A primer on the California manufacturer's investment credit.

I. Introduction

In 1993, the California Legislature passed, and Governor Wilson signed, Senate Bill (SB) 671,(1) which was one of the farthest reaching business tax reform bills in recent California history. The impetus for the bill was pressure to modify California's then-existing "water's-edge" election, but the final days of the legislative session saw SB 671 transformed into a comprehensive tax reform package which included a manufacturer's investment credit and a manufacturer's sales/use(2) tax exemption.(3) The following year saw the enactment of SB 676,(4) which amended the 1993 credit and exemption legislation.

This article summarizes the major provisions of the California manufacturer's investment credit. (The sales tax exemption will be the subject of a future article.) The article also discusses the status of both the California State Board of Equalization's Proposed Regulation 1525.2 on the sales tax exemption, and the California Franchise Tax Board's announced regulation project on the manufacturer's investment credit.

II. Background

A. The Legislative History of SB 671 and SB 676

The history of the manufacturer's investment credit (and the sales tax exemption) begins with Assembly Bill (AB) 1313, which was introduced during the 1993 California legislative session. AB 1313 was sponsored by the California Manufacturers Association and would have exempted from the State's portion of the sales tax (i.e., six percent) property used in the manufacturing process beginning July 1, 1994. The argument behind the bill was that California's tax on manufacturing equipment, which dated to 1933 when the sales tax was instituted, had become anachronistic: California was only one of eight states that taxed manufacturing equipment.(5) AB 1313 encountered significant resistance in the Senate Revenue and Taxation Committee, principally owing to a projected annual revenue loss of approximately $895 million beginning in 1994-1995. Through a series of political compromises and maneuvers, SB 671 - a bill originally drafted solely to reform California's water's-edge election - was amended to incorporate a tax incentive for the purchase of manufacturing equipment. Rather than the broad sales tax exemption proposed in AB 1313, however, SB 671 took a bifurcated approach:

* A sales tax exemption for qualified property used primarily in manufacturing or research or development for start-up companies that began business activity in California on or after January 1, 1994. The exemption would be available only during the first three years of operations. (In the alternative, the start-up company could choose the six-percent investment tax credit - below.)

* A six-percent investment tax credit for qualified property used primarily in manufacturing or research and development. The credit would be effective for purchases after December 31, 1993, and could be carried forward.

A series of amendments followed, culminating in SB 671's enactment into law in 1993. The 1994 legislative session brought additional developments, and SB 1292 was introduced to make two types of changes to SB 671's exemption and credit provisions. First, the 1994 bill was intended to clarify or modify some of the provisions of SB 671. Second, it was intended to expand the credit to include leased equipment.(6) Ultimately, SB 1292 failed to clear the Senate Appropriations Committee. Instead, another bill - SB 676 - was amended to include modifications to the credit and the exemption and to expand the credit to include leased equipment. SB 676 was then passed by the Legislature and signed by the Governor.(7)

B. SBE Proposed Regulation

1525.2 on the Sales

Tax Exemption

Although the focus of this article is the manufacturer's investment credit, the enactment of the credit should be placed in the context of the overall legislative effort that also produced the sales tax exemption. In 1993, the legislature took the sales tax exemption proposed in AB 1313, which would have been administered solely by the California State Board of Equalization (SBE), and in SB 671 split it into two pieces: (1) a sales tax exemption to be administered by the California SBE, and (2) an investment credit to be administered by the California Franchise Tax Board (FTB). As a result, two separate California tax administrative agencies are charged with implementing and administering separate provisions that contain parallel or identical language. Both agencies soon announced plans to issue regulations on the subject.

The sales tax exemption enacted in 1993 by SB 671 applies to sales made commencing January 1, 1994. Accordingly, the California SBE attempted as quickly as possible to promulgate regulations to implement the exemption. A draft of SBE Proposed Regulation 1525.2 appeared in early 1994, and the first of a series of public hearings was held on August 4, 1994. As this article goes to press, the regulation is not yet final.

