State Tax TreatmentOf a ‘Manufacturer’

by Suzanne Palms, David Pope, and Maria Todorova

Suzanne Palms David Pope Maria Todorova

Many states have created special treatment formanufacturers, including tax exemptions, credits,and special income tax apportionment rules. In thisedition of A Pinch of SALT, we explore the state taxtreatment of manufacturers, including their rel-evance, definitions, and special treatment.

IntroductionManufacturing has been woven into the fabric of

our economy for centuries, although its predomi-nance has diminished dramatically since the 1960s.In his 2012 State of the Union speech, PresidentObama discussed the need to ‘‘lay out a blueprint foran economy that is built to last’’ and said ‘‘thisblueprint begins with American manufacturing.’’This renewed focus on manufacturing has put aspotlight on federal and state law, motivating policy-makers to stimulate that sector of the U.S. economy.

Manufacturers generally require a significantamount of property in the state, employ numerousworkers from all skill levels, and frequently pur-chase materials from local businesses. Providingincentives to manufacturers to relocate or remain ina state is especially attractive for obvious reasons,including an improved economic climate.

To attract new business investment and boosttheir economy, most states offer manufacturers avariety of tax incentives, including exemptions,credits, and special apportionment rules. For ex-ample, states offer credits to manufacturers to lurethem into the state, while at the same time they canlimit the period and amount of the benefit. Special

income tax apportionment rules are also attractivefor retaining businesses; however, setting a timelimitation on those types of rules is challenging.1

Because the distinctions between manufacturingand other sectors are blurred in many cases,whether a particular taxpayer meets a state’s defi-nition of manufacturer and qualifies for that state’stax incentives is uncertain. The uncertainty is fur-ther highlighted by the difficulty of fitting today’sdigital goods and service economy into the tradi-tional meaning of manufacturing.

Relevance of ‘Manufacturing’ for StateTaxation Purposes

Categorizing a business activity as manufactur-ing is far from an exact science, and the determina-tion often turns on the taxpayer’s facts and circum-stances. Only some states define manufacturing,and of those, many statutes are antiquated or thedefinitions are general and subject to interpretation.

Determining whether a taxpayer is a manufac-turer or is engaged in manufacturing activities iscritical to ensuring proper application of core tax

1Oregon recently struggled with a related issue regardingNike Inc.’s operation in the state. The popular shoe companyrequested that Oregon guarantee its single-sales-factor ap-portionment formula for the next 40 years in exchange for apromise to invest $150 million in the state over five years andcreate 500 jobs. See http://online.wsj.com/article/SB100014241278873242966045781777710769 45076.html. Oregon sub-stantially agreed to Nike’s request and passed a law thatallows Nike to calculate its state taxes using a single-sales-factor apportionment formula for the next 30 years, regard-less of future changes to state law, in exchange for Nike’spromise to invest $150 million in the state over five years andcreate 500 jobs by 2016. See http://online.wsj.com/article/SB10001424127887323777204578189950366322648.html.The single-sales-factor apportionment formula is currentlyOregon’s standard formula (that is, it is not a special formula)and does not depend on whether the business is deemedengaged in manufacturing. Nike stated that it ‘‘would notconsider making this capital investment in the State ofOregon but for the favorable economic development climatecreated by the State’s use of the Single Sales Factor Method.’’Id.

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provisions. The definition and scope of manufactur-ing is particularly significant in a handful of states,including Massachusetts and Rhode Island, thatprescribe a different apportionment method formanufacturers. Manufacturer status could be eitherbeneficial or burdensome depending on the facts andcircumstances. For example, Massachusetts re-quires a manufacturing corporation to use a single-sales-factor apportionment formula.2 Similarly,Rhode Island allows manufacturers to elect todouble-weight the sales factor in place of the tradi-tional three-factor formula.3 Connecticut,4 Kansas,5and Maryland6 are examples of other states thatprovide a different apportionment method for manu-facturers. Those apportionment formulas can proveto be beneficial in many circumstances because themanufacturer incurs no additional tax for locating ina jurisdiction. The manufacturer’s apportionmentformula is now weighted more heavily to the statebased on its sales. The common notion is thatmanufacturing companies that have a large amountof property and payroll in state, and make most oftheir sales out of state, will benefit from those typesof formulas.

