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State & Local Tax Bulletin
(Volume 1, Number 2, August 1994)

California State Board of Equalization's
Proposed Regulation to Clarify the
Sales and Use Tax Exemption for
Manufacturing and Research
Property of Start-Up Companies

By Joanne Crowther, a former associate in our San Francisco office.

This information is only of a general nature, intended simply as background material, omits many details and special rules and cannot be regarded as legal or tax advice.

In September 1993, as part of what has been described as "the most significant business tax incentive package in modern times,"[fn. 1] the California Legislature enacted Revenue and Taxation Code ("Rev.& Tax.Code") § 6377[fn. 2] to grant certain start-up businesses a state sales and use tax exemption for purchases of specified property used in manufacturing and related activities. Since the State Board of Equalization ("SBE") will administer the exemption, the exemption's impact on California's business environment is heavily dependent upon the SBE's interpretation of the legislative intent surrounding the enactment of Rev.& Tax.Code § 6377. The SBE has promulgated Proposed Regulation § 1525.2[fn. 3] to clarify, in detail, the scope of the exemption. This article will explore the SBE's interpretation of Rev.& Tax.Code § 6377 as expressed through Proposed Regulation § 1525.2.

The State Sales and Use Tax Exemption Generally

Rev.& Tax.Code § 6377 provides an exemption from state sales and use tax for the gross receipts derived from the sale, storage, use or other consumption in California of tangible personal property purchased by a qualified person primarily for use in the manufacturing, processing, refining, fabricating or recycling of property.[fn. 4] The exemption also applies to property purchased for use in research and development and property used to repair, maintain, test or measure any other qualified property.[fn. 5]

The exemption extends to tangible personal property that is purchased by a contractor acting as an agent for a qualified business or which purchases the property for resale to a qualified business where the property is used in the performance of a construction contract for that qualified business and where that business will use the property as an integral part of any manufacturing, processing, refining, fabricating or recycling process or as a research or storage facility in connection with the manufacturing process.[fn. 6]

The rate of the exemption is 6%.[fn. 7] However, this exemption will not be allowed if the manufacturer plans to claim an investment tax credit for the property under the corporation franchise tax law or under the personal income tax law.[fn. 8]

The exemption provision will sunset on the later of January 1, 2001, or on January 1 of the first year thereafter in which total manufacturing sector employment on the preceding January 1 does not exceed by 100,000 jobs the total of such employment on January 1, 1994.[fn. 9]

Questions and Answers About the Exemption

What is a qualified person?

Qualified Persons are natural persons or business entities: (A) who first organize or form on or after January 1, 1994 and first conduct business activity in a new trade or business in California on or after January 1, 1994; and (B) who engage in lines of business described in Codes 2000 to 3999 of the Standard Industrial Classification Manual published by the U.S. Office of Management and Budget (1987).[fn. 10]

  1. A "qualified person" must have been formed or organized and must have first conducted business activity in California on or after January 1, 1994.

    1. The entity must have been legally formed or organized on or after January 1, 1994.

      Proposed Regulation 1525.2 does not appear to require that a qualified person be formed or organized in California, only that the entity be formed or organized on or after January 1, 1994.[fn. 11] A corporation is first formed or organized no later than the date of its incorporation and a partnership or joint venture no later than the date of its formation under the laws of the state where formed.[fn. 12] Additionally, an individual who first secures a seller's permit under Rev.& Tax.Code § 6066 after January 1, 1994 at a location where a new trade or business is to be conducted is considered to have met the requirement of formation or organization after January 1, 1994.

      Since the proposed regulation appears to view the terms "formed" and "organized" as the formal, legal recognition of a distinct business entity, and since Rev.& Tax.Code § 6005 does not recognize a division as a "person," the mere creation of a new division or other subpart of a business would not satisfy the requirements of the formation or organization of a new trade or business for purposes of Rev.& Tax.Code § 6377.