C. FTB Proposed Regulation on the Investment

Credit

The investment credit applies to qualified property purchased after December 31, 1993, but the credit cannot be claimed on the taxpayer's 1994 return. Instead, the 1994 credit will be allowed in the 1995 taxable year on the 1995 return (as will the amount allowed for purchases in 1995). Accordingly, the FTB chose not to begin work immediately on the investment credit regulations, but to wait until the SBE's exemption regulations were well under way. In November 1994, the FTB formally announced in Notice 94-5(8) its intention to draft and subsequently adopt a regulation, and solicited input on nine aspects of the credit.(9) In December 1994, the FTB announced in Notice 94-7(10) that it would conduct a public "symposium" to solicit input on its proposed regulatory action. Predictions are that a draft of the proposed regulation will be available in June 1995, and will be followed by a public hearing in late summer. Pending the issuance of regulatory guidance, the FTB in November 1994 released Publication 1137 (captioned "Manufacturers' investment Credit") to answer questions regarding the credit.

Recall the timing of the proceedings. The SBE regulation project on the sales tax exemption is now nearing completion, whereas the FTB project on the manufacturer's investment credit is only starting. Consequently, the FTB regulation will likely be modeled upon the SBE proposed regulation. For this reason, taxpayers wishing to anticipate the FTB's position on how the investment credit will be administered should note how the comparable issue is addressed in the SBE's exemption regulation.

III. Major Provisions of the California

Manufacturer's Investment Credit(11)

As a general principle, a "qualified taxpayer" will be allowed a credit against "tax" equal to six percent of the "qualified cost" of "qualified property" that is "placed in service" in California.(12) Each of these terms requires explanation.

A. Qualified Taxpayer

The statute is explicit that only a "qualified taxpayer" may claim the credit,(13) but does a poor job in defining that term.(14) Indeed, the statute states only that a qualified taxpayer is a taxpayer "engaged in those lines of business" described in SIC Codes 2000 to 3999 inclusive, which are generally regarded as the SIC codes for manufacturing operations. Obvious questions arise regarding whether a single taxpayer may have multiple SIC Codes, and what types of entities may be a taxpayer for purposes of the credit. Publication 1137 provides some answers. First. a qualified taxpayer may be an individual, partnership, corporation, limited liability company, or a trust. Second, Publication 1137 confirms that a taxpayer may have multiple SIC Codes for purposes of the credit:

An establishment is an economic unit, generally at a single physical location, where business is conducted or where services or industrial operations are performed. If distinct and separate economic activities are performed at a single physical location, each activity is treated as a separate establishment. For the purposes of this publication, the terms establishment and line of business are synonymous.

The significance of this language can be easily illustrated. Assume a corporation operating 20 retail grocery stores (SIC Code 5411) operates its own bakery (SIC Code 2051). SIC Code 5411 immediately precludes the grocery stores from obtaining the credit. But if the bakery is an "establishment" (i.e., if the bakery is at a separate physical location from the retail grocery stores or the bakery is at the same physical location as a grocery store but performs a distinct and separate economic activity), the credit may be claimed for qualified equipment purchased by the bakery (assuming all other requirements of the credit are met).

B. Qualified Cost

Qualified cost' is defined in detail in the statute(15). In summarizing the statute, Publication 1137 states that qualified costs are costs satisfying the following three requirements:

* Paid or incurred on or after January 1, 1994, for the acquisition, construction, or reconstruction of qualified property;

* Paid or incurred for property on which sales or use tax has been paid, either directly or indirectly, by the taxpayer; and

* For property chargeable to the capital account of the qualified taxpayer, except in the case of certain operating leases.

Publication 11-37 also states that "qualified cost" may include the value of capitalized labor that is either directly allocable to the construction or modification of qualified property or is a direct cost for constructing or modifying a special purpose building or foundation.(16)

The statute also sets forth a series of special rules regarding payments under a binding contract. An open issue under SB 671 was whether and to what extent the credit could be claimed for qualified property purchased under a contract entered into before January 1, 1994. SB 676 resolved this issue by providing that, in the case of qualified property constructed, reconstructed, or acquired by a qualified taxpayer pursuant to a binding contract(17) in existence on or before January 1, 1994, costs paid under the contract must be allocated to qualified property based on a ratio of costs actually paid before January 1, 1994, and total contract costs actually paid. Only costs allocated to the period after December 31, 1993, are qualified costs for purposes of the credit.(18) Other special rules apply to contracts that are replacement or successor contracts to contracts that were binding prior to January 1, 1994.(19)

