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California’s Partial Sales Tax Exemption for Manufacturing and Research and Development Takes Effect July 2014

California’s Partial Sales Tax Exemption for Manufacturing and Research and Development Takes Effect July 2014

California has enacted a partial sales tax exemption for purchases of equipment and other property used in certain manufacturing and research and development activities. The exemption, which applies to purchases beginning on July 1st, is subject to a number of requirements and restrictions, many of which are set forth in recently promulgated proposed regulations that are expected to be finalized in September. This article analyzes the law and regulations in detail; and the authors provide additional context by explaining how taxpayer and industry groups were able to influence the rule-making process and thereby improve various aspects of the regulations.

By Joseph A. Vinatieri and Patricia Verdugo

This article was originally published in the IPT July 2014 Tax Report.  You can read the article below or download the pdf file.

California Governor Jerry Brown signed legislation in 2013 that established a partial sales tax exemption for purchases of equipment and other property used in certain manufacturing and research and development (R&D) activities.[1]  The exemption, which is intended to attract new business into the state, applies to purchases made from July 1, 2014, through June 30, 2022.[2]  A proposed regulation for the exemption has been published and is expected to be approved on July 17, 2014, and finalized by September 2014.[3]  Under the exemption, qualifying purchasers would be subject to a reduced sales tax rate of 3.3125%[4] (instead of the current state-wide rate of 7.5%) on qualifying purchases of up to $200 million per calendar year.[5]  A company that takes advantage of the exemption could potentially save up to $8.375 million in sales taxes per year.[6]

During the rulemaking process, the California State Board of Equalization (“SBE”) staff issued three discussion papers and held three interested party meetings.[7]  As a result, taxpayer and industry groups significantly influenced the language in the proposed Regulation 1525.4, Manufacturing and Research & Development Equipment, which was approved for publication on April 22, 2014.[8]  The language in the proposed regulation ensures that a broad range of industries and purchases will qualify for the exemption.  Nonetheless, as with all tax incentives, significant requirements and restrictions apply.  Companies who wish to take advantage of the exemption should become familiar with these requirements and restrictions in order to ensure that their purchases will qualify for the exemption.  Furthermore, we strongly encourage companies that are unsure whether their transactions will qualify for the partial exemption to request a written opinion from the SBE.  Reliance on a written opinion from the SBE will provide relief from tax, penalties, and interest resulting from sales or purchases that are disallowed upon audit.[9]

In this article, we summarize some of the key provisions of the California partial sales tax exemption.  In general, the exemption applies to purchases (A) by or on behalf of a qualified person, (B) of qualified property, and (C) for use for a qualifying purpose.  In order to take advantage of the exemption, the purchaser must provide an exemption certificate to the seller.

A.        Qualified Person.

Manufacturing and R&D.  Only purchases for or on behalf of “Qualified Persons” are eligible for the partial exemption.[10]  The definition of a “Qualified Person,” however, includes companies in a broad range of industries, including aerospace, automotive, recycling, pharmaceutical, and biotechnology industries.  The proposed regulation defines a “Qualified Person” as a person that is primarily engaged in (1) manufacturing operations (as described under NAICS codes 3111 to 3999, inclusive), (2) biotechnology research and development operations (as described under NAICS code 541711), or (3) physical, engineering, and life sciences research and development operations (as described under NAICS code 541712).[11]

The proposed regulation clarifies that, where there is no applicable six digit NAICS code to describe a company’s line of business, the company may qualify for the exemption if the company’s business activities “are reasonably described in a qualified four digit industry group.”[12]  This clarification was added in response to the recycling industry’s concern that the lack of a six digit NAICS code for recycling would cause auditors to deny the exemption.  In order to assuage the recycling industry’s concerns, the SBE also added a specific example for businesses in the recycling industry.[13]  The SBE staff was less accommodating to industries that are explicitly excluded from the exemption, specifically, the agriculture, extractive, savings and loan, and banking and financial industries. [14]  For example, despite support from the poultry industry, the SBE refused to include language that would allow the exemption to apply where both non-qualifying agricultural and qualifying manufacturing operations are conducted by a single entity.[15]  The SBE staff stated that “regardless of whether a business otherwise meets the definition of a qualified person, any business that falls under the exclusion is statutorily excluded from claiming the partial exemption.”[16]  Although these excluded industries are not permitted to bifurcate operations between qualified and non-qualified operations, other industries are specifically permitted to do so.

Primarily Engaged.  As mentioned above, a Qualified Person must be “primarily engaged” in manufacturing or research and development under one of the specified NAICS codes.  SBE staff initially proposed to define “primarily engaged” as 50 percent or more of gross revenues.[17]  In response to comments and concerns by interested parties, SBE staff made several revisions to the definition.  As published, the proposed regulation provides several tests for meeting the 50 percent threshold and permits a qualified person to meet these tests at either the legal entity or establishment level.