    2. The entity must first conduct "business activity" in California on or after January 1, 1994.

      The SBE proposes that "business activity" be considered as beginning when operations commence or, at the very least, when operating assets have been purchased. The mere acquisition of business permits and licenses would not constitute commencement of business activity.

    3. The business activity must be in a "new trade or business."

      Although the SBE views its definition of "new trade or business" as "generous,"[fn. 13] some may consider the definition to be extremely restrictive and to result in anomalous determinations. The SBE believes that the purpose of the Rev.& Tax.Code § 6377 exemption is to provide a tax break to newly formed, start-up businesses that are not carrying on a predecessor business or one that was previously operated by a related party. Rather than looking at the nature of the property that is being used in the purportedly "new" operation, the SBE proposes to look to the type of business activity in which the newly formed operation is involved when making a determination regarding whether or not a "new trade or business" is being conducted.

      The proposed regulation indicates that for a trade or business to be considered a new trade or business, the newly organized operation at a minimum must fall within a different standard industrial classification ("SIC") than any preexisting or prior trade or business of the party seeking certification or of any related person.[fn. 14]

      Accordingly, under the proposed regulation, not only is there no "new trade or business" where the newly organized operation was ever owned, possessed or controlled by the party seeking certification,[fn. 15] but there is no "new trade or business" if the newly organized operation is substantially similar to a preexisting or previous trade or business of that party or of any related person. Although the proposed regulation does not specify whether this "substantially similar" test is to be applied on a statewide or a countrywide basis, there has been some indication that the test will be applied on a countrywide basis.[fn. 16]

      Since a "new trade or business" can be one that was previously owned by another party, so long as that other party is and always has been unrelated to the new owner,[fn. 17] an out of state automobile manufacturer could receive a sales tax exemption pursuant to organizing a subsidiary to purchase the assets of and to continue the operation of a California pie factory, but that same automobile manufacturer would not receive the sales tax exemption if it decided to build a new plant in California or to relocate its assets here.

      As the previous example demonstrates, the SBE's viewpoint is that the only beneficiaries of Rev.& Tax.Code § 6377 should be start-up companies entering new industries. This severely limits the reach of Rev.& Tax.Code § 6377.

  2. A qualified person must be engaged in certain specifically identified industries.

    An individual or business entity will not be considered a "qualified person" for purposes of the exemption unless, in addition to being newly organized and conducting a new trade or business, it is engaged in those manufacturing lines of business described in Codes 2000 to 3999 of the Standard Industrial Classification Manual published by the United States Office of Management and Budget (1987).[fn. 18] The Standard Industrial Classification Manual was developed for use in classifying business establishments by the type of activity in which they are engaged. This coding methodology facilitates the compilation of and promotes the uniformity and comparability of statistical data needed by various federal and state agencies. SIC codes are not the same as the "principal business activity" codes used on Form 1120, U.S. Corporation Income Tax Return, or on Form 100, California's Income and Franchise Tax Return.

    For purposes of classifying lines of business by their SIC code, the economic unit to be used is the "establishment" rather than the "enterprise" level of the business. An enterprise or company may contain more than one establishment. However, an establishment is distinguished from subunits or departments in a company. An "establishment" is an economic unit where significant business activities are conducted.[fn. 19] Although an establishment is generally located at a single physical location, there can be more than one "establishment" at a given single physical location.

    If distinct or separate economic activities are performed at a single physical location, each activity can be treated as a separate establishment if: (1) there is no one industry description that includes the combined activities; (2) there is significant employment in each individual activity; and (3) each individual activity can be accounted for separately.[fn. 20]

    Proposed Regulation § 1525.2(c)(5)(B)(1)(c) cautions that if business is conducted through more than one establishment, the purchasing entity is considered a qualified person only as to those purchases that are intended to be used and are actually used in the lines of businesses described in Codes 2000 to 3999 of the SIC Manual.

