Legal ruling 1998-1

Manufacturers' Investment Credit Capitalized Costs of Labor for Engineering and Design

Issue

To what extent may capitalized costs of labor paid or incurred by a qualified taxpayer for engineering and design services constitute qualified costs for purposes of California's Manufacturers' Investment Credit (MIC)?

Law

The MIC is allowed under Revenue and Taxation Code (Rev. & Tax. Code) §§ 17053.49 (Personal Income Tax (PIT) Law) and 23649 (Bank and Corporation Tax (B&CT) Law). Regulations for the MIC are at Title 18, California Code of Regulations (Cal. Code Regs.) §§ 17053.49-0 through 17053.49-11 (PIT) and 23649-0 through 23649-11 (B&CT). The MIC is allowable to qualified taxpayers who pay or incur qualified costs on or after January 1, 1994, for qualified property that is placed in service in California.

"Qualified taxpayer" for purposes of the MIC means any taxpayer that has an operating establishment properly classified under Division D (Codes 2011 through 3999, inclusive[1]) of the Standard Industrial Classification (SIC) Manual, published by the United States Office of Management and Budget, 1987 Edition. (Rev. & Tax. Code §§ 17053.49(c) and 23649(c); Cal. Code Regs., tit. 18, §§ 17053.49-3(a) and 23649-3(a).)[2]

Generally, qualified property for the MIC is tangible personal property as defined in Internal Revenue Code (I.R.C.) § 1245(a)(3)(A) for use in an establishment[3] of the qualified taxpayer that is properly classified under Division D of the SIC Manual and is primarily used in a qualified activity.[4] (Rev. & Tax. Code §§ 17053.49(d) and 23649(d); Cal. Code Regs., tit. 18, §§ 17053.49-5 and 23649-5.)

The MIC is equal to six percent (6%) of all qualified costs. Generally, qualified costs for the MIC are costs paid or incurred by a qualified taxpayer on or after January 1, 1994, for the construction, reconstruction, or acquisition of qualified property upon which California sales or use tax is paid. (Rev. & Tax. Code §§ 17053.49(b)(1)(B) and 23649(b)(1)(B).) Qualified costs for the MIC are limited to amounts that are properly chargeable to the capital account of the qualified taxpayer. (Rev. & Tax. Code §§ 17053.49(b)(1)(C) and 23649(b)(1)(C).)

Capitalized costs of labor that are "directly allocable to the construction or modification" of qualified property may also be included as qualified costs for purposes of the MIC. (Rev. & Tax. Code §§ 17053.49(d)(2) and 23649(d)(2).) Capitalized direct costs of labor are not required to be costs upon which California sales or use tax is paid. (Rev. & Tax. Code §§ 17053.49(b)(1)(B) and 23649 (b)(1)(B).) This is an exception to the general requirement that qualified costs for purposes of the MIC be amounts upon which California sales or use tax is paid.

For purposes of the MIC, the term "capitalized labor" means 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 qualified property. (Cal. Code Regs., tit. 18, §§ 17053.49-2(c) and 23649-2(c).) In determining whether direct costs of labor are properly allocable to the construction, modification, or installation of a specific item of qualified property, the qualified taxpayer is required to use the same method of allocation that is required to be used by the qualified taxpayer for California income or franchise tax purposes under the uniform capitalization (UNICAP) allocation rules in U.S. Treasury Regulation (Treas. Reg.) § 1.263A-1. (Cal. Code Regs., tit. 18, §§ 17053.49-2(c)(3) and 23649-2(c)(3).)

The UNICAP rules contained in I.R.C. § 263A[5] generally address the capitalization of costs associated with real and personal property produced by the taxpayer for resale and property acquired for resale.[6] For purposes of the MIC only, the UNICAP allocation rules of I.R.C. § 263A are only used to determine whether capitalized costs of labor associated with the construction or modification of qualified property for the MIC are direct costs of labor (as distinguished from indirect costs of labor). (Cal. Code Regs., tit. 18, §§ 17053.49-2(c) and 23649-2(c).) Accordingly, if costs of labor would be properly treated as direct costs of labor capitalized to an item of property produced by the taxpayer or acquired for resale under I.R.C. § 263A, then such costs of labor shall be treated as direct costs for purposes of the MIC.

