State & Local Tax Bulletin (May 2002)
California Manufacturers' Investment
M. Vesely, a tax partner in the
San Francisco office of Pillsbury Winthrop
Shaw Pittman LLP.
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Mr. Vesely presented this paper as part of the American
Petroleum Institute 30th Annual State and Local Income
And Franchise Tax Forum in New Orleans, Louisiana on
February 24-26, 2002.
This bulletin concerning state
and local tax
matters is part of the
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on the design or content of this material.
In 1993, to stimulate employment in California, the
Legislature enacted three key incentives.
First, under the corporation franchise tax and
personal income tax laws, the Legislature added a 6 percent
investment tax credit (MIC) for the purchase of certain
property (generally machinery and equipment) purchased
for use by qualified taxpayers who are engaged in
manufacturing activities. California Revenue and Taxation
Code (RTC) §§ 17053.49 (PIT) and
Second, under the sales and use
tax law, a partial sales or use tax
exemption was enacted for new or
start-up companies engaged in
manufacturing activities. The
exemption is limited to 5 percent of qualified costs
(compared to the 6 percent state sales tax rate). The
exemption generally applies to the same property as the
MIC. Taxpayers must elect either the MIC or the sales tax
exemption. They may not claim both. RTC § 6377.
Finally, in lieu of claiming the MIC or the sales tax
exemption, taxpayers are allowed to file a claim for refund
with the State Board of Equalization (SBE) for the sales
or use taxes paid. The refund is an amount equal to the
income tax credit that would have been allowed to offset
current year tax liability. RTC § 6902.2.
This article will focus on the MIC and will lead you
through the maze which the Franchise Tax Board (FTB)
has created in this area.
- Background of MIC
- Requirements for Claiming MIC
- Generally, a "qualified taxpayer" is allowed an
MIC equal to 6 percent of the "qualified costs"
paid or incurred for "qualified property" that is
placed in service in California after January 1,
- The MIC for qualified costs paid or incurred in 1994
must be claimed on the qualified taxpayer's return
- Qualified taxpayer, qualified costs and qualified
property are the three requirements for claiming
the MIC. All three must be met for the taxpayer
to claim the credit.
- There is a tension between the MIC statute and
the FTB's regulations and other administrative
pronouncements interpreting the same.
- Research Tools
- The MIC statute is critical to
review and is the starting point.
- RTC § 17053.49 (PIT).
- RTC § 23649 (CFT).
- Throughout its regulations, the FTB has taken a
narrow approach to the MIC.
- Title 18 California Code of Regulations sections
17053.49-0 to 17053.49-11 (PIT).
- Title 18 California Code of Regulations sections
23649-0 to 23649-11 (CFT).
- FTB Manuals
- Multistate Audit Technique Manual (MATM)
- General Tax Audit Manual (GTAM) sections
- FTB MIC Website
- Broken down into four sections.
- FTB Manuals and Publications
- Other FTB references
- Non-FTB references
- Code, Regulations, Notices and Rulings
- Contains links to these resources.
- FTB Publication 1113 (Frequently Asked
- FTB Form 3535
- Must be used by taxpayers to claim the MIC.
- FTB Tax News Articles monthly publication.
