McElhaney Cattle Co. v. Smith

OPINION JACOBSON, Judge. This case of first impression in Arizona requires the determination of whether the — 307 — cattle comprising the “inventory” of a commercial feedlot are exempt from taxation under the “wholesaler” exemption provided by Article IX, § 2 of the Arizona Constitution or the “manufacturer” exemption provided by Article IX, § 13 of the Arizona Constitution. This action was filed by McElhaney Cattle Company (McElhaney), S & V Cattle Company (S & V) and Gary Oden and Carol Oden (Odens) (collectively referred to as the taxpayers) against the taxing authorities of Yuma County, and the Arizona Department of Revenue. The action sought a determination that feeder cattle owned by the taxpayers during 1975 were exempt from ad valorem taxation and in addition sought a refund for the additional taxes paid under protest because of the disallowance of their claimed exemption. This suit was filed after the Yuma County assessor had denied their claimed exemption and the assessor’s action was upheld by the Yuma County Board of Equalization. After trial, the trial court found that all three taxpayers were entitled to the claimed exemptions under either § 2 or § 13 of Article IX of the Arizona Constitution and that McElhaney and S & V were entitled to a refund of taxes paid under protest in the sum of $1,655.25 and $248.23, respectively. The trial court further found that the taxpayers Oden were not entitled to a refund as they had failed to pay the 1975 taxes under protest. Only the taxing authorities have appealed. The taxpayers claim they are entitled to an exemption under either § 2 or § 13 of Article IX, of the Arizona Constitution. Section 2 provides, in part: Stocks of raw or finished materials, unassembled parts, work in process or finished products constituting the inventory of a ... wholesaler located within the state and principally engaged in the resale of such materials, parts or products, whether or not for resale to the ultimate consumer, shall be exempt from taxation. Section 13 provides: No tax shall be levied on raw or unfinished materials, unassembled parts, work in process or finished products constituting the inventory of a manufacturer or a manufacturing establishment located within the state and principally engaged in the fabrication, production, and manufacture of products, wares and articles for use, from raw or prepared materials, imparting thereto new forms, qualities, properties and combinations .... The facts which the trial court found gave rise to an application of both of these constitutional provisions to the taxpayers’ feeder cattle are that McElhaney is a corporation which operates a large commercial cattle feedlot in Yuma County, Arizona. Gary C. Oden is the president and general manager of McElhaney. S & V is a partnership comprised of Sam McElhaney and his wife, Vennie McElhaney. S & V was established as a separate partnership to engage in cattle owning and feeding, which partnership is separate and distinct from McElhaney. The Odens also own and feed cattle in their individual capacities.1 The McElhaney feedlot was established approximately 30 years ago and presently has a capacity of approximately 55,000 head of cattle. The feedlot has an inventory turnover of approximately 1.3 times per year, so that if it operated at capacity year-round, approximately 70,000 head of cattle would be processed through the feedlot. Because of line of credit limitations, the taxpayers at any given time are limited to feeding 20,000 to 25,000 head of cattle owned by them. Because of the fixed costs of the operation, significant economic savings per head of cattle can be achieved by operating the feedlot at full capacity. For this reason, feeder cattle owned by persons other than the taxpayers are fed at the McElhaney lot, thus reducing the taxpayers’ unit cost for feeding their own cattle. — 308 — The testimony indicated that this was the primary purpose for feeding other people’s cattle. The taxpayers are only claiming exemption on cattle owned by them. During the 30 years McElhaney has been in the feedlot business, significant technological and scientific developments have occurred in the preparation of cattle for ultimate human consumption. McElhaney’s original operation consisted primarily of feeding the cattle hay, cottonseed hulls, grain and cottonseed meal. The only equipment used was a grinder and a wagon to deliver the feed to the cattle. The mixing of the feed was by hand. Under this type of operation, it took two to four years to prepare an animal for market. The advances made in this business were basically in two areas, nutritional and genetic. On the nutritional front, scientists have isolated the various vitamins and nutrients which underly the metabolic process of the animal. Through research, some 12 or 13 different nutrients have been identified, their functional values determined, and various combinations developed which produce a given end effect in the animal. Among the scientific