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Manufacturers' investment credit:
Research and development activities

California allows a qualified taxpayer a manufacturers' investment credit (MIC) against tax equal to six percent of the qualified costs of certain property. In this article we discuss (1) qualified property used in the research and development (R&D) of new products and (2) whether product enhancements qualify for the MIC.

What's a qualified taxpayer?
A qualified taxpayer is any taxpayer engaged in an activity that is described in Division D, Manufacturing, of the Standard Industrial Classification (SIC) Manual, 1987 edition. Division D includes SIC codes 2011-3999. For tax years beginning on or after January 1, 1998, qualified taxpayer also includes certain activities described under SIC codes 7371-7373.

Generally, this means that a taxpayer must have, as part of its overall business operations, at least one business activity that is treated as a separate operating establishment and assigned a SIC code in Division D. The introductory section and appendices of the SIC Manual explain how to properly assign SIC codes to your business activities.

One error that taxpayers make is that they focus on whether their business activities are described in a Division D manufacturing activity without performing the classification analysis required by the SIC Manual. When the SIC code has properly been assigned using the classification principles discussed below, the taxpayer may find its SIC code is in another division of the SIC Manual, not manufacturing.

What are the SIC classification rules?
For purposes of determining whether the taxpayer is engaged in a qualified

activity for the MIC, you must identify the establishments operated by the taxpayer. An "establishment," defined by the SIC Manual, is an economic unit, generally at a single physical location, where business is conducted or where services are performed. When taxpayers have more than one establishment, then each separate establishment needs to be analyzed independently. Business activities that are conducted at different locations are generally treated as separate establishments and assigned their own SIC code based on the principal activity being conducted at that location.

For example, if X manufactures stuffed toys in Los Angeles and operates a retail toy store in San Jose, each of these activities would be treated as separate establishments and assigned SIC codes 3942 and 5945, respectively.

In the case where multiple activities are conducted at a single location, such as manufacturing and R&D, the activities must be analyzed to determine whether they constitute separate establishments. The regulations provide that a business activity will be treated as a separate establishment if all of the following apply:

  1. No single industry description in the SIC Manual defines the combined business activities;
  2. Separate reports and financial statements are prepared for each unit; and
  3. More than 25 percent of the total number of employees or the dollar amount of payroll at that location is assigned to the separate business activity being tested.

If the employee or payroll numbers do not meet the 25 percent threshold, a taxpayer may still be able to prove that a separate establishment classification should be assigned based upon the facts and circumstances of the business operations.

Once the taxpayer's business activities have been broken down into "establishments," the next step is to determine the type of each establishment. Under the SIC Manual's classification principles, there are two types of establishments—auxiliary and operating.

Auxiliary establishments are defined as establishments that are primarily engaged in performing management or support services for other establishments (i.e., support functions). Some examples of activities commonly performed by these establishments are accounting, R&D, and testing.

Any establishment that is not treated as an auxiliary establishment is treated as an operating establishment and will be assigned a SIC code based on its principal activity.

Pursuant to the SIC Manual classification system, R&D establishments primarily engaged in research for other establishments in the same enterprise will always be classified as auxiliary establishments. For purposes of the MIC, the most significant consequence of an establishment being classified as an "auxiliary establishment" is that it is assigned the same SIC code as the "operating establishment" it supports. For example, if X's manufacturing activity is assigned SIC code 3555 and its R&D activity is properly treated as an auxiliary establishment that supports that manufacturing activity, then the R&D activity would also be assigned SIC code 3555.

Continued from page 11

January/February 2001

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