A primer on the California sales/use tax manufacturing equipment exemption.

I. Introduction

In 1993, the California Legislature passed and Governor Wilson signed Senate Bill (SB) 671.(1)(*) SB 671 was a comprehensive tax reform bill, which included a manufacturer's investment credit and a manufacturer's sales/use tax exemption. The manufacturer's investment credit was the subject of a previous article in The Tax Executive.(2) This article summarizes the major provisions of the manufacturer's sales/use tax exemption as interpreted by a recent regulation issued by California's State Board of Equalization (SBE).

II. Background

A. Legislative History

The history(3) of the manufacturer's sales/use tax exemption begins in 1993 with Assembly Bill (AB) 1313, authored by Assembly Member (and then Assembly Speaker) Brown. California has imposed a tax on manufacturing equipment since the sales tax was instituted in 1933. It is one of eight states that taxes manufacturing equipment. AB 1313 was introduced to exempt from the state portion of the sales tax property used in the manufacturing process, while permitting the continued collection of locally-levied sales taxes (consisting of a 1.25-percent uniform rate plus local-option rates). The California Manufacturers Association, the sponsor of AB 1313, argued an exemption for manufacturing equipment would accomplish the following:

"We will immediately become competitive with 42 other states that are now luring manufacturers away from California with promises of lower taxes. We will provide California companies with an immediate incentive to expand their facilities and create new jobs. And we will send a very clear signal to companies throughout the world that California is back in business."(4)

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 manufacturing equipment. AB 1313 eventually died in committee, effectively supplanted by SB 671, even though the latter bill did not incorporate the broad sales/use tax exemption contained in AB 1313. Instead, SB 671 created a relatively broad six-percent manufacturer's investment credit and a relatively narrow sales/use tax exemption, which was limited to 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. Further, the exemption was available only during the first three years of operations.

A series of amendments followed, which culminated in SB 671's enactment into law in 1993. The 1994 legislative session brought additional developments, the most significant one being SB 676, which modified the exemption (as well as the manufacturer's investment credit). SB 676 was enacted into law in 1994.(5)

B. SBE Regulation 1525.2

The sales/use tax exemption is codified at section 6377 of the California Revenue Taxation Code. Because many questions were left unanswered by the statute, the SBE almost immediately began an interpretative regulation project. The January 1, 1994, effective date created pressure for regulations as quickly as possible, and by early 1994, tentative drafts of a proposed regulation had been prepared by the SBE staff. In April 1994, the SBE released Proposed Regulation 1525.2, captioned "Manufacturing Equipment," which was designed to implement the new exemption.(6)

This relatively modest, 11-page draft was the subject of a spirited public hearing on August 4, 1994. As a consequence of that hearing, the April draft was abandoned. In October 1994, the SBE issued a new and more comprehensive version of Proposed Regulation 1525.2.(7) A public hearing was held on this new draft on December 6, 1994. There followed two additional notices by SBE of further changes to the proposed regulation.(8) The final version of Proposed Regulation 1525.2 was then submitted to the Office of Administrative Law, and was approved on July 19, 1995. The regulation was officially promulgated as Regulation 1525.2 of Title 18 of Chapter 2, Subchapter 4, of the California Code of Regulations.

III. Major Provisions of Regulation 1525.2

The "exemption" provided by section 6377 is, in reality, only a partial exemption. For the period commencing on January 1, 1994, and ending on December 31, 1994, the exemption applies to the taxes imposed by the State of California (i.e., 6%), but does not apply to the taxes imposed by counties, cities, and districts pursuant to the Bradley-Burns Uniform Local Sales and Use Tax Law, or the Transactions and Use Tax Law. Beginning January 1, 1995, the exemption rate effectively drops to five percent, and continues not to apply to the Bradley-Burns Uniform Local Sales and Use Tax Law or the Transactions and Use Tax Law.(9)

A. Items Subject To The Exemption

Subject to the limitations set forth above, the exemption applies to gross receipts from the sale, storage, use, or other consumption in California of the following items:

