Tax Type
BPOL Tax
Description
Manufacturer's exemption from BPOL
Topic
Basis of Tax
Local Power to Tax
Date Issued
09-25-2002
September 25, 2002
Re: Appeal of Business, Professional and Occupational License (BPOL) Tax
Appeal of Business Tangible Personal Property (BTPP) Tax
Taxpayer: *****
Locality: *****
Dear *****:
This final state determination is issued upon the application for correction filed by you on behalf of ***** (the "Taxpayer") with the Department of Taxation. You appeal the ***** (the "County") determination that the Taxpayer should be classified as a business service rather than as manufacturer, and, therefore, is not entitled to the manufacturer's exemption from the BPOL tax and from certain BTPP taxation.
The local license tax and fee are imposed and administered by local officials. Code of Virginia § 58.1-3703.1(A)(5) authorizes the department to issue determinations on taxpayer appeals of certain BPOL tax assessments. Code of Virginia § 58.1-3983.1 authorizes the department to issue determinations on taxpayer appeals of certain BTPP tax assessments. On appeal, a BPOL tax or a BTPP assessment is deemed prima facie correct. In other words, the local assessment will stand unless the taxpayer proves that it is incorrect.
The following determination is based on the facts presented to the department as summarized below. This determination addresses the question of whether or not the Taxpayer should be classified as a manufacturer and, therefore, is not subject to the BPOL and BTPP taxes imposed by the County.
Copies of the Code of Virginia, regulations and public documents cited are included for reference purposes. These and other reference documents are also available online in the Tax Policy Library section of the Department of Taxation's web site, located at www.tax.state.va.us.
FACTS
The Taxpayer is a wholly owned subsidiary of a European-based, multi-national corporation engaged in the development of database canned software which it produces on a tangible medium - either a CD-ROM or a magnetic tape. The Taxpayer's American headquarters are in the County.
The Taxpayer represents itself as a "fully integrated company incorporating R&D, quality control, customer support and production" offering a range of professional services to meet its customers’ needs. The Taxpayer's revenues are primarily derived from license fees for the use of software products, fees for maintenance related to those products and fees for professional services.
The Taxpayer's parent European corporation electronically mails the software and related documentation to its Canadian office, which then forwards the files to the Taxpayer's headquarters in the County. The software is then tested on U.S. operational systems by the Taxpayer's research and development (R&D) unit where modifications and adjustments are made to allow the software to work with the types of computer systems the Taxpayer's American customers use. The Taxpayer then markets the products to potential customers. If a customer desires to purchase a product, a license agreement between the Taxpayer and the customer is negotiated. The agreement is for a specified period of time. The license agreement gives the customer the right to use the software and obtain any updates or technical support during this time period. If the customer wished to extend the license, it would enter into a maintenance agreement with the Taxpayer for an additional fee.
The Taxpayer provides customer training, and engages in time and material professional consulting contracts for software application development for a fee. The Taxpayer's office in the County performs accounting, legal, administrative, marketing, sales, training and other related services offered by the company. There are several hundred employees at this location.
The Taxpayer also has a logistics and distribution facility for the software in another county ("County B)". This facility converts data electronically transmitted from its facility in the County into CD-ROM software for its customers, creates documentation manuals for the software using a digital photocopier, and ships the software and manuals to its customers. The data originally created at its foreign parent's facility is modified for domestic consumption at the Taxpayer's facility in the County. While the marketing and sales functions and the provision of professional consulting services are coordinated through the headquarters office in the County, the actual production of the disks and accompanying instructional guides occurs at the Taxpayer's facility in County B.
The Taxpayer's Position
The Taxpayer contends the following:
- Its logistics and distribution facility department, which is engaged in the production of the canned software is neither a separate corporation nor a separate division of the Taxpayer's business; rather, it is a separate cost center, as are centers for Research and Development (R&D), Quality Control and Customer support.
Its customers are paying for a tangible product (the software on a tangible medium. The price of the "manufacture" of this product should include R&D.
As an integrated company, it is a manufacturer and should be exempt from the BPOL tax.