advances was the discovery of the compound glycogen, which develops the desired “marbling” qualities in meat (the presence of small flecks of fat between the muscle fibers). The marbling quality of meat is the primary standard utilized by the United States Department of Agriculture in grading a meat carcass as prime, choice, or a less desirable grade. Thus, through the scientific combination of roughage, minerals, proteins, vitamins and additives in a feeder steer’s diet, the desired end carcass can be achieved. In order to deliver this highly technical diet to the animal an elaborate and sophisticated system of machinery is now utilized. This consists of mixers, weighing systems, metering devices, electrical control systems, grain flaking equipment, bins and storage elevators. On the genetic front, research has isolated the female hormone DES and other hormones which can develop the desired characteristics of beef for human consumption. These hormones are either implanted in the steer’s ear or mixed with the feed ration. The introduction of female hormones into the feeder steer is important because of the necessity to castrate bull calves (99% of the taxpayers’ feeder cattle start as bull calves). Castration is necessary to avoid the heavy front shoulders and neck characteristics of bulls which produce undesirable cuts of meat. However, castration retards the potential rate of weight gain. The use of hormones offsets this loss of gain and allows the steers to “finish” at a more rapid rate than untreated steers. Also, hormones cause heavy development in the rear quarters of the animal, from which come the most desired cuts of meat. As a result of these scientific and technological advances, the time necessary to produce a marketable animal of 1,000 to 1,100 pounds has been reduced from a period of two to four years to a period of approximately 200 days (starting with a 400 pound calf) or 300 days (starting with a 250 pound calf). The animals that the taxpayers purchase for feeding, described as “range” or “pasture” calves, weigh between 250 and 400 pounds, have an extremely low fat content and glycogen level and are economically unmarketable for human consumption at time of purchase. The breed, grade and weight of range calves purchased by the taxpayers are determined for their ultimate sale to the chain store market, such as Safeway. This market requires a “finished” animal which will produce a carcass weighing between 600 and 650 pounds, graded choice with a yield grade (the amount of marketable meat) of two or three (on a one to six scale where one is the highest yield grade). As the result of the taxpayers’ treatment, a substantial transformation of the range calf to the “finished” steer occurs. The shape and contour of the animal is changed, its weight is shifted from the shoulder and neck area to the loin and hip area, the meat has more marbling than occurs in nature and the meat has a more desirable taste. As the taxpayers’ expert, Dr. William H. Hall, testified: — 309 — Yes, there have been changes in the morphology in the fact that the muscles are bigger, they are thicker; the back is covered over, and in the case of a bull, he’s lost a bull appearance .... You would not recognize the animal in terms of the animal that was originally purchased. In short, what is produced is an animal with a heifer form on a bull frame. All of the range calves purchased by the taxpayers (with a minimal exception for home and friend consumption) are ultimately destined for resale, at wholesale, to meat-packers who sell to the chain stores. The economics of the taxpayers’ feedlot operation is that a profit is derived if the finished steer sells for more than the original cost of the animal, plus the expense of producing the finished animal. In this regard, for the years prior to 1973, the taxpayers’ proceeds from the sale of steers exceeded their expenses. Following 1973, and in the year in question, because of adverse market conditions, the taxpayers, like other cattle feeders generally, suffered large losses on the sales of cattle raised. During this period, the amount of money received from other cattle owners whose cattle the taxpayers were feeding on the McElhaney lot exceeded the amount of losses suffered on the taxpayers’ own cattle. Charges to third parties for raising their cattle are based upon a fixed dollar fee per ton of feed used. This charge includes services provided and a flat markup of $20 per ton. The taxpayers “charge” themselves the same fixed fee in determining their profit or loss. For federal income tax purposes, the taxpayers are considered “cattle feeders” engaged in selling steers to customers in the ordinary course of business; gain on the sale of animals is considered ordinary income, not capital gain, and no depreciation is allowed on the animals. Based upon these facts, the trial court found that the cattle owned by the taxpayers in 1975 were exempt from taxation under the two provisions of the Arizona Constitution previously referred