A primer on the California sales/use tax manufacturing equipment exemption.

• Author: Coffill, Eric J.

1. Introduction

   In 1993, the California Legislature passed and Governor Wilson signed Senate Bill (SB) 671.(1)(*) SB 671 was a comprehensive tax reform bill, which included a manufacturer's investment credit and a manufacturer's sales/use tax exemption. The manufacturer's investment credit was the subject of a previous article in The Tax Executive.(2) This article summarizes the major provisions of the manufacturer's sales/use tax exemption as interpreted by a recent regulation issued by California's State Board of Equalization (SBE).

2. Background

   1. Legislative History

      The history(3) of the manufacturer's sales/use tax exemption begins in 1993 with Assembly Bill (AB) 1313, authored by Assembly Member (and then Assembly Speaker) Brown. California has imposed a tax on manufacturing equipment since the sales tax was instituted in 1933. It is one of eight states that taxes manufacturing equipment. AB 1313 was introduced to exempt from the state portion of the sales tax property used in the manufacturing process, while permitting the continued collection of locally-levied sales taxes (consisting of a 1.25-percent uniform rate plus local-option rates). The California Manufacturers Association, the sponsor of AB 1313, argued an exemption for manufacturing equipment would accomplish the following:

      "We will immediately become competitive with 42 other states that are now luring manufacturers away from California with promises of lower taxes. We will provide California companies with an immediate incentive to expand their facilities and create new jobs. And we will send a very clear signal to companies throughout the world that California is back in business."(4)

      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 manufacturing equipment. AB 1313 eventually died in committee, effectively supplanted by SB 671, even though the latter bill did not incorporate the broad sales/use tax exemption contained in AB 1313. Instead, SB 671 created a relatively broad six-percent manufacturer's investment credit and a relatively narrow sales/use tax exemption, which was limited to 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. Further, the exemption was available only during the first three years of operations.

      A series of amendments followed, which culminated in SB 671's enactment into law in 1993. The 1994 legislative session brought additional developments, the most significant one being SB 676, which modified the exemption (as well as the manufacturer's investment credit). SB 676 was enacted into law in 1994.(5)

   2. SBE Regulation 1525.2

      The sales/use tax exemption is codified at section 6377 of the California Revenue Taxation Code. Because many questions were left unanswered by the statute, the SBE almost immediately began an interpretative regulation project. The January 1, 1994, effective date created pressure for regulations as quickly as possible, and by early 1994, tentative drafts of a proposed regulation had been prepared by the SBE staff. In April 1994, the SBE released Proposed Regulation 1525.2, captioned "Manufacturing Equipment," which was designed to implement the new exemption.(6)

      This relatively modest, 11-page draft was the subject of a spirited public hearing on August 4, 1994. As a consequence of that hearing, the April draft was abandoned. In October 1994, the SBE issued a new and more comprehensive version of Proposed Regulation 1525.2.(7) A public hearing was held on this new draft on December 6, 1994. There followed two additional notices by SBE of further changes to the proposed regulation.(8) The final version of Proposed Regulation 1525.2 was then submitted to the Office of Administrative Law, and was approved on July 19, 1995. The regulation was officially promulgated as Regulation 1525.2 of Title 18 of Chapter 2, Subchapter 4, of the California Code of Regulations.

3. Major Provisions of Regulation 1525.2

   The "exemption" provided by section 6377 is, in reality, only a partial exemption. For the period commencing on January 1, 1994, and ending on December 31, 1994, the exemption applies to the taxes imposed by the State of California (i.e., 6%), but does not apply to the taxes imposed by counties, cities, and districts pursuant to the Bradley-Burns Uniform Local Sales and Use Tax Law, or the Transactions and Use Tax Law. Beginning January 1, 1995, the exemption rate effectively drops to five percent, and continues not to apply to the Bradley-Burns Uniform Local Sales and Use Tax Law or the Transactions and Use Tax Law.(9)

   1. Items Subject To The Exemption

      Subject to the limitations set forth above, the exemption applies to gross receipts from the sale, storage, use, or other consumption in California of the following items:

      1. "Tangible personal property" purchased for use by a "qualified person" to be used primarily in any stage of the manufacturing, processing, refining, fabricating, or recycling of property, beginning at the point that raw materials are received by the qualified person and introduced into the process and ending at the point at which the property has been altered to its completed form...