- March/April 2001 "Manufacturers' Investment
Credit Lives On" (p. 5);
- January/February 2001 "Manufacturers'
Investment Credit: Research and Development
Activities" (p. 10);
- November/December 2000 "Finance or
Operating Lease? Client Needs to Make
Distinction in Order to Qualify for MIC Credit"
- September/October 2000 "Manufacturers'
Investment Credit Qualified Property Plays
Major Role in Claiming Credit" (pages 6-8);
- September/October 2000 "Common Errors to
Avoid With Other MIC Elements" (p. 8);
- March/April 2000 "FTB Accepts BOE Use Tax
Audits" (p. 9);
- September 1999 "Manufacturers' Investment
Credit: For Your Information" (p. 10);
- September 1999 "Some Leases Qualify for the
MIC" (pages 10-12);
- March 1999 "Avoid Common Errors Found
With MIC" (pages 8-9); and
- July 1998 "MIC: What 'Qualified' Means"
- Spidell's California Taxletter
- "Business Tax Incentives," Oct. 1, 1993;
- "Sales Tax Exemption Small Businesses Can
Elect," Oct. 1, 1993;
- "Credits That Reduce Regular Tax Below
Tentative Minimum Tax," Oct. 1, 1993;
- "Investment Tax Credit A Great Idea That
Needs Fine Tuning," Jan. 1, 1994;
- "Manufacturers' Investment Tax Credit
Changes Make It Better," Nov. 1, 1994;
- "Manufacturers' Investment Tax Credit
Worksheet," Dec. 1, 1994;
- "MITC and Sales and Use Tax Exemption on
Leased Property," Jan. 1, 1995;
- "Manufacturers' Investment Credit and Sales Tax
Exemption," July 1, 1995;
- "Manufacturers' Partial Sales and Use Tax
Exemption," Sept. 1, 1995;
- "Manufacturers' Investment Credit Part I," Jan. 1,
- "Manufacturers' Investment Credit Part II,"
Feb. 1, 1996;
- "Manufacturers' Investment Credit Part III,"
Mar. 1, 1996;
- "Claiming the Manufacturers' Investment
Credit Use Form 3535 for 1994 and 1995,"
Feb. 1, 1996;
- "Manufacturers' Investment Credit Carryovers,
Recaptures, and Required Records," Apr. 1, 1996;
- "Manufacturers' Investment Credit Follow-Up,
Tax Traps and Clarifications," June 1, 1996;
- "Sales and Use Tax Exemption for New Business,"
June 1, 1996;
- "Manufacturers' Investment Credit and
Exemption Changes," Dec. 1, 1996;
- "Manufacturers' Investment Credit Did You
Overlook It?" Sept. 1, 1998;
- "FTB Audits MIC and R&D," Feb. 1, 1999;
- "FTB Audits MIC, Third Party Capitalized
Labor," April 1, 1999;
- "MIC Legal Ruling Position Tightened on
Thorny Contractor's Issue," July 1, 2000; and
- "Preparing for a MIC Audit," Sept. 1, 2001.
- Standard Industrial Classification Manual, 1987
- North American Industrial Classification System
- FTB Legal Rulings
- Legal Ruling 98-1, February 2, 1998
- Concerns capitalized costs of labor for
engineering and design services.
- Legal Ruling 2000-1, June 1, 2000
- Concerns capitalized labor costs under third
party contracts. It attempts to clarify Legal Ruling
98-1 regarding the qualification of capitalized
labor costs directly allocable to qualified property
for the MIC.
- Legal Ruling 2001-4, August 16, 2001.
- Concerns the MIC and its application to ready
mixed concrete and cement trucks. It involves
the issue whether the trucks are qualified
property and when does the manufacturing
- FTB Notices
- Notice 2001-6, October 23, 2001
- Concerns FTB audit policy regarding use of SBE
sales and use tax audit results.
- Notice 2002-1, February 4, 2002
- Concerns alternative computation of capitalized
direct labor costs under third party contracts.
- Qualified Taxpayer
- Any taxpayer engaged in those lines of business
described in Standard Industrial Classification
(SIC) Codes 2011 to 3999 (which is Division D,
Manufacturing), or 7371 to 7373 (software
developers) of the SIC Manual, 1987 edition.
- May be an individual, partnership, C or S
corporation, LLC, trust or estate.
- The MIC is determined at the entity (partnership)
level (RTC §§ 17053.49(c)(2) and 23649(c)(2)).
- The credit is generally allocated to the partners in
accordance with the partnership agreement.
- Separate But Unitary Issue
- It is the FTB's position that the MIC is specific
to the taxpayer which earned it and cannot be
allocated to other taxpayers, even if they are
members of the same unitary group.
- Guy F. Atkinson Co. of California v. FTB, No.