Treas. Reg. § 1.263A-1(e) provides in general that taxpayers "must capitalize all direct costs and certain indirect costs . . ." Direct costs of labor include costs of labor that can be identified or associated with particular units or groups of units of specified property. (Treas. Reg. § 1.263A-1(e).) Elements of direct costs of labor include basic compensation, overtime pay, vacation pay, holiday pay, sick leave pay, shift differential, payroll taxes, and payments to a supplemental unemployment benefit plan. (Treas. Reg. § 1.263A-1(e)(2)(i)(B); Cal. Code Regs., tit. 18, §§ 17053.49-2(c) and 23649-2(c).) Indirect costs are defined as all costs other than direct material costs and direct costs of labor. (Treas. Reg. § 1.263A-1(e)(3)(i); Cal. Code Regs., tit. 18, §§ 17053.49-2(c) and 23649-2(c).)

Treas. Reg. § 1.263A-1(e)(3) provides examples of indirect costs "that must be capitalized to the extent they are properly allocable to property produced . . ." Treas. Reg. § 1.263A-1(e)(3)(P) lists engineering and design costs as an example of indirect costs that are required to be capitalized. However, this reference is only applicable to design and engineering costs that are not properly treated as direct costs of labor. Costs paid or incurred to third-party or independent contractors that would be properly treated as direct costs capitalized to an item of qualified property produced by the taxpayer or acquired for resale under I.R.C. § 263A may also be qualified capitalized costs of labor for purposes of the MIC. (See Treas. Reg. § 1.263A-1(e)(2)(i)(B).)

Facts and Analyses

In each of the factual situations below, assume the following:

The business activities of each taxpayer are properly assigned to SIC Codes, as published in the SIC Manual, under Division D, Manufacturing (Codes 2011 through 3999, inclusive), and each taxpayer is a qualified taxpayer for purposes of the MIC. Each taxpayer is not doing business in an Enterprise Zone, the Los Angeles Revitalization Zone (LARZ), a Local Area Military Base Recovery Area (LAMBRA) or a Program Area. Unless otherwise specified, all property discussed is qualified property for the MIC. Except for engineering and design capitalized costs of labor, assume that all other costs discussed herein are qualified costs for the MIC and that no election is made to currently expense any portion of such costs under Rev. & Tax. Code §§ 17265 or 17266 (I.R.C. § 179) or any other similar provision, such as the accelerated expensing provisions provided to taxpayers doing business in an economic incentive zone.[7] For purposes of the MIC, each taxpayer uses the same method of allocation for purposes of determining whether costs of labor would be properly treated as direct costs capitalized to an item of property under I.R.C. § 263A as for California franchise and income tax depreciation purposes.

Situation 1

Facts

X Fuels, Inc. (X), is an integrated oil and gas company that refines petroleum products at its refining plant in the town of Bedrock, California. Among its various refined products, X produces reformulated and oxygenated gasoline that complies with the federal Clean Air Act and meets the standards established by the California Air Resources Board. In order to comply with these federal and state mandates, X is required to construct a new "coker", which is a specific item of refining equipment which will perform one of many steps in the petroleum refining process, at its refinery in Bedrock. The new coker is self-constructed by X. Only X's employees are engaged in the actual construction process. X directly purchases all of the materials necessary to complete the job. However, after January 1, 1994, X enters into a contract with an independent third-party contractor, Y, Inc. (Y), for certain engineering and design services necessary for the construction of the new coker.