The definition and scope ofmanufacturing is particularlysignificant in a handful of states,including Massachusetts andRhode Island, that prescribe adifferent apportionment method formanufacturers.

The definition of manufacturing is also importantto taxpayers in determining eligibility for creditsand incentives for property tax and income taxpurposes. Eligibility for income tax credits is oftendetermined by using different definitions than thosefor apportionment purposes. For example, SouthCarolina defines manufacturing in its income taxchapter for purposes of the job income tax credit andthe renewable energy income tax credit; however, itdoes not define manufacturer for apportionmentpurposes.7

In the sales and use tax context, the definition ofmanufacturing is critical in deciding whether ataxpayer is eligible for a sales or use tax exemption.

For example, most states provide a full or partialexemption for machinery and equipment used inmanufacturing. However, each state has its ownmethod of determining what activities constitutemanufacturing. Thus, whether machinery or equip-ment is exempt under a given statute turns on thestate’s interpretation of the scope of manufacturing.For example, the Virginia tax commissioner recentlydetermined that a taxpayer that sold packagingproducts did not qualify for Virginia’s sales taxexemption for machinery, tools, or repair parts usedin processing, manufacturing, or converting prod-ucts for sale because the taxpayer did not have amanufacturing business classification under theNorth American Industry Classification System(NAICS) manual.8 The tax commissioner found thatalthough converting corrugated cardboard into self-locking boxes may be ‘‘processing,’’ the taxpayer’sprimary business activity of selling packaging ma-terials was not industrial in nature.9

Varying Definitions of Manufacturer orManufacturing

The first hurdle in determining eligibility for acredit, an exemption, or an apportionment method isunderstanding how states define manufacturer ormanufacturing for each particular tax type. Becauseof the lack of clarity, courts are often required tointerpret the statutory definitions. Many courtshave required manufacturers to have operations,processes, or activities that result in the productionof a new and different article, product, or commodity.

For purposes of this article, we have grouped thestatutory definitions into two general categories —those that provide a specific definition, and thosethat incorporate an NAICS code to determinewhether one qualifies as a manufacturer. The stat-utes that provide a specific definition typically relyon ideas such as increased commercial value andtangible personal property, while others focus onchange in form.

Massachusetts provides a specific definition fordetermining whether a taxpayer is a manufacturerfor income tax apportionment purposes. A Massa-chusetts manufacturing corporation is a ‘‘corpora-tion engaged in manufacturing.’’10 To be consideredas engaged in manufacturing, the corporation mustbe substantially engaged in transforming raw orfinished physical materials by hand or machinery,and through human skill and knowledge, into a newproduct possessing a new name and nature, and2Mass. Gen. Laws ch. 63, section 38(l)(1).

3See R.I. Gen. Laws section 44-11-14.6.4Conn. Gen. Stat. section 12-218(k).5Kan. Stat. Ann. section 79-3279(b)(6).6Md. Code Ann. Tax-Gen. section 10-402(c)(2); Md. Regs.

Code section 03.04.03.10.7See S.C. Code Ann. section 12-6-3360(L)(5); S.C. Code

Ann. section 12-6-3588(B)(2).

8Virginia Public Document Ruling 12-119 (Va. Tax Comm’rJuly 25, 2012).

9Id.10Mass. Gen. Laws ch. 63, section 38(l)(1).

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adapted to a new use.11 Illinois defines the manu-facturing process for use tax purposes as ‘‘the pro-duction of an article of tangible personal property,whether the article is a finished product or an articlefor use in the process of manufacturing or assem-bling a different article of tangible personal prop-erty, by a procedure commonly regarded as manu-facturing, processing, fabricating, or refining thatchanges some existing material into a material witha different form, use or name.’’12 That statutoryapproach focuses on the concepts of tangible per-sonal property and change in form.