A085075, June 12, 2000.
- In an unpublished opinion, the Court of Appeal
issued a decision rejecting the taxpayer's
contention that a solar tax credit should be
applied against the tax liability of the unitary
group, or in the alternative, should be "intra-state
apportioned" against the tax liability of each of
the taxpayers of the unitary group.
- Taxpayer Does Not Need to be Primarily Engaged
in Manufacturing Activities.
- Save Mart Supermarkets, 2002-SBE-002 (SBE,
- On February 6, 2002, the SBE issued a rare formal
opinion in the first MIC case to reach the Board.
The SBE denied the FTB's petition for rehearing and
ruled for the taxpayer.
- Formal opinions, unlike other written decisions
by the SBE, are precedential and binding on the
FTB and taxpayers alike.
- The case involved the issue of whether Save Mart
was a qualified taxpayer with respect to its bakery
and meat processing activities.
- Both activities are described in Division D of the
- The FTB argued that Save Mart was not a qualified
taxpayer because "its primary activity" was retail
(not manufacturing) and therefore should be
assigned SIC Code 5411. As SIC Code 5411 is not
in the manufacturing section of the SIC Manual,
Save Mart did not meet the statutory requirement.
- Save Mart argued that it was a qualified taxpayer
under the plain meaning of the statute and that the
FTB's "qualified taxpayer" regulation (23649-3) was
invalid because it imposed restrictions not
contemplated by the MIC statute. Under that
regulation, the FTB required that the taxpayer be
classified or assigned a manufacturing SIC Code
while the statute only requires that the taxpayer's
activities be "described in" the manufacturing
section of the SIC Manual.
- Save Mart further argued that even if Regulation
23649-3 was somehow valid, Save Mart was a
qualified taxpayer because it satisfied the three
requirements under Regulation 23649-3(b)(1)(B),
the "separate establishment" test.
- The SBE agreed with Save Mart and overturned the
FTB's qualified taxpayer regulation (23649-3).
- It has been nearly 20 years since the SBE declared
an FTB regulation to be invalid. The most recent
example was Standard Oil Company of California
- The SBE specifically held that the MIC statute
should be liberally construed in favor of taxpayers
in order to effectuate the purposes of the legislation,
i.e., to encourage manufacturing in the State.
- The SBE held that Regulation 23649-3 is
interpretative and not quasi-legislative which means
it is entitled to less deference on review.
- Query, what about the remainder of the MIC
- Qualified Costs
- Three Requirements
- Costs paid or incurred by a qualified taxpayer
for the construction, reconstruction or
acquisition of qualified property on or after
January 1, 1994.
- Sales or use tax must be paid, directly or
indirectly, on such costs.
- Exception for costs paid or incurred for capitalized
labor (Regulation 23649-4(a)).
- The term "qualified costs" does not include the
amount of any sales or use tax paid directly or
indirectly, by the qualified taxpayer. (Regulation
- The costs must be properly chargeable to the
capital account of the qualified taxpayer.
- The costs must be properly includible in the
qualified taxpayer's basis for computing
depreciation on the qualified property under RTC
§ 24353 (Regulation 23649-4(c)).
- Capitalized Labor
- Qualified costs also include capitalized labor
costs for the constructing or modifying of
- Must meet the definition of direct labor costs under
the federal uniform capitalization (UNICAP) rules
in IRC § 263A and the regulations thereunder.
- The term "capitalized labor" shall mean all direct
costs of labor that can be identified or associated
with and are properly allocable to the construction,
modification, or installation of specific items of
- Includes full-time and part-time employees,
contract employees and independent contractors.
- Direct labor costs shall include all elements of
compensation, such as basic compensation,
overtime pay, vacation pay, holiday pay, sick leave
pay, payroll taxes. It does not include indirect
labor costs. (Regulation 23649-2(b)(1)).
- Indirect labor costs are costs that cannot be
identified or associated with the construction,
modification, or installation of specific items of
- Training costs, officers' compensation, pension
and other related costs.