As a manufacturer, pursuant to Code of Virginia § 58.1-1101, its personal property that is not defined as machinery and tools, motor vehicles and delivery equipment is intangible and, therefore, not subject to local taxation.
If anything, it is not a business service because it sells its products at wholesale.
The County's method of apportionment of gross receipts is incorrect.
The County's Position
The County rebuts these contentions, stating that only 11 of the Taxpayer's employees are at the "manufacturing" facility in County B; whereas, several hundred employees performing the accounting, legal, administrative, marketing, sales training and other related services are located at the headquarters facility in the County.
The County also states that the Taxpayer is classified as a business service, and only pays a license fee in County B. In County B, a taxpayer must have gross receipts in excess of $200,000 before it is subject to a license tax. Therefore, the Taxpayer's gross receipts attributed to its logistics and distribution center (the manufacturing "cost center") are less than $200,000. The Taxpayer's gross receipts attributable to Virginia in tax year 2000 were approximately *****.
The County relies on the Taxpayer's financial statements as an indicator of the nature of the Taxpayer's business, and finds that the Taxpayer is a business service. It also states that the Taxpayer's manufacturing facility consists of a state-of-the-art digital photocopier, which the County contends does not meet the criteria set forth qualifying printers as manufacturers in Public Document (PD) 99-200 (7/23/99).
Finally, the County allocates the Taxpayer's Virginia income based on payroll apportionment. The County formulated its method of apportionment based on the information available: the Taxpayer's federal 1120 returns from tax years 1997, 1998 and 1999, and the Taxpayer's state income tax returns for the same years.
ANALYSIS
Is the Taxpayer a Manufacturer?
The BPOL statutes do not define the term "manufacturing" for purposes of the local business license tax. However, the Supreme Court of Virginia has developed a test involving three essential elements in determining whether a manufacturing activity is being undertaken. These elements are: (1) original material, referred to as raw material; (2) a process whereby the original material is changed; and (3) a resulting product, which by reason of being subject to such processing, is different from the original material. County of Chesterfield v. BBC Brown Boveri, 238 Va. 64 (1989). In summary, for BPOL purposes, a manufacturer means one engaged in a processing activity whereby the original materials are transformed into a product that is substantially different in character from the original materials.
In BBC Brown Boveri, the Court held that after it is determined that a taxpayer is engaged in a manufacturing activity, the taxpayer's manufacturing activities must meet the test of substantiality.
Substantiality
The test of substantiality is clearly defined in PD 98-154 (10/16/98), which states: "[t]o be considered substantial, the manufacturing component of a business must not be de minimis, merely trivial, or only incidental to its principal business." 1
Furthermore, the 2000 BPOL Guidelines, following the principles enunciated in BBC Brown Boveri, offer constructive measures to be used in determining whether or not a business should be classified as a manufacturer for BPOL tax purposes. Among these are:
- the manufacturing component's financial receipts or proportion of total corporate income;
the percentage that manufacturing equipment, inventory, etc. comprises of the total capital investment;
the number of employees working in the manufacturing component as compared with the total number of employees; or
the ratio of manufacturing activities to the entire business. For example, if a developer of very complex custom software produces only a few copies of disks, the assembly of purchased components may or may not constitute manufacturing. However, if such production constitutes a majority of the business' activities, the business may be considered a manufacturer. [Emphasis added.] 2000 BPOL Guidelines, Appendix B, page 70.
In summary, to qualify as a manufacturer, the Taxpayer's activities must: (i) meet the four-pronged test cited above; and (ii) meet the test of substantiality.