Under the terms of the contract between X and Y, the new coker is the only item of property for which Y is to provide design and engineering services. All of X's payments under the contract to Y are properly capitalized to the cost basis of the new coker for federal and state tax depreciation purposes. For purposes of the MIC, X uses the same method of allocation for purposes of determining whether costs of labor would be properly treated as direct costs of labor capitalized to an item of property under I.R.C. § 263A as X uses for California franchise and income tax depreciation purposes.[8]

Analysis

In Situation 1, the issue is whether the third party contract costs paid to Y for engineering and design services related to the new coker would be properly treated as direct costs of labor capitalized to an item of property under I.R.C. § 263A. As discussed above, the UNICAP rules contained in I.R.C. § 263A are generally applicable to self-constructed property and property acquired for resale. They generally do not address the type of property that is qualified property for the MIC. However, for definitional purposes only, the MIC regulations mandate that the UNICAP rules be used to determine whether costs of labor are "direct" or "indirect." Only capitalized direct costs of labor may be qualified costs for purposes of the MIC. The test for whether costs of labor are direct costs of labor under I.R.C. § 263A is whether these costs "can be identified or associated with particular units or groups of units of specified property." (Treas. Reg. § 1.263A-1 (e)(2)(B); Cal. Code Regs., tit. 18, §§ 17053.49-2(c) and 23649-2(c).) The engineering and design costs represented by X's payments to the independent third party contractor, Y, would be properly treated as direct costs of labor capitalized to an item of property pursuant to I.R.C. § 263A under X's normal method of accounting because they are identified and associated with the new coker.

Holding

In Situation 1, X may include the engineering and design costs represented by X's payments to the third party contractor, Y, as qualified capitalized costs of labor for the MIC because they would be properly treated as direct costs of labor capitalized to an item of property pursuant to I.R.C. § 263A under X's normal method of accounting.

Situation 2

Facts

Assume the same facts as those in Situation 1, except that instead of utilizing the services of Y for engineering and design of the new coker, X utilizes the services of X's own employees for this work. Further assume that X has an "Engineering and Design Department" in which X employs five engineers to accomplish various engineering and design tasks on an as-needed basis. All five of these engineers jointly undertake the engineering and design of the new coker in addition to providing engineering and design for the construction of other items of X's property. X does not keep separate records of the time spent by each of these employees performing engineering and design services for the new coker.

Analysis

In Situation 2, the issue is whether the regular wages and overtime paid to X's five engineers for performing engineering and design services for the new coker would be properly treated as direct costs of labor capitalized to an item of property under I.R.C. § 263A. The regular wages and overtime paid to X's five engineers would not be properly treated as direct costs of labor because they cannot be identified or associated with a specific item of X's property. Pursuant to I.R.C. § 263A, the absence of records which show that costs (or some portion of such costs) are identified and associated with the new coker requires such costs to be properly treated as indirect costs. Such indirect costs are not qualified capitalized costs of labor for the MIC.

For purposes of the MIC, to the extent that the regular wages and overtime paid to X's five engineers would be properly treated as indirect costs required to be capitalized under I.R.C. § 263A, these costs would be allocated among all of the items of property for which X's engineers provided engineering and design services pursuant to the methods for allocation of such costs under I.R.C. § 263A. Therefore, for purposes of the MIC, these costs would be properly treated as indirect costs of labor required to be capitalized to an item of property under I.R.C. § 263A.[9]

Holding

In Situation 2, X may not include the regular wages and overtime pay for X's five engineers as qualified capitalized costs of labor for the MIC because they would not be properly treated as direct costs of labor required to be capitalized to an item of property pursuant to I.R.C. § 263A under X's normal method of accounting.

Situation 3

Facts

Assume the same facts as those in Situation 2, except that X maintains separate records on the number of hours that each of its five engineers spends engineering and designing the new coker. For example, employee Z spends fifty hours working solely on designing the new coker and X keeps a written record of this time. Based upon these separate records, X calculates the amount of each engineer's wages and overtime to be capitalized to the new coker for California depreciation purposes and is consistent with the accounting method X uses for inventory purposes.

Analysis

In Situation 3, the issue is whether the regular wages and overtime paid to X's five engineers, for which X maintains separate records, for the engineering and design of the new coker would be properly treated as direct costs of labor capitalized to an item of property under I.R.C. §263A. To the extent that these costs of labor are evidenced by separate records, they can be identified and associated with the new coker. The regular wages and overtime paid to X's five engineers for engineering and design of the new coker, for which X maintains separate records, would be properly treated as direct costs of labor capitalized to an item of property under I.R.C. § 263A.