Primarily Engaged at the Entity Level.  First, a person could be “primarily engaged” at the legal entity level if, in the prior year, the legal entity:

  1. Derived 50 percent or more of gross revenue (including inter-company charges) from a qualifying line of business; or
  2. Spent 50 percent or more of operating expenses in a qualifying line of business.[18]

In order to make it easier for companies to meet the 50 percent threshold, companies are permitted to combine revenues or expenses from more than one qualified line of business.[19]  For example, a company can combine revenues from qualified manufacturing and qualified R&D activities.

Primarily Engaged at the Establishment Level.  Second, a person could be “primarily engaged” at the cost center or economic unit level (referred to in the regulation as an “establishment”), if it maintains separate books and records for the qualified activity.[20]  The earlier drafts of the regulation referenced only physical locations.[21]  However, since companies maintain records by cost centers and not necessarily by physical location, there was concern that companies would have to recreate their financial records in order to prove upon audit that they had a qualifying establishment.  As a result, the proposed regulation now provides that an “establishment” can include multiple locations or portions of such locations, and a location may be described in more than one NAICS code.[22]  Under the proposed regulation, a person could be “primarily engaged” as an establishment if, in the prior year, the establishment:

  1. Derived 50 percent or more of gross revenues (including inter-company and intra-company charges) from a qualifying line of business;
  2. Spent 50 percent or more of operating expenses in a qualifying line of business; or
  3. Allocated, assigned or derived 50 percent or more of (1) employee wages, (2) value of production, or (3) number of full-time equivalent employees to a qualifying line of business. [23]

B.        Qualified Property.

The partial exemption applies to gross receipts from the sale of, and the storage, use, or other consumption in California of qualified tangible personal property (“Qualified Property”).[24]  This includes certain leases of Qualified Property.[25]

As defined by the statute, Qualified Property includes, but is not limited to, the following:

  1. Machinery and Equipment. [26] “Machinery and equipment, including component parts and contrivances such as belts, shafts, moving parts, and operating structures.”[27]
  2. Equipment Used to Operate Machinery.  “Equipment or devices used or required to operate, control, regulate, or maintain the machinery, including, but not limited to, computers, data-processing equipment, and computer software, together with all repair and replacement parts with a useful life of one or more years therefor, whether purchased separately or in conjunction with a complete machine and regardless of whether the machine or component parts are assembled by the qualified person or another party.”[28]
  3. Property used in Pollution Control.  “Tangible personal property used in pollution control that meets standards established by this state or any local or regional governmental agency within this state.” [29]
  4. Special Purpose Buildings and Foundations.  “Special purpose buildings and foundations used as an integral part of the manufacturing, processing, refining, fabricating, or recycling process, or that constitute a research or storage facility used during those processes.  Buildings used solely for warehousing purposes after completion of those processes are not included.” [30]

The proposed regulation provides additional guidance with respect to special purpose buildings and foundations.  This guidance generally follows the regulation for the prior partial exemption for manufacturing equipment, which was in effect from 1994 through 2003.[31]  In general, a “special purpose building and foundation” means a building and the foundation underlying the building that is specifically designed and constructed or reconstructed for the installation, operation, and use of specific machinery and equipment that will be used exclusively for a qualifying purpose.[32]  The building and foundation must be an integral part of the qualifying process, meaning that it is used directly in and is essential to the qualifying process.[33]  Although the building may be used for “incidental uses,” not more than one-third of the total usable volume of the building can be used for a non-qualifying purpose.[34]  Notably, buildings and foundations for general purpose industrial, commercial, or non-qualifying storage use do not qualify for the exemption.[35]  However, a portion of the building could qualify as a special purpose building and foundation if it satisfies all other requirements.[36]  This could be an especially attractive incentive for businesses contemplating new construction of engineering, R&D labs, etc.