C. Qualified Property

"Qualified property" is property that is describe as either of the following:(20)

* Tangible personal property defined in section 1245(a) of the Internal Revenue Code that is used(21) by a qualified taxpayer in one of the lines of business described in SIC Codes 2000 to 3999, inclusive, "primarily"(22) for any of the following:(23)

* Manufacturing,(24) processing,(25) refining,(26) fabricating,(27) or recycling.(28)

* Research and development.(29)

* Maintaining, repairing, measuring, or testing qualified property.

* Pollution control that meets or exceeds standards established by the State or any local or regional government agency within the State.

* "Special purpose buildings and foundations"(30) that are constructed or modified for use by a qualified taxpayer engaged in -

* Manufacturing activities described in SIC Code 357 (manufacturing computer or software equipment) or SIC Code 367 (electric components and accessories);

* Activities related to biotech described in SIC Code 8731 (commercial physical and biological research and development on a either contract or fee basis); or

* Activities relating to biopharmaceutical(31) establishments that are described in SIC Codes 2830 to 2836, inclusive (manufacturing, fabricating, or processing of medicinal chemicals and pharmaceutical products).(32)

In addition, the statute specifically enumerates items that cannot be "qualified property." Those items are furniture, facilities used for warehousing purposes after completing of the manufacturing process, inventory, equipment used in the extraction process, equipment used to store finished products that have completed the manufacturing process, any tangible personal property used in administration, general management, or marketing, and any vehicle for which the low-emission vehicle credit has been claimed.(33)

D. Placed in Service in California

A fundamental limitation upon the credit is that the property must be placed in service in California.(34) If any qualified property for which a credit is allowed is removed from California, disposed of to an unrelated party, or used for a nonqualifying purpose within one year from the date the property is first placed in service in California, the amount of the credit allowed must be recaptured by adding the credit amount to the qualified taxpayer's net tax in the taxable or income year in which the disposition occurs.(35)

E. Credit against "Tax"

The manufacturer's investment credit can be applied against a variety of taxes under the California Bank and Corporation Tax Law, including the corporation franchise tax, corporation income tax, and the tentative minimum tax. The credit, however, may not reduce the corporate minimum franchise tax.(36)

Any part of the credit exceeding the tax liability in the taxable or income year may be carried forward to future years. Generally, the credit may be carried over for a maximum of seven years.(37) If the qualified taxpayer operates a qualified 'small business,' however, the carryover period is nine years.(38)

F. Interplay of Credit and Exemption

Two points should be kept in mind about the interplay of the manufacturer's investment credit with the sales tax exemption. First, the credit and the exemption a mutually exclusive, since the credit will not be allowed for any property for which sales or use tax has not been paid.(39) Conversely, the exemption will not be allowed for any property for which the credit has been claimed.(40)

Second, a taxpayer who qualifies for the credit and paid sales tax on the property for which the credit could be claimed may instead file a claim for refund equal to the amount of the credit. The claim, which must be filed on a form prescribed by the SBE, cannot be filed earlier than the date a claim could have been made for a credit or carryover of the credit. In addition, a taxpayer's refund claim cannot be for an amount in excess of the amount of the credit that could have been used to offset bank or corporation tax liability. Moreover, no interest will be paid on such a refund.(41)

G. Recordkeeping

Although the statute does not contain any specific recordkeeping requirements regarding the credit, Publication 1137 states that the FTB "recommends" taxpayers claiming the credit maintain the following types of records "in sufficient detail to substantiate credit eligibility":

* Separate reports on the number of employees and their wages;

* Sales or other receipts;

* Property and equipment records; and

* Other types of financial data, such as financial statements, job costing, and profit center accounting information.

IV. Conclusion

The enactment of the manufacturer's investment credit represents a landmark in California's effort to create economic incentives for the California business. The newness of the credit, the lack of FTB regulations, and the ever-present specter of further legislative amendments, however, make its application unpredictable at the present time. Taxpayers with California activities should thoroughly review the statute in an effort to maximize the credit's effect and, hence, minimize their California tax liability.