Software Development
The 2000 BPOL Guidelines state that "engineering, design, research and development, and computer software development typically are not manufacturing. However, the actual production of tangible products based on engineering, design, research and development can be manufacturing. 2 While the development of computer software is not manufacturing, the production of boxes containing the software on disks and related instruction manuals may be manufacturing." [Emphasis added.] 2000 BPOL Guidelines, id
The determinative question for BPOL taxation purposes becomes that of whether or not a substantial portion of the Taxpayer's business is manufacturing. The Taxpayer's financial statements as revealed in its annual report of 2000 lists its annual income as follows: 3
Software license fees *****%
Maintenance fees *****%
Professional services fees *****%
No income is listed for the sale of tangible personal property. The Taxpayer's operating expenses are listed as:
Software product development *****%
Sales and marketing *****%
Administrative & general *****%
Lawsuit settlement *****%
The only line in this report related to the "manufacturing" of the product would be that of software development, which presumably includes the packaging of the products for shipment to customers. PD 99-296 (11/17/99) states that the development of the software is not manufacturing.
In an earlier case involving a business that engaged in computer hardware engineering, software development and consulting services, the Virginia Attorney General found:
- Unless a substantial portion of the business involves the manufacture of computer hardware ... as opposed to the design, modification or installation of such equipment, the business would not, in my opinion, be excluded from local license taxation by § 58.1-3703(B)(4). 1991 Op. Att'y. Gen. 248, 250. (March 14, 1991.)
Research and Development
The Taxpayer contends that its research and development activities should be considered to be a part of its manufacturing activities. The 2000 BPOL Guidelines, however, specifically exclude research and development from manufacturing in most cases. Considered alone, engineering, design, research and development, and computer software development typically are not manufacturing. However, the actual production of tangible products based on engineering, design, research and development can be manufacturing. 2000 BPOL Guidelines, Appendix B.
In determining whether a business is substantially engaged in manufacturing, and hence qualifies as a manufacturer for BPOL, BTPP and Machinery and Tools (M&T) tax purposes, the manufacturing component of the business must be evaluated in terms of the four criteria set forth in BBC Brown Boveri. Satisfying one or two of the criteria is not necessarily sufficient to meet the test of substantiality. If it is determined that the manufacturing component of the business meets the test of substantiality for BPOL, BTPP and M&T tax purposes, and engages in ancillary activities related to research and development, such activities may be considered manufacturing for BPOL, BTPP and M&T tax purposes.
Printing Operation
The Taxpayer argues that the process used in burning the discs to create useable software for its customers and the printing of instructional guidelines on a digital copier then binding the booklets qualify it as a printer entitled to the manufacturer's exemption. Upon examination of the facts presented, the printing portion of the Taxpayer's business is a sophisticated duplicating photocopier that is driven by desktop software. While the binding and packaging of the products may be manufacturing, it is not clear from the facts presented if the actual printing on a digital photocopier is. However, it does not appear that the Taxpayer's printing operation meets the criteria for a manufacturer's classification as set forth in PD 99-200 (7/23/99).
Based on the facts presented, the Taxpayer has failed the fundamental test of substantiality to qualify as a manufacturer for BPOL tax purposes. I will now turn to the other issues in the Taxpayer's appeal.
Wholesale Sales
As part of its contention that it is a manufacturer, the Taxpayer states that it sells its products either for resale or to governmental, business, institutional or industrial entities that use the product for "consumption, use or incorporation in an assembly, manufacturing or processing operation." This definition of its activities is consistent with that in the 2000 BPOL Guidelines § 5.3.2, which describes wholesalers.
Payroll Apportionment
The County used payroll in determining the amount of gross receipts that should be apportioned to Virginia. Code of Virginia § 58.1-3703.1(A)(3)(a)(4) provides that, as a general rule:
- the gross receipts from the performance of services shall be attributed to the definite place of business at which the services are performed or, if not performed at any definite place of business, then to the definite place of business from which the services are directed or controlled.
However, if the licensee has more than one definite place of business and it is impractical or impossible to determine to which definite place of business gross receipts should be attributed under the general rule, "the gross receipts of the business shall be apportioned between the definite places of businesses on the basis of payroll." Code of Virginia § 58.1-3703.1(A)(3)(b).
In addressing the question of which employees could be included on the basis of payroll, the Tax Commissioner in PD 97-308 (7/22/97) found that a local taxing authority may include only those employees who directly participate in the business's licensed activity, because the purpose of apportionment by payroll is to divide gross receipts among the definite places of business, not to impose a disguised payroll tax on all employees.
