Tax Type
BPOL Tax
Description
Exceptions; Computer assemblers not exempt
Topic
Local Power to Tax
Date Issued
03-05-1998
Superseded by PD 98-154
March 5, 1998
Re: Request for an Advisory Opinion
Business, Professional, & Occupational License
(BPOL) Tax
Dear****************:
In your letter dated November 3, 1997, you asked for an advisory opinion concerning the business classification of a company that supplies computer hardware, software, and consulting services to its clients. Specifically, you ask if a computer company that assembles the computers that it sells is considered a manufacturer and, consequently, is excluded from BPOL tax on its gross receipts from sales at wholesale, pursuant to Code of Virginia § 58.1-3703(C)(4).
Although the BPOL tax is a local license tax that is imposed and administered by local officials, the Virginia Department of Taxation may promulgate guidelines and issue advisory opinions on a limited basis according to Virginia statute. The Tax Department, however, is not required to interpret local ordinances.
While addressing the questions raised in your letter, this response is intended to provide advisory guidance only and does not constitute a formal or binding ruling. Copies of cited statutory sources are enclosed for your review.
FACTS
As you state in your letter, Company A supplies its clients with local area networks (LANs), computers, software, peripherals, and consulting services. The majority of the Company's receipts are derived from network and computer sales. The Company makes the computers that it sells, which procedure includes acquiring various computer parts, such as motherboards, memory chips, video controllers, power switches, cables, cases, monitors, and other necessary parts from original equipment manufacturers (OEMs). The Company puts these parts together according to client specifications to make a computer hardware product. The Company also incorporates the required programming software that is necessary to operate the computers as standalones or as part of a network. There is some wiring or soldering of OEM parts to the computer case. These OEM parts are complete, modular units that are ready to be used. The Company's clients are business companies, educational institutions, and local government.
OPINION
"Manufacturing" activities are determined by using a three-element analysis, which requires that (1) an original material (2) be processed and (3) changed substantially into a product of a different character from the original material. A "process" (factor 2) is a procedure in which original material is treated and has a change in its marketability or value and usefulness. In this case, attaching OEM parts together is neither manufacturing nor processing, but more closely resembles "assembling" various parts together. Consequently, Company A is not a manufacturer for the purposes of the exemption in § 58.1-3703(C)(4). This result is based on the following analysis.
Localities in Virginia may subject businesses to a BPOL license fee and tax for the "privilege" of engaging in a licensable business within their locality. Code of Virginia § 58.1-3703.1 (A)(1). Localities, however, may not levy a license fee or tax on a "manufacturer for the privilege of manufacturing and selling goods, wares, and merchandise at wholesale at the place of manufacture." Code of Virginia § 58.1-3703(C)(4). For a business to qualify for this exclusion, the manufacturing part of the business must be a substantial portion of the total business. County of Chesterfield v. BBC Brown Boveri. Inc., 238 Va. 64, 70 (1989). Consequently, Company A's activities will be analyzed in two parts, the first part will examine whether the Company's activities are manufacturing, and, if so, whether the manufacturing activities are a "substantial" portion of the Company's total activities.
"Manufacturing" is not defined in the Code of Virginia for local license tax purposes. However, the Tax Department's guidelines for BPOL tax has incorporated the three-element analysis used by the Virginia Supreme Court to determine whether or not a business activity is "manufacturing." These elements are:
(1) original material,
(2) a process by which the original material is changed, and
(3) a resulting product that, by reasons of being subjected to a process, is substantially different from the original material.
Guidelines for Business. Professional. and Occupational License Tax (Va. Dep't of Tax'n) Jan. 1, 1997, App. B; Prentice v. City of Richmond,197 Va. 724, 729-30 (1980).
Before determining if a process is manufacturing, the issue of whether a procedure is a process (the second element) must be addressed since all procedures are not processes. A "process" is defined as a procedure in which the original material undergoes a treatment rendering it more marketable or useful but does not require that the treatment produce an article of substantial change from the original material. Dep't of Tax. v. Orange-Madison Coop. Farm Service, 220 Va. 655, 657-58 (1980). In the following cases, the Court came to two different conclusions as a result of the factual differences between the cases.
In Orange-Madison Cooperative Farm Service, the Cooperative sold feed and fertilizer that the Cooperative formulated. To make the feed mixture, the Cooperative combined corn, barley, and wheat that was steamed, cracked, flattened, and dried. Certain ingredients were added and blended into the grain mixture, such as soybean or peanut meal, vitamins, minerals, salt, and liquid molasses. To make fertilizer, the Cooperative blended nitrogen, potash, phosphate, and other chemicals to form a final product that met the farmers’ individual needs. The Court adopted the dictionary definition of processing1 (because no statutory definition was available) and concluded that the procedures of making feed and fertilizer was "processing" because both procedures resulted in products that were more marketable and useful. Id. at 658.
In Virginia v. Flow Research Animals. Inc., the Virginia Supreme Court held that bio-medical research which produced various strains of animals was not "processing" because there was no treatment of the animals. The company merely provided "a protected hygienic environment" and allowed nature to proceed. Even under a broad interpretation of processing, previous case law contemplated that the original material be treated in some manner, whether by heat (as in the pasteurization of milk) or by blending (as in the production of feed and fertilizer). The company's procedure provided none of that. 221 Va. 817, 820 (1981).