Notes

(1) 1993 Cal. Stat. ch. 881. (2) Throughout this article, the term "sales tax exemption" is used to refer to the sales/use tax exemption enacted by the California legislature. (3) For a more detailed history of SB 67 1, see Eric J. Coffill, A Kinder, Gentler "Waters-Edge" Election: California Wards Off Threats of U.K. Retaliation as Part of Comprehensive Business Incentive Tax Package, Tax Notes, Oct. 25, 1993, at 477. (4) 1994 Cal. Stat. ch. 751. (5) See Analysis of AB 1313 (as amended on Aug. 16, 1993) by California Senate Revenue and Taxation Committee; Analysis of AB 1313 (as amended on Aug. 24, 1993) by California Senate Revenue and Taxation Committee. (6) See Analysis of SB 1292 (as amended on May 12, 1994) by the California Senate Revenue and Taxation Committee; Analysis of SB 1292 (as amended on June 13, 1994) by the California Senate Revenue and Taxation Committee. (7) The 1995-1996 California legislative session commenced on December 5, 1994, and is not scheduled to adjourn until September 15, 1995. Accordingly, ample opportunities remain for more changes to the credit and exemption provisions during the current legislative session. (8) See FTB Notice 94-5, Request for Public Comment, Drafting of Proposed Regulations, Manufacturers' Investment Credit (Nov. 23, 1994). (9) The areas identified in FTB Notice 94-5 are (1) defining the beginning and the end of the manufacturing process; (2) clarifying the determination of who is a "qualified taxpayer"; (3) providing specific rules applicable to "turn-key" and other fixed-price construction contracts; (4) further defining "recycling"; (5) further defining "research and development"; (6) clarifying the reporting requirements applicable to successor leases; (7) defining "capitalized labor costs"; (8) defining binding contracts, including option contracts; and (9) further defining special purpose buildings. (10) See FTB Notice 94-7, FTB Pre-Drafting Symposium on Proposed Regulations for Manufacturers' Investment Credit (Dec. 16, 1994). (11) There are a multitude of unknowns regarding the credit's scope of operation. For example, a series of special rules enacted in SB 676 now extend the credit to operating leases. See Cal. Rev. & Tax. Code [sections] 23649(f) and Publication 1137. These rules are beyond the scope of this article, but FTB Notice 94-5 does state that an issue needing further clarification by regulation is "clarifying the reporting requirements applicable to successor lessees." As previously stated, the statute's complexities are compounded by the following facts: (1) the SBE exemption regulation, which is expected to serve as the model for the FTB regulation, is not yet final; (2) the FTB has not started the public hearing process on its project; and (3) the legislature may make additional changes to the credit. Accordingly, the description in the text that follows is necessarily only a tentative summary of the major provisions of the credit. Readers are urged to study the statute, regulations (when they are issued), and other pronouncements (such as Publication 1137) for further details. (12) Cal. Rev. & Tax. Code [sections] 23649(a)(1). (13) Cal. Rev. & Tax. Code [sections] 23649(a)(1). (14) FTB Notice 94-5 states that one of the issues needing further clarification by regulation is "clarifying the determination of who is a `qualified taxpayer.'" (15) Cal. Rev. & Tax. Code [sections] 23649(b)(1). (16) See also Cal. Rev. & Tax. Code [subsections] 23649(b)(1)(A), 23649(b)(1)(C), 23649(d)(2), and 23649(d)(3)(B). FTB Notice 94-5 states that one of the issues needing further clarification by regulation is "defining capitalized labor costs." (17) "Binding contract" is not specifically defined in the statute. Cal. Rev. & Tax. Code [sections] 23649(b)(3) states, however, that a contract shall be treated as binding even if the contract is subject to a condition, and that certain option contracts may be treated as binding. See also Publication 1137. FTB Notice 94-5 states that one of the issues needing further clarification by regulation is "defining binding contracts, including option contracts." (18) See Cal. Rev. & Tax. Code [sections] 23649(b)(1)(A). (19) See Publication 1137; Cal. Rev. & Tax. Code [subsections] 23649(b)(2)(A) and 23649(b)(2)(B). (20) Cal. Rev. & Tax. Code [sections] 23649(d). (21) Cal. Rev. & Tax. Code [sections] 23649(d)(1)(A) provides that "use" (i) begins at the point at which any raw materials are received by the qualified taxpayer and introduced into the process and (ii) ends at the point at which the manufacturing, processing, refining, fabricating, or recycling has altered tangible personal property to its completed form, including packaging, if required. Further, Cal. Rev. & Tax. Code [sections] 23649(d)(5) states that qualified property includes (i) neither equipment used for warehousing purposes after completion of the manufacturing process, (ii) nor equipment used to store finished products that have completed the manufacturing process. Publication 1137 is silent on this issue, but FTB Notice 94-5 states that one of the issues needing further clarification by regulation is "defining the beginning and the end of the manufacturing process." (22) "Primarily" is defined in Cal. Rev. & Tax. Code [sections] 23649(e)(3) to mean tangible personal property used 50 percent or more of the time in a qualified activity. (23) Cal. Rev. & Tax. Code [sections] 23649(d)(1). (24) "Manufacturing" is defined in Cal. Rev. & Tax. Code [sections] 23649(e)(2). (25) "Processing" in defined in Cal. Rev. & Tax. Code [sections] 23649(e)(4). (26) "Refining" is defined in Cal. Rev. & Tax. Code [sections] 23649(e)(5). (27) "Fabricating" is defined in Cal. Rev. & Tax. Code [sections] 23649(e)(1). (28) "Recycling' is not specifically defined in the statute. FTB Notice 94-5 states that one of the issues needing further clarification by regulation is "further defining `recycling.'" (29) "Research and development" is defined in Cal. Rev. & Tax. Code [sections] 23649(e)(6) as "those activities that are described in section 174 of the Internal Revenue Code or in any regulations thereunder." FTB Notice 94-5 states that one of the issues needing further clarification by regulation is "further defining `research and development.'" (30) "Special purpose building and foundation" is a complex term of art under the statute. See Cal. Rev. & Tax. Code [sections] 23649((d)(3)(C). FTB Notice 94-5 states that one of the issues needing further clarification by regulation is "further defining special purpose buildings." (31) "Biopharmaceutical activities" is defined in Cal. Rev. & Tax. Code [sections] 23649(d)(3)(D). (32) Cal. Rev. & Tax. Code [sections] 23649(d)(3). (33) Cal. Rev. & Tax. Code [sections] 23649(d)(5). (34) Cal. Rev. & Tax. Code [sections] 23649(a)(1). As an aside, query whether a tax incentive which is conditioned upon investment in a state can survive a constitutional attack. See generally Walter Hellerstein, West Lynn Creamery Inc. v. Healy and the Constitutionality of State Tax Incentives: A Preliminary Analysis, State Tax Notes, October 24, 1994, at 1182. (35) Cal. Rev. & Tax. Code [sections] 23649(g). (36) Cal. Rev. & Tax. Code [subsections] 23649(a)(1) and 23036. (37) Cal. Rev. & Tax. Code [sections] 23649(h)(1). (38) Cal. Rev. & Tax. Code [sections] 23649(h)(2). Cal. Rev. & Tax. Code [sections] 23649(e)(7) defines "small business" to mean a taxpayer that meets any of the following requirements during the income year for which the credit is allowed: (1) gross receipts of less than $50 million, or (2) net assets of less than $50 million, or (3) a total manufacturer's investment credit of less than $1 million. (39) Cal. Rev. & Tax. Code [sections] 23649(b)(1)(B). (40) Cal. Rev. & Tax. Code [sections] 6377(b)(9)(C). (41) 1994 Cal. Stat. ch. 547, which enacted Cal. Rev. & Tax. Code [sections] 6902.2.

ERIC J. COFFILL is Of Counsel in the Sacramento office of Morrison & Foerster, where he practices with the State and Local Tax Group. He is also an Adjunct Professor at McGeorge School of Law and is a faculty member at the University of California's Center for State and Local Taxation Summer Institute. He was a participant in the California legislative process that resulted in the enactment of the manufacturer's investment credit.