- FTB auditors are instructed to strictly apply the
tests for determining direct labor costs.
- Legal Ruling 98-1
- Issue addressed as to what extent may capitalized
costs of labor paid or incurred by a qualified
taxpayer for engineering and design services
constitute qualified costs.
- Three different factual situations set forth.
- Situation 1 deals with the issue whether third
party contract costs paid to an independent
contractor for engineering and design services
related to a new coker would be properly treated
as direct costs of labor capitalized to an item of
property under IRC § 263A and thus qualified
costs for purposes of the MIC. The FTB
concluded they were qualified costs since they
met the test under IRC § 263A, i.e., the costs could
be identified or associated with the new coker.
- See, however, Legal Ruling 2000-1 and Notice
- Situation 2 is the same as Situation 1 except that
the taxpayer uses the services of its own
employees, not independent contractors. No
separate records are kept of the time spent by each
of the employees performing services for the new
coker. The FTB concluded that due to the absence
of the records, the regular wages and overtime
paid to the employees could not be direct costs
of labor capitalized to an item of property under
IRC § 263A. Rather, they would be indirect costs
required to be capitalized under IRC § 263A and
allocated among all items of property for which
these employees provided engineering and design
services. Accordingly, the FTB concluded that the
regular wages and overtime paid would not be
includible as qualified costs for purposes of the
- Situation 3 is the same as Situation 2 except that
separate records are kept on the number of hours
each employee spends engineering and designing
the new coker. The FTB concluded that the
regular wages and overtime paid to these
employees and which were related to the new
coker are qualified costs for purposes of the MIC.
- Legal Ruling 2000-1
- Intended to clarify Legal Ruling 98-1 and supersedes
that ruling to the extent of any inconsistency.
- Issue addressed is to what extent may capitalized
labor costs paid or incurred by a qualified taxpayer
to a third party contractor for the construction,
modification or installation of qualified property
constitute qualified costs.
- Retreats from Legal Ruling 98-1 and equates costs
related to third party contracts with costs related to
- For third party contracts, a taxpayer is only allowed
to include those costs which the taxpayer could
include if the taxpayer itself had constructed the
equipment using its own employees.
- The taxpayer is required to "look through" its third
party contracts and in effect put itself in the shoes
of the third party contractor for purposes of
computing its qualified costs for the MIC.
- Burden is on the taxpayer to prove what amounts
paid to the third party contractor are qualified costs.
- The ruling's application of the direct versus indirect
labor costs analysis for payments to independent
contractors appears inconsistent with the MIC
statute and MIC regulations. See, e.g., Regulation
23649-4(b), Ex. 1, 2 and 3; Regulation 23649-4(d),
- FTB Notice 2002-1
- Modifies Legal Ruling 2000-1.
- Purpose to provide an alternative computation
provision with respect to third-party capitalized
direct labor costs where a taxpayer has made a good
faith effort but is unable to obtain direct labor cost
data from a third-party contractor.
- Taxpayer shall calculate the direct labor cost
percentage of the labor costs paid or incurred by
the taxpayer to its own employees engaged in the
qualified activity in which the qualified property
constructed by the third-party contractor is
placed in service.
- The taxpayer shall apply the percentage in (1)
above to the total labor costs (excluding overhead,
profit or any other non-labor costs) paid or
incurred to the third-party contractor to
compute the capitalized labor costs that are
eligible for the MIC.
- FTB may impute a direct labor cost amount
utilizing available industry labor cost data.
- Pending cases at SBE
- Baxter Healthcare
- Case involves the question whether only direct
costs of labor under IRC § 263A qualify for the
- Conflict between Legal Rulings 98-1 and 2000-1
a key aspect of case.
- Taxpayer arguing that the FTB regulation
impermissibly narrows the scope of the statute.
- Foster Dairy Farms
- Case involves the question whether there must
be an allocation between direct and indirect labor
paid to third party contractors.
- Validity of Legal Ruling 2000-1 is in issue.