    One significant caveat regarding SIC classification decisions is that the SBE has noted that some SIC lines of business are merely subparts of a more comprehensive or broader category of trade or business activity. Accordingly, a trade or business is not necessarily the same as a line of business under the SIC Manual. An example that the SBE provides is that while the SIC Manual lists separate classifications for the manufacture of electronic capacitors and electronic resistors, both of those business activities would be considered part of the broader trade or business of manufacturing electronic components for purposes of Rev.& Tax.Code § 6377.[fn. 21]

  3. There are time constraints on retaining "qualified person" status.

    Once an entity has conducted business activities in a new trade or business within the meaning of Rev.& Tax.Code § 6377 for three or more years, that entity will no longer be considered to be in a "new trade or business" and will no longer qualify for the exemption.[fn. 22]

What types of "tangible personal property" qualify for the exemption?

According to Rev.& Tax.Code § 6377(b)(9), tangible personal property includes, but is not limited to:

  1. machinery and equipment;

  2. computer, data processing and computer software equipment or devices used to operate, control, regulate or maintain the machinery;

  3. property used in pollution control;

  4. special purpose buildings and foundations used as an integral part of the manufacturing or research;[fn. 23]

  5. fuels used or consumed in the manufacturing process; and

  6. property used in recycling.

Proposed Regulation § 1525.2(c)(9) further defines the list of items that are specifically to be included within the definition of "tangible personal property." The proposed regulation provides that "tangible personal property" includes but is not limited to:

  1. Machinery and equipment within the meaning of paragraph (a)(6) of Sales and Use Tax Regulation 1521,[fn. 24] including component parts and contrivances such as belts, shafts, moving parts, and operating structures;

  2. All equipment or devices used or required to operate, control, regulate, or maintain the machinery, including, without limitation, computers, data processing equipment, and computer software, including both operating programs and application programs, together with all repair and replacement parts with a useful life of one or more years . . . 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.

Additionally, Proposed Regulation §§ 1525.2(a)(2) and (c)(7) provide that tangible personal property purchased for use in research and development includes property used in only those research and development activities that are described in Internal Revenue Code § 174 and the associated regulations.

Per Rev.& Tax.Code § 6377(b)(8), tangible personal property does not include:

  1. consumables with a normal useful life of less than one year (except for fuels used or consumed in the manufacturing process);[fn. 25]

  2. furniture, inventory, equipment used in the extraction process, and equipment used to store finished products that have completed the manufacturing process; and

  3. property for which a corporation franchise or a personal income tax credit is claimed under Rev.& Tax.Code § 17053.49 or 23649.[fn. 26]

Additionally, the exemption does not apply to any tangible personal property that is used 50% or more of the time in administrative, marketing or general management functions.[fn. 27]

What activities are included in the "manufacturing process"?

Rev.& Tax.Code § 6377 indicates that qualifying tangible personal property is that which is used in manufacturing and other qualifying processes beginning at the point where raw materials are received by the entity and introduced into the process and ending at the point at which the process has altered any inputs into the product's completed form, including any packaging that is required.

However, the SBE has determined that the transportation of raw material from the receiving area to the raw material inventory is not part of the manufacturing process for the purposes of Rev.& Tax.Code § 6377. Accordingly, Proposed Regulation § 1525.2 (a)(1) indicates that the manufacturing process does not begin until raw materials are taken from the raw material inventory and delivered to the factory floor for commencement of manufacturing activities.

In the proposed regulation, the SBE sets forth some specific examples of activities that will be considered part of the manufacturing, etc., process. In Proposed Regulation § 1525.2(b)(2), the SBE notes that property used primarily to clean and maintain a factory floor of a manufacturing facility is considered to be used primarily in a stage of the manufacturing process. In Proposed Regulation § 1525.2(b)(3), the SBE addresses fire safety equipment and states that if it is used primarily at and in connection with the factory floor of a manufacturing facility, such equipment is used primarily in a stage of the manufacturing process.

