A primer on the California manufacturer's investment credit.

• Author: Coffill, Eric J.

1. Introduction

   In 1993, the California Legislature passed, and Governor Wilson signed, Senate Bill (SB) 671,(1) which was one of the farthest reaching business tax reform bills in recent California history. The impetus for the bill was pressure to modify California's then-existing "water's-edge" election, but the final days of the legislative session saw SB 671 transformed into a comprehensive tax reform package which included a manufacturer's investment credit and a manufacturer's sales/use(2) tax exemption.(3) The following year saw the enactment of SB 676,(4) which amended the 1993 credit and exemption legislation.

   This article summarizes the major provisions of the California manufacturer's investment credit. (The sales tax exemption will be the subject of a future article.) The article also discusses the status of both the California State Board of Equalization's Proposed Regulation 1525.2 on the sales tax exemption, and the California Franchise Tax Board's announced regulation project on the manufacturer's investment credit.

2. Background

   1. The Legislative History of SB 671 and SB 676

      The history of the manufacturer's investment credit (and the sales tax exemption) begins with Assembly Bill (AB) 1313, which was introduced during the 1993 California legislative session. AB 1313 was sponsored by the California Manufacturers Association and would have exempted from the State's portion of the sales tax (i.e., six percent) property used in the manufacturing process beginning July 1, 1994. The argument behind the bill was that California's tax on manufacturing equipment, which dated to 1933 when the sales tax was instituted, had become anachronistic: California was only one of eight states that taxed manufacturing equipment.(5) AB 1313 encountered significant resistance in the Senate Revenue and Taxation Committee, principally owing to a projected annual revenue loss of approximately $895 million beginning in 1994-1995. Through a series of political compromises and maneuvers, SB 671 - a bill originally drafted solely to reform California's water's-edge election - was amended to incorporate a tax incentive for the purchase of manufacturing equipment. Rather than the broad sales tax exemption proposed in AB 1313, however, SB 671 took a bifurcated approach:

      * A sales tax exemption for qualified property used primarily in manufacturing or research or development for start-up companies that began business activity in California on or after January 1, 1994. The exemption would be available only during the first three years of operations. (In the alternative, the start-up company could choose the six-percent investment tax credit - below.)

      * A six-percent investment tax credit for qualified property used primarily in manufacturing or research and development. The credit would be effective for purchases after December 31, 1993, and could be carried forward.

      A series of amendments followed, culminating in SB 671's enactment into law in 1993. The 1994 legislative session brought additional developments, and SB 1292 was introduced to make two types of changes to SB 671's exemption and credit provisions. First, the 1994 bill was intended to clarify or modify some of the provisions of SB 671. Second, it was intended to expand the credit to include leased equipment.(6) Ultimately, SB 1292 failed to clear the Senate Appropriations Committee. Instead, another bill - SB 676 - was amended to include modifications to the credit and the exemption and to expand the credit to include leased equipment. SB 676 was then passed by the Legislature and signed by the Governor.(7)

   2. SBE Proposed Regulation

      1525.2 on the Sales

      Tax Exemption

      Although the focus of this article is the manufacturer's investment credit, the enactment of the credit should be placed in the context of the overall legislative effort that also produced the sales tax exemption. In 1993, the legislature took the sales tax exemption proposed in AB 1313, which would have been administered solely by the California State Board of Equalization (SBE), and in SB 671 split it into two pieces: (1) a sales tax exemption to be administered by the California SBE, and (2) an investment credit to be administered by the California Franchise Tax Board (FTB). As a result, two separate California tax administrative agencies are charged with implementing and administering separate provisions that contain parallel or identical language. Both agencies soon announced plans to issue regulations on the subject.

      The sales tax exemption enacted in 1993 by SB 671 applies to sales made commencing January 1, 1994. Accordingly, the California SBE attempted as quickly as possible to promulgate regulations to implement the exemption. A draft of SBE Proposed Regulation 1525.2 appeared in early 1994, and the first of a series of public hearings was held on August 4, 1994. As this article goes to press, the regulation is not yet final.

   3. FTB Proposed Regulation on the Investment

      Credit

      The investment credit applies to qualified property purchased after December 31, 1993, but the credit cannot be claimed on the taxpayer's 1994 return. Instead, the 1994 credit will be allowed in the...