1. "Tangible personal property" purchased for use by a "qualified person" to be used primarily in any stage of the manufacturing, processing, refining, fabricating, or recycling of property, beginning at the point that raw materials are received by the qualified person and introduced into the process and ending at the point at which the property has been altered to its completed form, including packaging, if required.(10) The regulation provides guidance on when raw materials will be considered to have been introduced into the process,(11) and also sets forth a definition of "packaging."(12)

2. Tangible personal property purchased for use by a qualified person to be used primarily in research and development, as defined.(13)

3. Tangible personal property purchased for use by a qualified person to be used primarily to maintain, repair, measure, or test any property described in items (1) and (2) above.(14)

4. Tangible personal property purchased for use by a contractor purchasing that property either as an agent of a qualified person or for the contractor's own account and subsequent resale to a qualified person for use in the performance of a construction contract for the qualified person who will use the tangible personal property as an integral part of the manufacturing, processing, refining, fabricating, or recycling process, or as a research or storage facility for use in connection with the manufacturing process.(15)

The exemption is not available for property used primarily in administration, general management, or marketing. "Primarily' is defined to mean 50 percent or more of the time.(16)

B. Tangible Personal Property Defined

"Tangible personal property" is defined for purposes of the exemption to exclude and include certain specified items. Generally, the exclusions are the following: (1) real property, including tangible personal property to be incorporated into an improvement to real property (except for special purpose buildings discussed below), and conveyance systems and assembly lines;(17) (2) consumables with a normal useful life of less than one year (except fuels used or consumed in the manufacturing process);(18) (3) furniture, inventory, and equipment used in the extraction process, equipment used to store raw materials that have not yet entered or commenced the manufacturing process, or equipment used to store finished products that have completed the manufacturing process;(19) and (4) any property for which the California manufacturer's investment credit is claimed.(20)

Tangible personal property is then defined by the regulation to include, but not be limited to, the following: (1) machinery and equipment, as defined;(21) (2) equipment or devices used or required to operate, control, regulate, or maintain the machinery, including computers, data processing equipment, and computer software, and all repair and replacement parts with a useful life of one or more years;(22) (3) property used in pollution control that meets or exceeds standards established by the State of California or any local or regional governmental agency within the State of California;(23) (4) "special purpose buildings and foundations"(24) that either (i) are used as an integral part of the manufacturing, processing, refining, or fabricating process, (ii) constitute a research facility used during the manufacturing process as an integral part of a manufacturing, processing, refining, or fabricating activity, or (iii) constitute a storage facility used during the manufacturing process as an integral part of a manufacturing, processing, refining, or fabricating activity;(25) (5) fuels used or consumed in the manufacturing process;(26) and (6) property used in recycling.(27)

C. Qualified Person

Only a "qualified person" may claim the exemption. A "qualified person" is defined by the statute as any person that satisfies two requirements:(28) First, the qualified person must have first commenced trade or business activities in a new trade or business in California on or after January 1, 1994.(29) The second requirement is that the qualified person must be engaged in those manufacturing lines of business described in SIC Codes 2,000 to 3,999, inclusive.(30)

1. The New Trade or Business Requirement

A major limitation of the exemption is that it only applies to persons who first commence trade or business activities in California on or after January 1, 1994. (This is in sharp contrast to the manufacturer's investment credit, which contains no such limitation.(31) The new trade or business requirement is a highly technical one that is addressed in some detail in the regulation, There follows a general overview of the requirement.

First, "trade or business activities" does not mean the mere formation or organization of a corporation or other business entity that is intended to conduct a business. Thus, a corporation or business entity first conducts activities when it starts or commences the trade or business for which it was organized.(32) Second, a person will not be considered to have first commenced activities in a new trade or business in California on or after January 1, 1994 if, at any time within the 36 months preceding that date, that person or any related person was required to have secured a seller's permit for that trade or business or any other trade or business classified under the same division of the SIC Manual.(33) Third, a trade or business is not a new trade or business in California if, within the 36 months preceding the date that activities were first commenced in that trade or business in California, either the person claiming the exemption or any related person had conducted any activities in California in any trade or business classified under the same division of the SIC Manual.(34) Fourth, where a person or any related person is engaged in one or more trade or business activities in California, or has been engaged in one or more trade or business activities in California within the preceding 36 months, and thereafter commences an additional trade or business activity in California, that additional activity will be treated as a new trade or business only if it is classified under a different division of the SIC Manual than are any of the person's or related person's current or prior trade or business activities in California within the preceding 36 months.(35)