What are the mechanics for claiming the exemption?

Rev.& Tax.Code § 6377 mandates that the SBE provide an exemption certificate form and procedure for implementation of the sales and use tax exemption. Since the statute specifically provides that exemption certificates should contain the sales price of the tangible personal property, the statute could be interpreted as requiring that certificates be issued by the SBE on a purchase-by-purchase basis. However, rather than certifying each transaction through the SBE, Proposed Regulation § 1525.2(h) instead provides for "prequalification" of the purchasing entity and subsequent retailer documentation of exempt purchases. The purchasing entity must be certified as a "qualified person" pursuant to Proposed Regulation § 1525.2 and must hold a valid seller's permit or have a consumer use tax account with the SBE.

After certification as a "qualified person," the purchasing entity will receive an exemption certificate from the SBE. This exemption certificate may be reproduced as needed for subsequent qualified purchases.[fn. 28] A manufacturer's exemption certificate will be provided for purchases subject to the sales tax and a manufacturer's use tax declaration will be provided for purchases subject to the use tax. Both will contain a control number and an expiration date for easy verification by the retailer.

For purchases from establishments that are engaged in business in California, Proposed Regulation § 1525.2(f) provides the following procedure:

  1. the purchaser must provide the retailer with a copy of an exemption certificate within forty-five days after the date of purchase;[fn. 29] and

  2. the retailer must submit that exemption certificate at the time that the retailer files his or her sales and use tax return for the tax period in which the exemption was claimed.

If sales to a single purchaser are $25,000 or less during a single calendar quarter, the retailer does not need to furnish copies of that purchaser's exemption certificates with the sales tax return. However, retailers are required to collect and retain copies of exemption certificates for any and all exempt purchases under Rev.& Tax.Code § 6377. Additionally, retailers must retain all of these exemption certificates for a minimum period of four years after the date on which the retailer claimed a sales tax exemption based on receipt of the respective exemption certificate. The retailer must be able to furnish these to the SBE within forty-five days of any SBE request.

The use tax exemption functions similarly. When tangible personal property is purchased from a retailer that is not engaged in business in California, Proposed Regulation § 1525.2(g) would permit the exemption from the use tax only if:

  1. the purchaser files a timely sales and use tax return for the period in which the purchase took place and pays any local sales and use tax due; and

  2. the purchaser attaches an executed manufacturer's use tax declaration.

If the purchaser fails to file a timely and completed sales and use tax return or does not attach the required declaration from a retailer that is not engaged in business in California, then the exemption is considered waived.

Once an entity has received a sales tax exemption for a given purchase, can that exemption ever be revoked?

If within a year of the purchase the purchaser either removes the property from California, converts the property for use in a manner not qualifying for the exemption, uses the property in a manner that does not qualify for the exemption or fails to place the property into service in an exempt use, the purchaser will be liable for sales tax plus applicable interest, as though a taxable retail sale was conducted at the time the property was so removed, converted or used. The value of that taxable sale is the property's original purchase price.[fn. 30]

Property is considered converted to a use not qualifying for the exemption if the property is sold, transferred or assigned within one year from the date of purchase to a person who was not a "qualified person" on the date that the property was purchased.[fn. 31] Therefore, transfers from "qualified" parent/subsidiary corporations to unqualified affiliates would be considered conversions of property to a use not qualifying for the exemption. Consequently, the exemption would be lost and the transferring entity would be liable for payment of sales or use tax plus applicable interest.

What are the differences between the sales and use tax exemption and the investment tax credit?

Rev.& Tax.Code §§ 23649 (for corporation franchise tax) and 17053.49 (for personal income tax), respectively, provide a 6% tax credit for certain manufacturing and research property purchased or paid for on or after January 1, 1994. The credit, termed the investment tax credit ("ITC"), is administered by the Franchise Tax Board ("FTB")[fn. 32] and is available for tax years beginning after 1993.[fn. 33] However, for the 1994 tax year, the credit must be claimed on the 1995 return.