Washington has adopted a similar definition forpurposes of its business and occupation tax. Wash-ington defines manufacturing as ‘‘all activities of acommercial or industrial nature [in which] labor orskill is applied, by hand or machinery, to materialsso that . . . a new, different, or useful substance orarticle of tangible personal property is produced forsale or commercial or industrial use.’’13 Change inform or a transformation process is evident in most,if not all, statutory definitions and is what onetypically thinks of when referring to the manufac-turing process.

New Mexico defines manufacturing as ‘‘combin-ing or processing components or materials to in-crease their value for sale in the ordinary course ofbusiness’’ for purposes of qualifying for the manu-facturing equipment investment credit.14 NewMexico focuses on the increased commercial value.That concept is common among state statutes butseems to be less important than the requirementthat there be a change in form and production of anew and different article.

States that look to a taxpayer’s NAICS code,which is determined based on the taxpayer’s pri-mary activity, seek to apply industry standards todefine manufacturing. There are three NAICS codesfor manufacturing — sectors 31 through 33. Themanufacturing sector as a whole ‘‘comprises estab-lishments engaged in the mechanical, physical, orchemical transformation of materials, substances, orcomponents into new products.’’15 Under the NAICS,a wide variety of activities qualify as manufactur-ing. Plants, factories, or mills obviously qualify, butso do other types of establishments one may nottypically consider to be manufacturing establish-ments, such as bakeries or custom tailors. Interest-ingly, the Office of Management and Budget, whichpublishes the NAICS definitions, acknowledges that

‘‘the boundaries of manufacturing and the othersectors of the classification system can be somewhatblurry.’’16

Rhode Island is an example of a state that incor-porates the NAICS codes into its definition of manu-facturing for income tax apportionment purposes.For that purpose, Rhode Island defines a manufac-turer as a taxpayer whose principal business isdescribed in sector 31, 32, or 33 of the NAICS asadopted by the OMB.17 Similarly, Virginia refers tothe manufacturing NAICS codes to determinewhether a taxpayer is eligible for optional single-sales-factor income tax apportionment availableonly to manufacturers.18 Virginia, however, alsoincludes the agriculture, forestry, and fishing andhunting sector, sector 11, in its definition of manu-facturing for that purpose. Georgia uses the NAICScodes in determining whether a taxpayer is eligiblefor the manufacturer’s and telecommunications in-vestment tax credit.19 The statute defines manufac-turing to include ‘‘those establishments classified bythe [NAICS] Codes . . . that belong to Sectors 31-33.’’20 Although not every state uses the same exactcodes in its definition, there does seem to be ageneral consensus that sectors 31 through 33 shouldbe included. Some states add codes that are deemedsimilar to the manufacturing codes.

Although it appears that usingNAICS codes could provide morecertainty than using a statutorydefinition, the use of NAICS codescould be over- or underinclusiveand result in outcomes unintendedby state legislatures.

Although it appears that using NAICS codescould provide more certainty than using a statutorydefinition, the use of NAICS codes could be over- orunderinclusive and result in outcomes unintendedby state legislatures. Another potential problemwith using NAICS codes is that the codes focus onthe product and assigns the same code to all estab-lishments related to those products regardless ofwhether manufacturing actually occurs at the estab-lishment.

In some cases, a determination that a taxpayer isa manufacturer or engages in manufacturing activi-ties does not end the analysis, even in states thatstatutorily define those terms. For example, in the

11Mass. Gen. Laws ch. 63, section 38(l)(2).1235 ILCS 105/3-50(1).13Wash. Rev. Code section 82.04.120.14N.M. Stat. Ann. section 7-9A-5.152012 NAICS Definitions, sector 31-33 — Manufacturing,

availableathttp://www.census.gov/eos/www/naics/index.html.