to. We first turn to a determination of whether the trial court’s ruling can be justified under Article IX, § 2, which exempts from taxation the “raw” materials and “work in process” of “wholesalers.” The taxing authorities first urge that the evidence in this case must be viewed from the perspective that the presumption is against tax exemption and the burden is on the taxpayer to establish the right to the exemption. See Conrad v. County of Maricopa, 40 Ariz. 390, 12 P.2d 613 (1932); Fry v. Mayor and City Council of Sierra Vista, 11 Ariz.App. 490, 466 P.2d 41 (1970). From this premise, they argue that the tax exemptions involved here should be narrowly construed. The taxpayers, on the other hand, contend that the stated purpose of these constitutional amendments was to encourage the greater industrial development of this state, thereby producing more jobs for more Arizona people and result in producing more revenue for the state. See County of Apache v. Southwest Lumber Mills, Inc., 92 Ariz. 323, 376 P.2d 854 (1962). From this premise, the taxpayers argue that the constitutional amendments should be liberally construed. In the court’s opinion, rules of construction, either liberal or restrictive, are not particularly helpful in resolving the issues involved. These constitutional amendments appear clear and unambiguous. Either the evidence established that the taxpayers were primarily engaged in the business of wholesaling (there is no contention by either party that the taxpayers are “retailers”) and that the feeder cattle constitute either raw materials or work in process, or it did not. The taxing authorities next argue that the taxpayers are not wholesalers. This argument is two-pronged. First, the argument is made that in ordinary parlance, a wholesaler is a merchant who buys and sells merchandise, and live cattle are not merchandise. No citation of authority is given for this proposition. In our opinion, neither the constitutional provisions nor “ordinary — 310 — parlance” requires such a restrictive definition. “Wholesaler” is defined under the transaction privilege tax statutes (A.R.S. § 42-1301(24)), as “any person who sells tangible personal property for resale and not for consumption by the purchaser.” This same statute defines “tangible personal property” as that “which may be seen, weighed, measured, felt, touched or is in any other manner perceptible to the senses.” A.R.S. § 42-1301(21). We see no reason why this statutory definition of “wholesaler” is not equally applicable to define “wholesaler” in Article IX, § 2. The fact that the inventory of the wholesaler is “alive” should not change the definition. A wholesaler who supplies pet shops with puppies, guppies, kittens and mice is no less a wholesaler simply because his merchandise is not inanimate. The second prong of the taxing authorities’ argument is that the taxpayers are not wholesalers because they consider themselves to be “cattle feeders.” This argument overlooks, insofar as the taxpayers’ own cattle are concerned, from what business they intend to derive a profit. They derive no profit from feeding their own cattle. It is only when that feeder steer is sold that a profit (or loss) is realized. They purchase a product which according to the testimony has no marketability for human consumption. They hold that product for between 200 and 300 days and perform certain operations on the product. Simply because they hold the product in inventory for a period of time and somehow change that product while it is in their possession does not change the nature of the business from which they ultimately hopq to derive a profit. The product is then resold to a slaughterer who then sells to a retailer who sells to the ultimate consumer. We realize that underlying the taxing authorities’ “non-wholesalers” argument is an unarticulated concern that the taxpayers are really engaged in animal husbandry which has not traditionally been thought of in commercial terms as wholesaling. While we find nothing in the constitutional provisions which would automatically exclude any person engaging in animal husbandry from the classification of a wholesaler, we do not rest our decision that the taxpayers here are wholesalers on this ground. Rather, in our opinion, the evidence established that the taxpayers’ sophisticated operation so changed and accelerated nature’s basic product as to remove their business from the general classification of raising livestock. Therefore, even if we assume that an ordinary raiser of livestock could not under our constitution be classified as a “wholesaler,” this assumption would still not preclude the taxpayers’ operation from such classification. We therefore hold that insofar as the taxpayers’ own feeder steers are concerned, the taxpayers fall within the definition of a “person who sells tangible personal property for resale and not for consumption by the purchaser” and qualify as a wholesaler. The taxing authorities next argue that if the taxpayers can be classified