Similar to the sales and use tax exemption, the ITC extends to "qualified persons" for amounts paid for qualified property that is placed in service in California. As stated earlier, taxpayers may not avail themselves of both the ITC and the sales and use tax exemption.[fn. 34] However, due to several distinctions between the exemption and the ITC, the exemption should not be viewed strictly as an "in lieu of" provision.

First, the scope of the ITC is much broader than that of the exemption because, for purposes of the ITC, "qualified persons" are not limited to start-up companies. Any company classified (per the SIC Manual) as engaged in manufacturing activities is eligible for the credit.

Second, although the definition of "qualified property" under the ITC is similar to the definition under the sales and use tax exemption, the ITC statutes go on to specifically limit property qualifying for the ITC to tangible depreciable property defined at Internal Revenue Code § 1245(a) with only a limited exception for certain manufacturing and biotech industries. However, it should be noted that SB 1292 would limit the sales and use tax exemption to I.R.C. § 1245 property.[fn. 35]

Third, the ITC explicitly excludes leased equipment from its definition of qualifying property while the sales tax exemption extends to leased property. This issue is also considered in SB 1292. The bill proposes extending the ITC to leased property.[fn. 36]

As this discussion demonstrates, the ITC is designed to benefit a larger number of businesses; but--unless and until certain SB 1292 provisions are enacted--it is applicable to a more narrowly defined list of property. Although excess ITC may be carried forward, a business which is forecasting minimal net income in its early years might be more advantaged by claiming the sales tax exemption. Accordingly, businesses that qualify for both the ITC and the exemption should undertake careful tax planning in order to derive the greatest benefit from these provisions.


The state sales and use tax exemption is directed specifically at start-up companies that might not be able to take the ITC in earlier years and that would be more advantaged by being able to reduce their sales tax burden in these years.[fn. 37] However, there are a number of considerations in determining whether or not the exemption is available and/or advantageous in a given set of circumstances.

Taxpayers should carefully monitor the progress of Proposed Regulation § 1525.2, the amendments advanced in SB 1292 and any proposed regulations that the FTB may promulgate to clarify the scope of the ITC.


  1. Caltaxletter Special Report: Historic Business Tax Incentive, Unitary Reform Bill Passed, Caltaxletter vol. VI, Special Report No. 1, Sept. 13, 1993, at 1. [return to text]

  2. Sen. Bill No. 671, ch. 881. [return to text]

  3. A public hearing regarding this proposed regulation was held on August 4, 1994. [return to text]

  4. See Rev.& Tax.Code § 6377(a)(1). [return to text]

  5. See Rev.& Tax.Code §§ 6377(a)(2), 6377(a)(3). [return to text]

  6. See Rev.& Tax.Code § 6377(a)(4). [return to text]

  7. See State Board of Equalization, Tax Information Bulletin, June 1994. However, during a recent seminar, Caltax Seminar - S.B. 671 Panel Discussion, Sacramento Convention Center, Mar. 3, 1994, some commentators asserted that the state sales and use tax exemption is only 5%. They viewed Code section 6377 as providing merely a partial exemption and concluded that there should be no exemption from locally imposed, state administered, Bradley-Burns taxes and district taxes. [return to text]

  8. Rev.& Tax.Code §§ 23649, 17053.49, respectively. [return to text]

  9. See Rev.& Tax.Code § 6377(g). [return to text]

  10. For a copy of the Standard Industrial Classification Manual, contact the U.S. Government Printing Office, 710 N. Capitol St., NW, Washington, DC 20401. Telephone number (202) 783-3238; Fax (202)512-1355. [return to text]

  11. However, in a recent publication, the SBE stated that a qualifying person must be formed or organized in California. See State Board of Equalization, Tax Information Bulletin, June 1994. [return to text]