The following property is specifically excluded from the definition of Qualified Property:

  • consumables with a useful life of less than one year
  • furniture
  • inventory
  • equipment used in the extraction process (including mining, oil and gas extraction)
  • equipment used to store finished products
  • tangible personal property used primarily in administration, general management, or marketing. [37]

C.        Qualified Uses of Qualified Property.

Qualified Property purchased by or on behalf of a Qualified Person must be used “primarily” (defined as 50 percent or more of the time) (1) in any stage of the manufacturing, processing, refining, fabricating, or recycling process (a “Process”), (2) in research and development, or (3) to maintain, repair, measure, or test qualified property. [38]  A qualified use may occur from the point when raw materials are introduced into a Process, which includes when the raw materials are stored on the same premises as the Process, until the property is in its completed form, including packaging.[39]  In addition, a qualified use includes the testing of products for quality assurance before the property is in its completed form.[40]

The Qualified Property may also be purchased by a contractor for use in a construction contract with a Qualified Person who will use the resulting improvement on or to real property as an integral part of a Process or as a research or storage facility in connection with such Process.[41]  Notably, a Qualified Person that is primarily engaged in manufacturing can use qualifying purchases for research and development, and a Qualified Person that is primarily engaged in research and development can use qualifying purchases for use in manufacturing.[42]

D.        Exemption Certificate.

Purchasers who wish to take advantage of the partial tax exemption will need to provide sellers with an exemption certificate.[43]  The retailer must collect the exemption certificate on a timely basis, meaning any time before it bills the purchaser, any time within the normal billing cycle, or any time before delivery of the property to the purchaser.[44]  The proposed regulation provides exemption certificate forms that can be used for specific purchases or as a blanket certificate for future purchases.[45]

Note that a qualified purchase will lose its exempt status if, within one year of the purchase, it is moved out of state, is converted to a non-exempt use, or is otherwise used in a manner that does not qualify for the exemption.[46]  If the purchaser did not pay the tax at the time of the purchase, the purchaser will be required to pay the sales tax plus applicable interest at the time the purchase loses its exempt status.[47]  In addition, if the purchaser later determines that the purchase exceeded the $200 million limitation, the purchaser will be required to pay the sales tax plus applicable interest.[48]  When determining whether this limitation has been exceeded, companies must take into account purchases made by all entities included in their combined California franchise tax return. [49]  The difficulty of tracking all purchases by all combined entities will depend on the nature of the taxpayer’s enterprise.  The possible onerous nature of this bookkeeping requirement was acknowledged by SBE staff during the interested party process.

E.        Request for Advice (Opinion Letters).

California law permits taxpayers to obtain relief from any tax, penalty, or interest charges if the taxpayer relied on erroneous written advice from the SBE.[50]  During the Business Taxes Committee meeting before the elected Board Members, the author testified to the need for strong staff outreach efforts, including publicizing the right of taxpayers to utilize the written ruling process.  Companies that are unsure whether their transactions will qualify for the partial exemption are encouraged to request a written opinion from the SBE.  Reliance on a written opinion from the SBE could provide relief if sales or purchases are later disallowed upon audit.  Although the SBE does not specifically reference this relief in the proposed regulation, it does include information on how to obtain a written opinion on its Manufacturer’s Exemption webpage. [51]  SBE staff has confirmed that taxpayers are already taking advantage of this resource.[52]

F.         Conclusion

Manufacturers and R&D companies looking to expand or locate in California have been given an $8.375 million per year incentive to do so.  The SBE’s expansive interpretation of the new multi-year partial sales tax exemption bodes well for the taxpayer looking to grow in the Golden State.



[1] Assembly Bill 93 (Stats. 2013, Ch. 69), as amended by Senate Bill 90 (Stats. 2013, Ch. 70).  The legislation is codified in Section 6377.1 of the California Revenue & Taxation Code.  As noted by the SBE, the new partial exemption is modeled after the prior partial exemption for manufacturing equipment, which was in effect from 1994 to 2003 in conjunction with the manufacturer’s investment credit (MIC).  See Cal. Rev. & Tax. Code § 6377 (repealed) and Cal. Code Regs. Tit. 18, § 1525.2 (repealed).

[2] Cal. Rev. & Tax. Code § 6377.1(a).

[3] See Register 2014, No. 22-Z Cal. Regulatory Notice Reg. p. 1026 (May 30, 2014).  SBE staff has indicated that it anticipates that the Office of Administrative Law (OAL) will complete their review and approval of the regulation by the end of September 2014.

[4] The exemption does not apply to certain components of the state-wide sales and use tax rate or to taxes levied by a county, city or district.  See Cal. Rev. & Tax. Code § 6377.1(d).  The exemption would reduce the current state-wide sales and use tax rate of 7.50% by 4.1875% to 3.3125%.  After 2016, the state-wide rate is expected to decrease to 7.25%.  The exemption would reduce the post-2016 state-wide rate of 7.25% by 3.9375% to 3.3125%.  Additional local taxes may apply.  See https://www.boe.ca.gov/news/sp111500att.htm (Detailed Description of the Sales &Use Tax Rate).

[5] Cal. Rev. & Tax. Code § 6377.1(e)(1).

