qualifies as “machinery or equipment” must be

considered in light of the second element of the exemption, that

it be “used directly” in a manufacturing or other qualifying

process. For example, a computer used in a business is

“machinery” or “equipment.” A computer used purely for

administrative purposes, however, may not qualify for the

exemption because it is not “used directly in manufacturing . .

. operations.” But if the computer is used to manage and

control specific tasks conducted on an automated assembly line,

the computer may well qualify for the exemption as it is “used

directly in manufacturing . . . operations.” Similarly, certain

items not traditionally considered to be machinery or equipment

may qualify as such depending on their function in the process.

For example, in Cyprus Sierrita, the tax court found that three

chemicals, “sulfuric acid, LIX, and Orfom 7,” qualified as

machinery or equipment. 177 Ariz. at 302, 304, 867 P.2d at 872,

874. Although the chemicals did not fall within the commonly

14
held notions of machinery or equipment, the court found that

they functioned as such in the processes of extracting copper

from ore. Because the chemicals functioned like items

traditionally thought to be machinery or equipment, they were

exempt from use tax. Id. at 304, 867 P.2d at 874.

¶23 As these examples show, a functional approach requires

consideration of both of the exemption’s elements, as neither

element standing alone may be dispositive. By embracing Duval

Sierrita and its ultimate function and integrated rule tests,

the legislature expressed its intent to extend the exemption for

machinery or equipment beyond the narrow confines created by

Capitol I.

¶24 From this evidence, we conclude that the 1999

amendment was specifically intended to overrule Capitol I and to

reinstate the Duval Sierrita tests. Thus, in analyzing whether

an item is exempt from use tax under § 42-5159(B)(1), a court

should consider a number of factors to determine whether the

item qualifies as “[m]achinery, or equipment, used directly in

manufacturing . . . operations.” First, a court must apply

flexible and commonly used definitions of machinery and

equipment within the relevant industry. See supra ¶ 12. In

determining whether the items at issue here were machinery or

equipment, the court of appeals in Capitol I relied upon the

concept of “fixed assets,” which it defined as “physical

15
resources” such as “machinery or tools” other than land and

buildings. 193 Ariz. at 94, ¶ 19, 970 P.2d at 448. The court

in Capitol II relied upon the definition set forth in Capitol I,

finding no legislative intent to change it in the 1999 amendment

to § 42-5159(C)(1). 205 Ariz. at 266, ¶ 32, 69 P.3d at 37. In

light of the legislature’s implicit approval of Duval Sierrita’s

broader, more flexible approach, however, we find the analogy to

“fixed assets” too narrow and therefore unhelpful in determining

what constitutes machinery or equipment, especially in light of

the legislature’s disavowal of “cost or useful life” in the

expendable materials exclusion from the exemption. See A.R.S. §

42-5159(C)(1). Applying the more expansive definition of

machinery or equipment better serves the legislative goal than

does applying accounting terminology used for balance sheet and

income statement purposes.

¶25 Next, bearing in mind these flexible definitions, a

court should examine the nature of the item and its role in the

operations. Items essential or necessary to the completion of

the finished product are more likely to be exempt. See Duval

Sierrita, 116 Ariz. at 205-07, 568 P.2d at 1103-05. The

prominence of an item’s role in maintaining a harmonious

“integrated synchronized system” with the indisputably exempt

items will also directly correlate with the likelihood that the

16
exemption applies.4 Id. at 205, 568 P.2d at 1103. The closer

the nexus between the item at issue and the process of

converting raw materials into finished products, the more likely

the item will be exempt. As part of its analysis, the court

should consider whether the item physically touches the raw

materials or work in process, whether the item manipulates or

affects the raw materials or work in process, or whether the

item adds value to the raw materials or work in process as

opposed to simply reducing costs or relating to post-production

activities. In an environment such as Capitol’s, for example, a

furnace that melts scrap metal into a molten form would be

essential or necessary to enable the scrap metal to be shaped

into grinding balls or custom castings. The furnace also

affects and manipulates the scrap metal when it melts the raw

material into the desired cast shapes. Finally, by transforming

the scrap metal into a molten metal that can be shaped into

usable forms, the furnace increases the value of the scrap

metal. Throughout its analysis, a court must bear in mind that

the goal of the exemption – promoting economic development – must

4
ADOR’s failure to challenge the exemption for the metal
components of the molds suggests that both the metal and the
sand used in the grinding ball molds should qualify for the
exemption, because both the metal and sand components seem to
have performed the same functions. In an “integrated
synchronized system,” it does not seem logical that two items
performing the same function, but composed of different
materials, should be treated differently for purposes of the
exemption afforded by § 42-5159(B)(1).

17
not be frustrated by too narrow an application of § 41-5159(B).5

¶26 Applying these tests to the items at issue in this

case, we conclude that the silica sand, chemical binders,

exothermic sleeves, mold cores, mold wash, and hot topping

qualify for the exemption because they were used directly in and

were an integral part of a qualifying process under A.R.S. § 42-

5159(B)(1). The items functioned the way machinery or equipment

might in an integrated, synchronized system within the industry.

All had a close nexus to the process as they directly touched

the raw materials in the process of converting them into the

finished product. The cement and lime, on the other hand,

appear to have served the ancillary purpose of pollution control

and therefore were not as integrally related to the process. We

conclude, therefore, that the cement and lime do not qualify for

the exemption.

¶27 The record is less clear with respect to the coxy sand

and cerwool blankets that were used as refractory materials. We

remand to the tax court to determine whether these items qualify

for exemption pursuant to A.R.S. § 42-5159(B)(1).

CONCLUSION

¶28 We conclude that the court of appeals interpreted the

5
ADOR’s concession that the molds would have qualified as
machinery or equipment had Capitol purchased them preassembled,
but not if Capitol assembled the molds itself, frustrates the
legislative goal of the exemption and fails to apply Duval
Sierrita’s ultimate function test.

18
amendment to A.R.S. § 42-5159(C)(1) too narrowly and the tax

court similarly erred in its analysis in this case. We vacate

the opinion of the court of appeals, reverse the decision of the

tax court, and remand the case to the tax court for entry of

judgment as to the decided issues and for further proceedings

consistent with this opinion.

__________________________________
Rebecca White Berch, Justice

CONCURRING:

_________________________________________
Charles E. Jones, Chief Justice

_________________________________________
Ruth V. McGregor, Vice Chief Justice

_________________________________________
Michael D. Ryan, Justice

_________________________________________
Andrew D. Hurwitz, Justice

19