- Qualified Property
- Tangible personal property, whether new or used,
that is defined in IRC § 1245(a)(3)(A).
- MIC statute limits the tangible personal property
to IRC § 1245(a).
- MIC regulation excludes property described in IRC
- Must be primarily used in manufacturing,
processing, refining, fabricating or recycling of
property, beginning at the point at which any raw
materials are received by the taxpayer and
introduced into the process and ending at the
point at which the manufacturing, etc., has
altered tangible personal property to its
completed form, including packaging, as
- May be primarily used in research and development;
to maintain, repair, measure or test any property
described above; or for pollution control.
- Off-the-shelf computer software.
- Special purpose buildings and foundations used
in certain activities.
- Computer and office equipment.
- Electronic components and accessories.
- Commercial physical and biological research.
- Semiconductor equipment.
- Space vehicles.
- For taxpayers engaged in refining activities,
qualified property also includes tangible property
defined in IRC § 1245(a)(3)(B), that is used in
the line of business classified in SIC Code 2911
(petroleum refining); primarily used in refining;
and is used to produce reformulated gasoline or
oxygenated gasoline (Regulation 23649-5(f)).
- Effective on or after March 1, 1996.
- Excluded Property
- Facilities or property used for warehousing
- Equipment used in the extraction process, such
as rigging, drill bits and pumps. (Regulation
23649-5(d)(4)). Equipment used to store
finished products that completed the
- Property used primarily in administration,
general management or marketing.
- Property for which the taxpayer has claimed the
California low-emission vehicle credit under
RTC §§ 17052.11 and 23603.
- Key Definitions.
- Process of converting a natural resource
to an intermediate or finished product.
(RTC § 23649(e)(8)).
- Does not include any transportation, storage,
conveyance, or piping of the natural resource prior
to the commencement of the refining process
- This additional limitation is not contained in the
MIC statute or in Regulation 1525.2(c)(7) (sales
- Process of converting or conditioning property by
changing the form, composition, quality or
character of the property for ultimate sale at retail
or use in the manufacturing of a product.
(RTC § 23649(e)(3)).
- Improvements to tangible personal property that
result in greater service life or greater functionality
than that of the original property.
- Used 50 percent or more of the time in a qualified
activity. (RTC § 23649(e)(5)).
- Research and development
- Activities described under IRC § 174 or in the
regulations thereunder. (RTC § 23649(e)(9)).
- Process of modifying, changing, or altering the
physical properties of manufacturing, processing,
refining, fabricating, or pollution control waste.
- Does not include transportation, baling, shredding,
grinding, compressing or any other activity that
does not otherwise change the physical properties
of the waste. (Regulation 23649-2(o)).
- Undefined in the MIC statute.
- Pending Cases at the SBE
- Milpitas Materials
- Case involves question whether a ready-mixed
concrete truck is qualified property and at what
point does the manufacturing process end.
- Taxpayer challenges Legal Ruling 2001-4 which was
issued during the pendency of the case.
- In Legal Ruling 2001-4, the FTB concluded that
the manufacturing process ends when the
ready-mixed concrete reaches the job site.
- The FTB also concluded in Legal Ruling 2001-4
that only the mixing drum, and not the chassis
of the truck qualifies for the MIC.
- The taxpayer challenges the FTB's bifurcation
approach, while the FTB counters by pointing to
old federal investment tax credit law.
- Bronco Winery
- Case involves question whether certain large steel
tanks qualify for the MIC or whether they are
inherently permanent structures.
- The taxpayer challenges the regulation's
requirement that only tangible personal property
under IRC § 1245(a)(3)(A) qualifies since the MIC
statute only references IRC § 1245(a) property.
- Impact of Federal Investment Tax Credit Law.
- FTB has looked to the concepts and definitions
from the federal investment tax credit (ITC) in
drafting the MIC regulations and analogized the
MIC to the ITC. See FTB's Initial Statement of
Reasons for the Adoption of Regulation
17053.49-0 through 17053.49-11 and 23649-0
- Under the ITC, the credit shall be liberally
construed in favor of allowing the credit.