  12. Prop.Reg. § 1525.2(c)(5)(A). [return to text]

  13. Gary Jugum, Assistant Chief Counsel for the SBE, Caltax Seminar - SB 671 Panel Discussion, Sacramento Convention Center, Mar. 3, 1994. [return to text]

  14. Prop.Reg. § 1525.2(c)(5)(A)(3). [return to text]

  15. Prop.Reg. § 1525.2(c)(5)(A)(2). [return to text]

  16. Gary Jugum, supra, note 13. [return to text]

  17. Prop.Reg. § 1525.2(c)(5)(A)(3). [return to text]

  18. Prop.Reg. § 1525.2(c)(5)(B). [return to text]

  19. Some examples provided in Proposed Regulation section 1525.2(c)(5)(B)(1): a factory, a mill, a store, a mine, a farm, a ranch, a bank, a railroad depot, an airline terminal, a sales office, a warehouse or a central administrative office. [return to text]

  20. See Prop.Reg. § 1525.2(c)(5)(B)(1)(a). [return to text]

  21. See SBE Initial Statement of Reasons, 18 Cal.Admin.Code, for discussion regarding Proposed Regulation section 1525.2(c)(5)(A). [return to text]

  22. Prop.Reg. § 1525.2(d). [return to text]

  23. Proposed Regulation section 1525.2(c)(9)(D) defines these as structures that are used as an integral part of the manufacturing, etc., processes. They must be "specifically designed and constructed for the installation, operation and use of specific machinery and equipment which is considered to have a special purpose and which after installation will become affixed to or a fixture of the real property. A building or foundation is considered specially designed and constructed if it is uneconomical to design and construct the building or foundation for the intended qualifying purpose and then use the building or founda- tion for a different purpose." An example provides that wafer fabrication facilities or "clean rooms" are housed in special purpose buildings. General purpose manufacturing plants are not special purpose buildings. [return to text]

  24. Per Regulation section 1521(a)(6), the definition of "machinery and equipment" includes property intended to be used in the production, manufacturing or processing of tangible personal property, the performance of services or for other purposes not essential to the fixed works, building or structure itself, but which incidentally may, on account of its nature, be attached to the realty without losing its identity as a distinct piece of machinery or equipment and that, if attached, is readily removable without damage to the unit or to the realty. The definition of "machinery and equipment" does not include wiring, pipes, etc., incorporated into fixed works, buildings or other structures, whether or not such items are used solely or partially in connection with the operation of machinery and equipment, nor does it include items of tangible personal property such as power shovels, cranes, trucks, and hand or power tools used to perform a construction contract. [return to text]

  25. Property that a qualified person treats as having a useful life of less than one year for state income or franchise tax purposes should be classified similarly for the purposes of Rev.& Tax.Code section 6377. See Prop.Reg. § 1525.2 (c)(8)(B). [return to text]

  26. See also Prop.Reg. § 1525.2(e). [return to text]

  27. Prop.Reg. § 1525.2(b)(1). [return to text]

  28. However, the purchase of more than one piece of qualifying property can be included on a single exemption certificate where the purchases are from the same retailer. [return to text]

  29. If the purchaser fails to provide the retailer with an exemption certificate within 45 days, the exemption is waived. [return to text]

  30. Prop.Reg. § 1525.2(j). [return to text]

  31. Prop.Reg. § 1525.2(i). [return to text]

  32. The FTB has not yet released any proposed regulations in connection with the ITC. [return to text]

  33. Senate Bill ("SB") 1292 would cut this date back to October 6, 1993 for binding contracts that were in effect as to that date. On July 5, 1994, SB 1292 failed passage in the Senate Committee on Appropriations. Although reconsideration was not granted immediately, the bill may be revived. [return to text]

  34. See discussion accompanying note 26. [return to text]

  35. But see note 33. [return to text]

  36. But see note 33. [return to text]

  37. Gary Jugum, supra, note 13. [return to text]

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