as wholesalers, then they are not “principally engaged” in the resale of the feeder steers. This argument is both definitional and practical. From the definitional standpoint, the argument is made that wholesaling involves only the buying and selling of inventory. Since only a small fraction of the taxpayers’ time is spent in actually buying the range cattle and selling the finished steers, while the majority of the taxpayers’ time is spent in putting the feeder steers into a marketable condition, the argument continues that the taxpayers are not “principally engaged” in the resale of the inventory. The attempt to create a separation between “feeding” and “selling” insofar as the taxpayers’ operation is concerned is not supported by the evidence. The evidence here clearly shows that the sole end result of the taxpayers’ operation was the wholesaling of the finished steers. The evidence was uncontradicted that the “feeding” operation was simply an integrated component of this end result. It would appear that the constitutional provision providing that a wholesaler’s “work in process” would be exempt contemplates some activity on behalf of the — 311 — wholesaler to prepare his product for resale. The evidence clearly establishes that the “feeding” operation was simply part of this activity and could not be separated from the overall purpose of being “principally engaged” in resale of the product. The taxing authorities’ other argument that the taxpayers are not “principally engaged” in wholesaling is on a more practical level. They point to the dictionary definition of “principally” as being “in a principal manner; in the chief place or degree; primarily, chiefly, namely.” They then point to the evidence that from an economic standpoint more income was derived by the taxpayers from their feedlot operations in feeding other persons’ cattle than from the sale of the taxpayers’ own cattle. From this premise, they argue that the taxpayers’ primary or chief occupation is custom feeding cattle owned by others rather than wholesaling their own cattle. This argument is the strongest of the taxing authorities’ contentions. As both parties agree, what constitutes an occupation in which one is “principally engaged” is a question of fact as the word “principally” is in itself an indefinite and vague adverb. Sutton v. Hawkeye Cas. Co., 138 F.2d 781 (6th Cir. 1943). It would appear to us that comparable time, effort, income, cattle units fed and the subjective intent of the persons owning the business are all material in determining whether a person is “principally engaged” in a particular activity. However, the taxing authorities’ contention that economic benefit is the sole criterion upon which this issue should be resolved, is not necessarily true. The fact that an individual does not derive a profit from a given activity does not mean that individual is not principally engaged in that activity. We therefore will review the evidence to determine whether it supports the trial court’s express finding that the taxpayers are principally engaged in the wholesaling of feeder cattle. The evidence shows that approximately 45% of the carrying capacity of the feedlot is comprised of feeder cattle owned by the taxpayers. While this number is less than 50%, the testimony shows that the limitation on the number of cattle the taxpayers could own was dictated by a line of credit limitation rather than a desire to limit the number of owned cattle. Moreover, the evidence shows that prior to 1973, the primary source of the taxpayers’ income was the sale of their own cattle. The reason for the turnaround in 1973,1974 and 1975 was a drop in the beef market which was viewed as a temporary condition. Also, the “losses” for these years were computed on the basis of the paper markup the taxpayers charged themselves for feeding the cattle— the same markup they charged other persons for feed and services. The testimony also showed that the sole purpose for feeding other cattle at the feedlot was to lower the unit cost of feeding their own animals. While the trial court was free to draw other conclusions from this evidence, we are not. We find that the evidence presented supports the trial court’s conclusion that the taxpayers were “principally engaged” in the wholesale business. We therefore conclude that the evidence supports the trial court’s determination that the feeder steers owned by the taxpayers were exempt from taxation under Article IX, § 2 of the Arizona Constitution. Since the trial court’s judgment can be affirmed on this basis, we do not determine whether the taxpayers’ operation qualified them as “manufacturers” under Article IX, § 13 of the Constitution. Judgment affirmed. HAIRE, P. J., concurs. Footnotes [1] The taxing authorities, in their presentation before this court, have not attempted to distinguish among McElhaney, S & V and Odens, insofar as the legal principles applicable here are concerned. For this reason, this opinion shall treat all these taxpayers similarly.