- Compare Save Mart.
- Leasing Transactions
- MIC Available to Lessee, Not Lessor
- Lessee must be qualified taxpayer.
- Lessor must pay California sales or use tax when
it acquired the property.
- Normal qualified cost rules do not apply.
- In an operating (true) lease, a lessee may generally
claim the MIC based upon the purchase price
amount on which the lessor paid sales or use tax,
plus any capitalized labor costs related to the lessor's
construction or modification of the property.
- In an operating lease, lessor must provide the lessee
with a written statement within 45 days after the
close of the lessee's income year, containing the
amount of costs on which the lessor paid California
sales or use taxes.
- If the lease is a finance lease for sales and use tax
purposes, then the rules applicable to it will
generally apply in calculating the lessee's qualified
- Finance lease is treated as a purchase.
- Rental payments are treated as payments of the
- FTB has prepared for its auditors a flowchart
analyzing the differences between operating and
finance leases for purposes of the MIC.
- Miscellaneous Issues
- Recapture Rules
- MIC is not allowed or must be recaptured in any
case where a disposition occurs within one year
of the date that the qualified property is first
placed in service in California.
- The term "disposition" includes the following
- Removal of the qualified property from California;
- Disposition of the qualified property to an unrelated
party (sale, gift, etc.);
- Use of the qualified property by the qualified
taxpayer primarily in a non-qualified activity; or
- Acquisition by a lessee of qualified property that is
being leased by such lessee.
- "Disposition" does not include:
- Mere transfer of legal title to a creditor that takes a
- Election by a C corporation to become an S
- Destruction of qualified property that qualifies as
an involuntary conversion under IRC § 1033.
- IRC §§ 338(g) and 338(h)(10) elections do not
- FTB proposal.
- Chapter 543, Statutes of 2001.
- MIC Carryforward Rules
- MIC may reduce the regular tax below the
tentative minimum tax.
- Excess MIC credits may be carried forward for
- Small businesses can carry forward the excess credits
for ten years.
- Small business means a qualified taxpayer
determined as of the last day of the income year for
which the MIC is allowed that meets any of the
- Gross receipts of less than $50 million.
- Net assets of less than $50 million.
- Total MIC credit of less than $1 million.
- Engaged in biopharmaceutical or biotech
- Small business determination made on separate
- Interaction With Other Tax Incentives
- Enterprise Zone
- Sales and use tax credit for enterprise zone and MIC
may be claimed.
- Reduce MIC amount by sales or use tax paid.
- Enterprise Zone business expense deduction may
be claimed on the same property as the MIC.
- Reduce MIC qualified costs by the deduction.
- Los Angeles Revitalization Zone (LARZ)
- May not claim both the LARZ sales or use tax credit
and the MIC for the same property.
- May not claim the LARZ business expense
deduction and the MIC on the same property.
- No specific requirements in the MIC statute.
- MIC regulations provide rules for recordkeeping
by qualified taxpayers (Regulation 23649-10).
- Qualified taxpayer is required to maintain books
and records that are adequate to substantiate its
MIC claims for as long as the statute of
limitations remains open.
- 2001 Proposed Legislation
- Expand MIC to energy producers.
- AB 1169, AB 1276, AB 96X, AB 240.
- Expand to oil and gas extractive industries.
- AB 85X, AB 1275.
- Expand to renewable energy producers.
- AB 45X.
- All failed to pass.
- Sunset Provision.
- Since the MIC satisfied the requirement of
increasing manufacturing jobs (excluding the
aerospace sector) in California in 2000 by more
than 100,000 over 1994 totals (204,000 actual
count), the MIC did not sunset as of January 1,
- Annual reports required by the Employment
Development Department to the Legislature
regarding manufacturing jobs.
- The MIC shall cease to be operative on January 1
of the year in which the manufacturing jobs, as
described above, do not exceed by 100,000 the
total manufacturing sector employment in
California on January 1, 1994.
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