Fifth, where a person or any related person is engaged in trade or business activities wholly outside California and that person first commences doing business (as defined) in California after December 31, 1993, the newly commenced trade or business activity in California will be treated as a new trade or business.(36) Sixth, on or after January 1, 1995, in any case where a person acquires all or any portion of the assets of an existing trade or business that is doing business in California, the trade or business thereafter conducted by that person will not be treated as a new trade or business if the aggregate fair market value of the acquired assets used by that person in the conduct of the trade or business exceeds 20 percent of the aggregate fair market value of the total assets of the person being used in the same trade or business both within and outside California.(37) Seventh, in any case where the legal form under which a trade or business activity is being conducted is changed, the change in form will be disregarded and the determination of whether the trade or business activity is a new business will be made by treating the person as having purchased or otherwise acquired all or any portion of the assets of an existing trade or business.(38)

For purposes of all these rules a "related person" is defined by reference to sections 267 and 318 of the Internal Revenue Code.(39)

2. The SIC Code Requirement

The second requirement is that a qualified person must be engaged in those manufacturing lines of business described in SIC Codes 2,000 to 3,999, inclusive. For purposes of classifying a line or lines of business, the classification of the line or lines of business will be based upon the "establishment's" single most predominant activity based upon value of production. "Establishment" means an economic unit, generally at a single physical location, where business is conducted or where services or manufacturing or other industrial operations are performed. A factory, mill, store, hotel, movie theater, mine, farm, ranch, bank, railroad depot, airline terminal, sales office, warehouse, or central administrative office are listed in the regulation as generally constituting an "establishment."(40) Where distinct and separate economic activities are performed at a single physical location, each activity should be treated as a separate establishment where (1) no one industry description in the classification includes such combined activities; (2) the employment in each such economic activity is "significant"; and (3) separate reports are prepared on the number of employees, their wages and salaries, sales or receipts, property and equipment, and other types of financial data, such as financial statements, job costing, and profit-center accounting. Whether or not employment in a economic activity is "significant" is based upon all the facts and circumstances. Nevertheless, employment in an economic activity will be considered significant whenever more than 25 percent of the taxpayer's total number of employees at a single physical location, or more than 25 percent of the taxpayer's total dollar value of payroll at a single physical location, is attributable to the economic activity being tested for separate establishment status.(41) Thus, under these rules, a company may consist of one or more establishments.(42) Where a person conducts business at more than one establishment, then the person is a qualified person only with respect to those purchases intended to be used and actually used in those lines of business described in SIC Codes 2,000 to 3,999, inclusive.(43)

D. Three-Year Limitation

Another major aspect of the exemption is the three-year limitation. Notwithstanding any other provision, once a person has conducted business activities in a new trade or business for three or more years, that person will no longer be considered to be in a new trade or business nor qualified for the exemption.(44)

E. Exemption Certificates

In order to claim the exemption, a person must be both pre-qualified by the SBE and either registered to hold a seller's permit or maintain a consumer use tax account. Exemption certificates issued to qualified persons contain a control number and expiration date for verifying a person's status as a qualified person. An exemption certificate is not valid if it has not been issued by the SBE or if it is accepted after the expiration date on the certificate. Qualified persons who have been pre-qualified may reproduce the issued certificates as needed for their qualifying purchases.(45)

The regulation contains model exemption certificates, and certificates issued by the SBE will be in substantially the same form as that model.(46) Qualified persons who purchase or lease tangible personal property from a California retailer (or from a retailer outside California that is obligated to collect the use tax) must provide the retailer with a manufacturer's exemption certificate in order to claim the exemption. The manufacturer's use tax declaration must be completed by a qualified person to claim the exemption from use tax on purchases of tangible personal property from a retailer outside California who is not obligated to collect use tax.(47)