Holding

In Situation 3, for purposes of the MIC, X may include as qualified capitalized costs of labor the regular wages and overtime paid to X's five engineers related to the new coker, for which X maintains separate records, because these costs would be properly treated as direct costs of labor capitalized to an item of property pursuant to I.R.C. § 263A under X's normal method of accounting.

Drafting Information

The principal author of this ruling is E. Scott Ewing of the Franchise Tax Board Legal Branch. For further information regarding this notice, contact Mr. Ewing at the Franchise Tax Board Legal Branch, P.O. Box 1720, Rancho Cordova, CA 95741-1720.

Footnotes

1. These SIC Codes reflect technical amendments to the MIC statutes, Rev. & Tax. Code §§ 17053.49 and 23649, by Senate Bill (SB) 38 (Stats. 1996, Ch. 954). Prior to SB 38, these statutes identified SIC Codes 2000 through 3999, inclusive..↵Return to reference
2. The determination of whether a taxpayer is engaged in an activity that is described in Division D of the SIC Manual shall be made under the rules and methods described in the SIC Manual and the MIC regulations on the basis of all of the facts and circumstances. For purposes of the MIC, a SIC Code assignment to a given taxpayer's activity made by any federal, state (other than the Franchise Tax Board), regional, or local government agency shall not be controlling. (Cal. Code Regs., tit. 18, §§ 17053.49-3(a) and 23649-3(a).) .↵Return to reference
3. According to the SIC Manual, there are two types of establishments - operating and auxiliary. For purposes of determining whether property is for use in a Division D manufacturing activity, the property must be for use in an operating establishment that is properly assigned a Division D SIC Code or an auxiliary establishment which is assigned the same Division D SIC Code as the operating establishment it supports, regardless of the primary activity being conducted in such an auxiliary establishment..↵Return to reference
4. Qualified activities for MIC property are specified in Rev. & Tax. Code §§ 17053.49(d)(1)(A) through (E) and 23649(d)(1)(A) through (E) and are further defined in Cal. Code Regs., tit. 18, §§ 17053.49-2 and 23649-2. ↵Return to reference
5. All references in this Legal Ruling to I.R.C. § 263A incorporate by reference the regulations thereunder. Discussion or application in this Legal Ruling of federal or state statutes or regulations dealing with capitalization of property is only for purposes of defining direct costs of labor for the MIC.↵Return to reference
6. For the general scope of I.R.C. § 263A, see Treas. Reg. § 1.263A-1(a)(3).↵Return to reference
7. Unlike under the Personal Income Tax Law, for most Bank and Corporation Tax purposes, California does not conform to I.R.C. § 179. However, I.R.C. 179-type deductions are generally available to corporations doing business in a geographic-based economic incentive zone, such as an enterprise zone (Rev. & Tax. Code § 24356.2), the LARZ (Rev. & Tax. Code § 24356.4), or LAMBRA (Rev. & Tax. Code § 24356.8). Under these provisions, a qualified taxpayer may generally elect to treat the cost of such property (subject to specified limitations) as an expense that is not chargeable to capital account. ↵Return to reference
8. For purposes of this Legal Ruling, assume that X must capitalize the coker under the general authority of I.R.C. § 263. (Comm. v. Idaho Power Co. (1974) 418 US 1 (94 S.Ct. 2757).)↵Return to reference
9. For the methods of allocating indirect costs of labor that are required to be capitalized, see Treas. Reg. §§ 1.263A-1(c), 1.263A-2(b), 1.263A-3(d) and related sections. Generally, indirect costs are allocated using either a specific identification method, a standard cost method, a burden rate method, or any other reasonable allocation method (as defined under the principles of Treas. Reg. § 1.263A-1(f)(4)). (Treas. Reg. § 1.263A-1↵Return to reference