Once a procedure is determined to be a process, the process must be analyzed to determine if it is manufacturing. Because all manufacturing requires that the original material undergoes a substantial change, not all processing is manufacturing - only those processes that produce substantial changes. Discerning whether or not a procedure is "processing" or "manufacturing" can be a very fine distinction, which is based on the facts and surrounding circumstances of the business activities. In the cases listed below, the three-element analysis was applied to various fact patterns and produced the following results:
* In Richmond v. Dairy Co., the Virginia Supreme Court held that the business of buying fluid milk, pasteurizing and selling it as fluid milk and cream was not manufacturing because there was no difference in form, use, and appearance. The original material was liquid and the ending product was liquid and had the same taste and use. However, the manufacturing classification did apply to the production of cheese, powdered milk, and condensed milk. 156 Va. 63, 75 (1931).
* In Commonwealth v. Meyer, the Virginia Supreme Court determined that meat packers were manufacturers because the carcasses were subjected to a diverse process that required various materials, ingredients, skill, care, and attention to produce the proper forms of the final products. The meat packers purchased and slaughtered the animals, carved the carcasses into various cuts of meat, prepared and sold sausage, head cheese, mince meats, canned meats, bacon, smoked meats, chitterlings, and lard. "The original product was not destroyed but was so transformed through art and labor that without previous knowledge it could not have been recognized in the new shape it assumed or in the new uses to which it was applied." 180 Va. 466, 467, 471 (1942).
* However, in Prentice v. City of Richmond, the processing of live chickens was not considered to be manufacturing. While the process included buying chickens that were slaughtered, plucked, eviscerated, and washed, the chickens were not transformed into an article or product of substantially different character for the process to be manufacturing. Even though manufacturing implies a change, the change must be something more - a transformation into a new and different article that has a distinct name, character, or use. "Mere manipulation or rearrangement of the raw materials is not sufficient, there must be a substantial, well signalized transformation in form, quality, and adaptability...." 197 Va. at 728.
* In Solite Corporation v. King George County, the Court held that the processing of sand and gravel did not constitute manufacturing. The process included washing, screening, grading, removing impurities, segregating the various grades of sand and gravel, and blending of various grades of gravel and sand. An increase in value or usefulness was not a determining factor when evaluating whether or not a process was manufacturing. The original material was not transformed into a product of substantially different character, it was just mixed together. The "mere blending" of different ingredients without transforming the material into a substantially different product is not "manufacturing." 220 Va. 661, 663, 665 (1980).
In the present situation, the procedure of putting the OEM parts together into a personal computer or server is not "manufacturing" or even "processing." Specifically, there are no second and third elements to complete the three-element analysis - no process (the second element) caused a substantial transformation of the original material (the third element). As case law has shown, "manufacturing" requires that the process transform the original material into an article of substantially different character, form, use, quality, and adaptability, while "processing" requires that a treatment of some kind be applied to the original materials to increase their value and usefulness. Neither one of these operations is present in the current situation.
In this case, the original materials that Company A buys are the same at the beginning as they are at the end of the procedure. They have the same name, character, use, and form. The only difference is that they are situated in a certain place. No "process" applies a treatment or causes them to change much less cause a substantial change as case law requires in order for the process to be manufacturing. At the end of the procedure, a motherboard is still a motherboard, a monitor is still a monitor, a cable is still a cable, except that they are situated together inside or connected to a case by cables that snap onto or into another part. The original materials have not changed or transformed in any way - they have merely been arranged with other parts.
This procedure more closely resembles the assembling of parts to form a product. In the absence of statutory or case law definition, the common meaning of the verb "to assemble" in Webster's ll New College Dictionary (1995), is defined, in pertinent part, as "1. [t]o bring or gather together into a group or whole. 2. [t]o fit or join together the parts of." Company A's personnel places the OEM parts together in an empty case and connects them with cables. Occasionally, some parts are attached to the case with solder or wire, but the parts are not changed or treated in any way. Further, the OEM ships the computer parts to Company A that are ready to be used for assembling or "joining together" or "gathering into a group." No other treatment or work is necessary to make the parts work except for attaching them together into a computer case.
Consequently, comparing Company A's procedure to the elements of "manufacturing" reveals something less than what the three-element analysis allows. The original material is merely "manipulated or rearranged" - no substantial "well signalized transformation in form, quality, and adaptability" takes place. Prentice, 197 Va. at 730.
A determination of whether a procedure is "manufacturing" must be based on the facts and circumstances of each case. Based on the information before me, I conclude that Company A is not engaged in manufacturing computer products. Since Company A's activities are not manufacturing, it is not necessary to address the "substantiality" of manufacturing activities in relation to total activities.
I hope that the above information will be beneficial to you. Although I believe this letter conforms with the requirements of the law, it is written only for your guidance. If you have other questions, please do not hesitate to contact me.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP13147G
1 "To process" is defined as: "to subject to a particular method, system, or technique of preparation, handling or other treatment designed to effect a particular result: put through a special process: as ... (1): to prepare for market, manufacture, or other commercial use by subjecting to some process (processing cattle by slaughtering them) (processing the milk by pasteurization it) (processing grain by milling) (processing cotton by spinning) (2): to make usable by special treatment (processing rancid-butter) (processing waste material) (processing the water to remove impurities)." Orange-Madison Coop., at 657-58. (quoting Webster's Third International Dictionary (1966).
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