1. Manufacturer's Exemption Certificates

In general, the exemption will not be allowed by the SBE unless two elements are satisfied. First, the qualified person must furnish the retailer with a manufacturer's exemption certificate no later than 60 days after the date of the purchase. Second, the retailer must timely file a sales and use tax return claiming the exemption and, together with that timely return, provide the SBE with a copy of the manufacturer's exemption certificate.(48) Retailers claiming the exemption in timely filed returns, however, will not be required to furnish the SBE with copies of the exemption certificates for sales or leases of tangible personal property to a single qualified purchaser that do not exceed an aggregate total of $25,000 during a single calendar quarter.(49)

A retailer must retain each exemption certificate for a period of four years from the date on which the retailer claims a partial exemption based upon the certificate.(50) Within 45 days of the SBE's request, retailers must furnish to SBE any and all manufacturer's exemption certificates received from qualified persons, including certificates for aggregate sales or leases of $25,000 or less to a single qualified person during a single calendar quarter.(51)

2. Manufacturer's Use Tax Declaration

In general, the use tax exemption will not be allowed by the SBE unless two elements are satisfied. First, the qualified person must timely file a sales and use tax return or consumer use tax return for the period in which the purchase occurs and timely pay any applicable tax in full that is excluded from the (partial) exemption.(52) Second, the qualified person must attach a completed manufacturer's use tax declaration to the sales and use tax return or consumer use tax return that is timely filed with the SBE.(53)

Failure to file a timely return for an otherwise qualified purchase from a retailer not engaged in business in California, or failure to attach a completed manufacturer's declaration to such a timely filed return, constitutes a waiver of the use tax partial exemption for that purchase and, as a consequence, the partial exemption cannot be claimed on that purchase.(54)

F. One-Year Requirement And Conversion to Non-Qualified Use

The exemption does not apply to any sale, storage, use, or other consumption in California of property that, within one year from the later of the date of purchase or the date that the property was first placed into service by the purchaser in an exempt use is (1) removed from California, (2) converted from an exempt use to some other use not qualifying for the exemption, or (3) used in a manner not qualifying for the exemption.(55) Various technical rules are provided regarding when a transfer (directly or indirectly) of property (in whole or in part) will cause loss of the exemption.(56)

G. Purchaser's Liability for the Payment of Sales Tax

The regulations provide a general rule for situations in which a purchaser submits a copy of a manufacturer's exemption certificate to the seller and then, within one year from the later of the date of purchase or the date the property was first placed into service by the purchaser in an exempt use, either removes the property from California or converts the property to a non-qualified use. In such a case, the purchaser is liable for payment of sales tax, with interest, to the same extent as if the purchaser were a retailer making a retail sale of the property.(57)

III. Pending Legislative and Regulatory Developments

Those interested in the exemption, and in the manufacturer's investment credit discussed in the previous article, should keep abreast of several pending developments that may affect both provisions. The California legislature completed the first year of the 1995-1996 Regular Legislative Session on September 15, 1995. As of that date, there were three bills that would amend the exemption or credit provisions either pending in the legislature or on the Governor's desk awaiting action. SB 531 (Kelly) would make the "in lieu" refund provisions of the manufacturers' credit a refundable credit, which would allow businesses operating at a loss to benefit from the credit. SB 681 (Alquist) and AB 397 (Hannigan) would (1) change the definition of "qualified property" for the exemption to include clean rooms relating to semiconductor equipment manufacturing; (2) clarify the application of the exemption to leases of manufacturing equipment; and (3) provide that, in the case of a partnership or S corporation, qualification for the credit would be determined at the entity level and the credit would pass through to the partner or shareholder.

With respect to regulatory developments, the SBE had considered adopting Proposed Regulation 1525.3, which addressed the application of the exemption in the context of leased property. That regulation project, however, is now inactive because the issue is addressed in SB 681 and AB 397. Finally, on June 9, 1995, the Franchise Tax Board released draft proposed regulations on the manufacturers' investment credit. Written comments are invited even before the commencement of the formal regulatory process, which should begin this fall.