Finally, localities must deduct any gross receipts attributable to another state or foreign country that has an income or income-like tax. The taxpayer does not have to actually pay any tax to take the deduction. 2000 BPOL Guidelines § 2.6.
BTPP: Is the Taxpayer's Equipment "Intangible" Property?
Section 58.1-1100 of the Code of Virginia provides that intangible personal property is segregated for state taxation only. One definition of such property is that "[c]apital which is personal property, tangible in fact, used in manufacturing ...businesses." Code of Virginia § 58.1-1101(A)(2).
To be a classified as a "manufacturing business," for BTPP tax purposes, a substantial portion of the business' activity must be the actual manufacturing process. BBC Brown Boveri, op.cit. Two subsequent cases before the Court began with the premise that the taxpayer had met the substantiality test to qualify as a manufacturer for BTPP tax purposes. In City of Winchester v. American Woodmark, 250 Va. 451 (1996), only after accepting this premise did the Court find the manufacturer's personal property to be intangible. In City of Martinsville v. Tultex Corp., 238 Va. 59 (1989), the parties involved had stipulated that computer equipment in question was "personal property, tangible in fact, used or employed in a manufacturing business." [Emphasis added.] In Tultex, the Court found the computer equipment to be "capital and deemed to be intangible personal property segregated for state taxation only."
Computer application software or operating systems software designed to be read by a computer and to enable it to perform specific operations with data or information stored by the computer is classified as intangible property and, therefore, segregated for state
taxation. Code of Virginia § 58.1-1101(A)(8). This refers to only application operating software used internally.
DETERMINATION
Based upon the limited information available to me, it appears, without deciding, that the Taxpayer may not qualify as a manufacturer for purposes of BPOL or BTPP. Additional information may very well alter that tentative conclusion.
In a meeting with the Taxpayer's representative granted at the Taxpayer's request, the Taxpayer's representative stated that he would be able to furnish financial information that more accurately and more completely reflects the manufacturing component's financial receipts, the number of employees working in the manufacturing component, the percentage of capital investment devoted to manufacturing equipment and inventory and the ratio of manufacturing activities to the entire business.
Accordingly, this matter is returned to the County to allow for additional information to be supplied by the Taxpayer bearing on the question of the substantiality of the manufacturing activity consistent with the remainder of this determination.
Outstanding Issues
The Taxpayer's financial records indicate that much of its business activity is in the nature of business services: professional services; selling and marketing of licensing agreements; as well as, charging maintenance fees for existing contracts. However, the Taxpayer's contention that it is in the business of selling products at wholesale merits some attention. While it is not clear whether its activities as a wholesaler rise to the level of separate licensable activities, the Taxpayer may request a limited reconsideration of the facts on that issue. It is the Taxpayer's responsibility to supply the County with that information.
Finally, the County has requested the Taxpayer to supply it with additional information regarding the question of apportionment. It is my understanding that the County proceeded to decide the issue with the information to which it had access. If the Taxpayer has additional information, on either the question of wholesale activities or apportionment that it would like the County to consider, it must supply the County with that information in addition to the additional information bearing on the question of the substantiality of the manufacturing activity within 45 days from the date of this letter.
If you have any questions regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
Sincerely,
Kenneth W. Thorson
Tax Commissioner
AR/37877H
1In BBC Brown Boveri, the Virginia Supreme Court noted that the parties agreed that the taxpayer could be "classified as a manufacturer only if its manufacturing activities, when compared to its total activities are substantial."
2 Footnote #5 in BBC Brown Boveri discusses the question of whether the design and engineering stages of a manufacturing job constitute manufacturing. In that particular case, the Court found that the design and engineering work were ancillary to the manufacturing work and therefore such work was classified as manufacturing. The footnote concludes: "Thus because [Taxpayer's] design and engineering are integral parts of its manufacturing activity, such work is properly classified as manufacturing."
3 Percentages are rounded.
Rulings of the Tax Commissioner