16Id.17R.I. Gen. Laws section 44-11-14.6.18Va. Code Ann. section 58.1-422(D).19See Ga. Reg. section 560-7-8-.37.20Id.

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sales and use tax context, it may be necessary todetermine which property used by the taxpayerwould qualify for manufacturing machinery andequipment exemptions. Traditionally, machineryand equipment used in manufacturing qualifies forsales or use tax exemptions only if they have a directand immediate effect on the physical transformationof raw material into new material.21 Some states,however, use the ‘‘integrated plant theory’’ as aconcept to broaden the scope of those exemptions toencompass all parts of an integrated manufacturingoperation.22 The integrated plant theory allows foradditional machinery and equipment to qualify forsales or use tax exemption — including propertyused between manufacturing activities — as long asthe property is integral or necessary to the manu-facturing process, without regard to whether themachinery and equipment touch or act on the mate-rial or product. For instance, Virginia follows anintegrated plant theory and statutorily definesmanufacturing to include ‘‘the production line of theplant starting with the handling and storage of rawmaterials at the plant site and continuing throughthe last step of production where the product isfinished or completed for sale and conveyed to awarehouse at the production site.’’23

Problems With Special ManufacturingTreatment

In addition to the definitional issues, determiningwhether a taxpayer qualifies for special tax treat-ment offered to manufacturers becomes problematicwhen the taxpayer has mixed sales of services andtangible personal property. Some states look to thetaxpayer’s predominant business activity, but inmany cases it is unclear how the predominant activ-ity is to be determined (by sales, costs, profits, orgross revenue). Other states provide no clear guid-ance. That uncertainty or lack of guidance mightcreate compliance challenges and also discouragein-state investment.

Other common problems with preferential treat-ment for manufacturers include defining manufac-turer or manufacturing for one tax type (for ex-ample, income tax), but not another (for example,sales tax). State revenue departments and courtsacross the country have issued inconsistent opin-

ions, some holding that the definitions of the termsin a different tax context (or a nontax context)should control the meaning of the terms in other taxcontexts, and other courts finding to the contrary.24

Some states look to the taxpayer’spredominant business activity, butin many cases it is unclear howthe predominant activity is to bedetermined.

Similarly, courts and state tax agencies havestruggled to apply those definitions to electric com-panies,25 telecommunications companies,26 andcompanies that provide electronic goods27; the re-sults have been inconsistent. More recently, stateshave struggled in determining whether to include asmanufacturers taxpayers that provide digital goods,services, and other intangibles. For example, theWashington attorney general has opined that pro-viding customers with access to computer databasesand Internet search engines does not constitutemanufacturing for purposes of the rural county salestax deferral program because doing so does not

21See, e.g., Colo. Rev. Stat. section 39-26-709(1)(a)(II); 6Ind. Admin. Code section 6-2.5-5-3(b); N.J.S.A. section54:32B-8.13.

22See, e.g., Ga. Code Ann. section 48-8-3(34); Ark. CodeAnn. section 26-52-402(c)(2)(A)(ii); Kan. Stat. Ann. section79-3606(kk)(1)(A).

2323 Va. Admin. Code section 10-210-920(B)(2); Va. CodeAnn. section 58.1-602. New York, Georgia, and Kansas areother states that have legislatively adopted the integratedplant theory.

24See, e.g., S-D-176, S.C. Dep’t of Revenue (Aug. 22, 1986)(declining to extend definition of manufacturer from other taxcontexts when no definition existed for sales tax exemptionpurposes); Turner Const. Co. v. Cantor, 196 A.D. 213 (1stDept. 1921) (holding that even though a corporation fallsunder the definition of a manufacturing corporation underthe Bankruptcy Act, that does not dictate that the corporationis a manufacturer for purposes of the tax law); Grant v.Zoning Hearing Board of the Township of Penn, No. 2255 (Pa.Com. Pl. Westmoreland County July 24, 2000) (using thedefinition of manufacturing from a tax context in deciding azoning ordinance issue despite recognizing that differentconsiderations should be made).