[6] $200 million * 4.1875% (7.5% - 3.3125%) = $8.375 million.  The savings would be reduced to $7.875 million per calendar year after 2016 as a result of the decrease in the state-wide rate: $200 million * 3.9375 (7.25% -3.3125%) = $7.875 million.

[7] The discussion papers were published on September 27, 2013, November 14, 2013, and January 31, 2014.  The interested party meetings were held on October 9, 2013, December 5, 2013, and February 18, 2014.  An issue paper was also published on April 11, 2014, for the April 22, 2014, Business Taxes Committee meeting.

[8] The proposed Regulation 1525.4, Manufacturing and Research & Development Equipment, [hereinafter Prop. Reg. § 1525.4] can be found at https://www.boe.ca.gov/meetings/pdf/Proposed1525-4.pdf.

[9] Cal. Rev. & Tax. Code § 6596.

[10] Cal. Rev. & Tax. Code § 6377.1(a).

[11] Prop. Reg. § 1525.4(b)(8)(A).  References to the NAICS are to the North American Industry Classification System published by the United States Office of Management and Budget (OMB), 2012 edition.

[12] Prop. Reg. § 1525.4(b)(8)(A).

[13] Id.

[14] See Cal. Rev. & Tax. Code § 6377.1(b)(6)(B); Prop. Reg. § 1525.4(b)(8)(B); Cal. Rev. & Tax. Code § 25128.

[15] At the SBE’s April 22, 2014, Business Taxes Committee meeting, representatives from the poultry industry again asked the SBE to provide guidance that would allow their industry to quality for the exemption.  The representatives were encouraged to work through the legislature, and staff was directed to bring the issue to the SBE’s Legislative Committee.  See Board of Equalization, Business Taxes Committee Meeting Minutes (April 22, 2014), https://www.boe.ca.gov/meetings/pdf/042214.pdf.

[16] Board of Equalization, Formal Issue Paper 14-001 (April 11, 2014), https://www.boe.ca.gov/meetings/pdf/1525-4IPweb.pdf.

[17] See Board of Equalization, Second Discussion Paper on proposed Regulation 1525.4, Manufacturing and Research & Development Equipment (November 14, 2013), https://www.boe.ca.gov/meetings/pdf/1525-4SDPweb.pdf.

[18] Prop. Reg. § 1525.4(b)(8)(A)1. The company can use the one year period after a purchase if the company was not a Qualified Person in the prior year.

[19] Id.

[20] Id. § 1525.4(b)(8)(A)2.

[21] See Third Discussion Paper on proposed Regulation 1525.4, Manufacturing and Research & Development Equipment (January 31, 2014), https://www.boe.ca.gov/meetings/pdf/1525-4TDPweb.pdf.

[22] Prop. Reg. § 1525.4(b)(8)(A)2.

[23] Id. § 1525.4(b)(8)(A)1.

[24] Cal. Rev. & Tax. Code § 6377.1(a).

[25] Id. § 6377.1(f).

[26] Manufacturing aids may also be considered machinery and equipment.  See Prop. Reg. § 1525.4(b)(9)(A)1.

[27] Cal. Rev. & Tax. Code § 6377.1(b)(7)(A).

[28] Id.

[29] Id.

[30] Id.

[31] See Cal. Code Regs. tit. 18, § 1525.2 (repealed).

[32] Prop. Reg. § 1525.4(b)(9)(A)4.a. and 4.c.

[33] Id. § 1525.4(b)(9)(A)4.f.

[34] Id. § 1525.4(b)(9)(A)4.c.

[35] Id. § 1525.4(b)(9)(A)4.e.

[36] Id. § 1525.4(b)(9)(A)4.d.

[37] Cal. Rev. & Tax. Code § 6377.1(b)(7)(B).

[38] Id. § 6377.1(a); Prop. Reg. § 1525.4(a).

[39] Prop. Reg. § 1525.4(b)(6).

[40] Id.

[41] Id. § 1525.4(a)(4).

[42] Id. § 1525.4(b)(8)(A)3.

[43] Cal. Rev. & Tax. Code § 6377.1(c).

[44] Prop. Reg. § 1525.4(c).

[45] Id. § 1525.4, Appendix A (Partial Exemption Certificate for Manufacturing and Research & Development Equipment – Section 6377.1) and Appendix B (Construction Contracts – Partial Exemption Certificate for Manufacturing and Research & Development Equipment – Section 6377.1).

[46] Cal. Rev. & Tax. Code § 6377.1(e)(1)(B).

[47] Id. § 6377.1(e)(2).

[48] Id.

[49] Id. § 6377.1(e)(1)(A).

[50] Id. § 6596; Cal. Code Regs. tit. 18, § 1705.

[52] Telephone Interview with SBE staff, Cal. (June 25, 2014).

 

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