IV. Conclusion

Taxpayers with California activity should review the exemption in an effort to minimize sales and use tax liability. The trade or business requirement, with its related three-year limitation, however, significantly limits the availability of the exemption. In addition, tax executives should recall that the statute in reality provides only a partial exemption, and that certain local sales/use tax liabilities will remain in any event. (*) Footnotes appear on page 383.

Notes

(1) 1993 Cal. Stat. ch. 881. (2) See Eric J. Coffill, A Primer on the California Manufacturer's Investment Credit, 47 Tax EXECUTIVE 125 (March-April 1995). (3) For a more detailed legislative history of AB 1313, SB 671, and SB 676, see Eric J. Coffill, supra note 2. (4) See Analysis of AB 1313 (as amended on Aug. 24, 1993) by California Senate Revenue and Taxation Committee, at 4. (5) 1994 Cal. Stat. ch. 751. (6) See Notice of Proposed Regulatory Action by the State Board of Equalization, Regulation 1525.2 (April 29, 1994). (7) See Notice of Proposed Regulatory Action by the State Board of Equalization, Regulation 1525.2 (Oct. 21, 1994). (8) State Board of Equalization, Notices (Dec. 9, 1994 and Jan. 23, 1995). Neither of these "5 Day Notices" making minor changes to the text of the proposed regulation required a public hearing. (9) Regulation 1525.2(a), 1525.2(e). (10) Regulation 1525.2(a)(1). (11) Regulation 1525.2(a)(1)(A). (12) Regulation 1525.2(a)(1)(B). (13) Regulation 1525.2(a)(2). (14) Regulation 1525.2(a)(3). (15) Regulation 1525.2(a)(4). (16) Regulation 1525.2(b)(1). (17) Regulation 1525.2(c)(8)(A). (18) Regulation 1525.2(c)(8)(B). (19) Regulation 1525.2(c)(8)(C). (20) Regulation 1525.2(c)(8)(D). (21) Regulation 1525.2(c)(9)(A). (22) Regulation 1525.2(c)(9)(B). (23) Regulation 1525.2(c)(9)(C). (24) Special purpose building and foundations" is defined under a series of complex rules in Regulation 1525.2(c)(9)(D)(1) through (6). (25) Regulation 1525.2(c)(9)(D). (26) Regulation 1525.2(c)(9)(E). (27) Regulation 1525.2(c)(9)(F). (28) Regulation 1525.2(c)(5). (29) Regulation 1525.2(c)(5)(A). (30) Regulation 1525.2(c)(5)(B). (31) See Eric J. Coffill, supra note 2. (32) Regulation 1525.2(c)(5)(A)(1). (33) Regulation 1525.2(c)(5)(A)(2). (34) Regulation 1525.2(c)(5)(A)(3). (35) Regulation 1525.2(c)(5)(A)(4). (36) Regulation 1525.2(c)(5)(A)(5). (37) Regulation 1525.2(c)(5)(A)(6). (38) Regulation 1523.2(c)(5)(A)(7). (39) Regulation 1523.2(c)(5)(A)(8). (40) Regulation 1523.2(c)(5)(B)(1). (41) Regulation 1525.2(c)(5)(B)(2)(a). (42) Regulation 1525.2(c)(5)(B)(2)(b). (43) Regulation 1525.2(c)(5)(B)(2)(c). (44) Regulation 1525.2(d). (45) Regulation 1525.2(f). (46) Regulation 1525.2(f); see Appendices A and B of the regulation. (47) Regulation 1525.2(f). (48) Regulation 1525.2(f)(1)(A). (49) Regulation 1525.2(f)(1)(B). (50) Regulation 1525.2(f)(1)(C). (51) Regulation 1525.2(f)(1)(C). (52) Regulation 1525.2(f)(2)(A). (53) Regulation 1525.2(f)(2)(B). (54) Regulation 1525.2(f)(3)(A). (55) Regulation 1525.2(g). (56) Regulation 1525.2(g). (57) Regulation 1525.2(h).

ERIC J. COFFILL is a partner in the Sacramento office of Morrison & Foerster, where he practices with the Staet 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 and regulatory process that resulted in the sales/ use tax manufacturing equipment exemption. Mr. Coffill's article on California's manufacturer's investment credit was published in the March-April 1995 issue of The Tax Executive.