25See, e.g., Public Serv. Co. v. Department of Revenue, 2011WL 4089971 (Colo. 2011); United Illuminating Co. v. Groppo,601 A.2d 1005 (Conn. 1992).

26See, e.g., Southern Bell Tel. & Tel. Co. v. South CarolinaTax Comm’n, 377 S.E.2d 358 (S.C. Ct. App. 1989); BellAtlantic Mobile Systems, Inc. v. Commonweath of Pennsylva-nia, 799 A.2d 902 (Pa. Commw. Ct. 2002), aff’d per curiam,845 A.2d 762 (2004).

27Compare Random House, Inc. v. Comm’r of Revenue,Docket no. C303502, Mass. Appellate Tax Bd. (Oct. 2, 2012)(holding that a book publisher using electronic processes wasa manufacturing corporation for apportionment purposes),and Tex. Policy Letter Ruling 200808142L (Aug. 15, 2008)(ruling that a software developer qualified as a manufac-turer), with Schawk, Inc. v. Zehnder, 326 Ill. App. 3d 752 (1stDist. 2001) (finding that a graphic arts company that was inthe business of providing digital imaging prepress services forthe consumer products industry was not a manufacturer forpurposes of the investment tax credit, but was instead aservice business).

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involve any production of tangible personal prop-erty.28 The Pennsylvania Supreme Court has heldthat a provider of cellular telephone service is not amanufacturer entitled to an exemption from salestax, because the provider did not change tangiblepersonal property from its original composition intoa different form or product.29

In contrast, the Missouri Supreme Court hasfound that a telephone company’s purchases of ma-chinery and equipment were exempt from use taxbecause they were used directly in manufacturingbasic and vertical telephone services.30 Recently, theMassachusetts Appellate Tax Board determinedthat a book publisher — even though it used elec-tronic processes — was a manufacturing corporationfor apportionment purposes because the processeshad a substantial and physical effect on the finaltangible product produced, and the publisher re-

tained control over the exact specifications of thefinal product.31 Those differing opinions illustratethe need for states to fix their outdated tax provi-sions to reflect today’s information-based serviceeconomy and provide more certainty for taxpayers.

Conclusion

Many states have developed a complex set of taxincentives for manufacturers in their effort to at-tract new business to the state and stimulate theireconomy. Yet in today’s ever-evolving economic land-scape, it is not always clear what the terms ‘‘manu-facturer’’ and ‘‘manufacturing’’ encompass. Thus, itis important for states to provide guidance to tax-payers other than traditional manufacturers. ✰

28Wash. AGO 2007 No. 8, Nov. 21, 2007.29Bell Atlantic Mobile Systems, Inc. v. Com., 799 A.2d 902

(Pa. Commw. Ct. 2002), aff’d per curiam, 845 A.2d 762 (Pa.2004). After Bell Atlantic was decided, Pennsylvania updatedits statute to provide that production of mobile telecommuni-cations services qualified as processing. Thus, cellular tele-phone providers are now entitled to a sales tax exemption onpurchases of tangible personal property used in the provisionand production of mobile telecommunications services. See 72Pa. Stat. section 7201(k)(8)(D); 72 Pa. Stat. section7201(d)(17).

30Southwestern Bell Tel. Co. v. Dir. of Revenue, 182 S.W.3d226 (Mo. 2005).

31Random House, Inc. v. Comm’r of Revenue, Docket no.C303502, Mass. Appellate Tax Bd. (Oct. 2, 2012).

Suzanne Palms, David Pope, and Maria Todorova areassociates with Sutherland Asbill & Brennan LLP’s Stateand Local Tax Practice. Sutherland’s SALT Practice iscomposed of more than 25 attorneys who focus on planningand controversy associated with income, franchise, sales anduse, and property tax matters, as well as unclaimed prop-erty matters. Sutherland’s SALT Practice also monitors andcomments on state legislative and political efforts.

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