December 16, 2011

I.  Issue

You request a letter ruling on behalf of your client, ********************* (“Company”), that it is engaged in manufacturing which is substantial within the meaning of G.L. c. 63, § 38(l) and thus required to utilize a single sales factor to apportion its taxable net income to Massachusetts.  In support of your request, you state the relevant facts as follows:

II.  Facts

Company is a global consumer products company located in California that is engaged in the development, manufacture and distribution of several brands of lubricants and a wide array of cleaning products.  Company’s products are sold worldwide to retail chain stores, hardware stores warehouse club stores, automotive part outlets and industrial distributors and suppliers.

A major portion of Company’s revenue, i.e., approximately 70%, is derived from the manufacture and sale of ***********, (“the Product”) a moisture displacement and lubricant product.  The formula for the Product, originally developed in 1953, consists of several raw ingredients, each of which must be heated to a specific temperature and then blended in a specific order.  The formula and the blending process are proprietary and closely-held trade secrets developed and owned by Company.

The production of the Product begins with the manufacture of a concentrate from which the final product is produced.  Historically, Company produced 100% of the concentrate internally (i.e., using its own employees and facilities).  However, in 2007, Company began shifting some of the concentrate production to third-party contract manufacturers.  As of today, third-party contract manufacturers account for approximately 70% of concentrate production.  The remaining 30% continues to be produced internally by Company.

The manufacturing process for the Product starts with the acquisition of specific component ingredients that make up the concentrate.  The component ingredients are acquired from different suppliers, many hand-selected by Company, and are delivered in various stages of refinement.  The ingredients are delivered to manufacturing facilities where they are blended into batches of bulk concentrate.  Company holds legal title to the Product ingredients upon acquisition and throughout the blending process while in the possession of the contract manufacturer.

The contract manufacturers are required to follow the proprietary formula and blending process developed and owned by Company.  As stated previously, the blending procedure requires having ingredients at specific temperatures and mixing them together in specific orders of addition.  Today, the manufacturing process is largely computer-assisted.  Any computers utilized in the manufacturing process are programmed to the specifications required by Company. 

After mixing, testing procedures related to physical and chemical composition are applied to confirm quality and consistency of the concentrate.  The bulk concentrate is then shipped to separate facilities to perform a finishing process.  The finishing process starts with the manufacture of specially designed spray cans and components, such a permanently-attached *************** (“Straw Assembly”).  The concentrate, along with other ingredients, is injected into the specially-designed spray cans.  The finished Product is then packaged and shipped to distributors across the United States.

The finishing process has always been performed entirely by third-party contract manufacturers.  There are three separate groups of contracts manufacturers at different locations involved in the finishing process.  One makes the specially-designed spray can, another makes the Straw Assembly and a third group of contract manufacturers performs final assembly and the injection of concentrate and other ingredients.  Company owns manufacturing assets, including an assembly machine and molds, used by the contract manufacturers to make the specialized spray can and Straw Assembly components.  Company holds a patent for the “look and feel” of Straw Assembly.

Company is closely involved in the activities performed by its contract manufacturers, both for concentrate production and finishing.  You state that Company’s philosophy is to maintain control of the process from start to finish.  The following is a summary of Company’s involvement with its contract manufacturers:

  • Company provides the concentrate manufacturers with the Product formula and process, which is a proprietary and closely-held trade secret developed by  Company.  The formula and process includes specific ingredients, a blending procedure (including required temperature of ingredients and the order in which to mix them) and quality testing procedures for the final product.  The concentrate manufacturer is required to follow the formula and provide to  Company a Certificate of Analysis attesting to the quality of each finished concentrate batch.
  • Company provides the various finishers with proprietary specifications for manufacturing the spray can and Straw Assembly and putting the concentrate and other ingredients into the spray can as part of the finishing process.
  • Company holds legal title to the Product ingredients upon acquisition and throughout the blending process at the concentrate manufacturer.
  • Company owns manufacturing assets, including an assembly machine and molds, used by the contract manufacturers to make the specialized spray can and Straw Assembly components.
  • Company was involved in the development of the Straw Assembly accessory and its manufacture.  Company holds a patent for the “look and feel” of Straw Assembly.
  • Company manages procurement of raw material ingredients used in the concentrate manufacturing process.  Many of these ingredients are unique and the Company has established relationships with certain suppliers.  Company mandates that raw material ingredients meet specific quality requirements and requires contract manufacturers to submit reports to substantiate the quality.
  • Company negotiates volume discounts with the tin plate (raw material) suppliers which are provided to the spray can manufacturer.
  • Company personnel manage the flow of finished concentrate batches from the concentrate manufacturer to the finisher.  Company houses information systems used for order processing on-site at concentrate manufacturing facilities.

III.  Discussion

Pursuant to the provisions of G.L. c. 63, § 38(l), a “manufacturing corporation” that has income from business activity that is taxable both within and without Massachusetts is required to apportion its net income to Massachusetts by use of a single sales factor.  See G.L. c. 63, § 38(l)(2)(v).  For purposes of G.L. c. 63, § 38(l), a “manufacturing corporation” [“Section 38 manufacturer”] is defined as:

[A] corporation that is engaged in manufacturing.  In order to be engaged in manufacturing, the corporation must be engaged, in substantial part, in transforming raw or finished physical materials by hand or machinery, and through human skill or knowledge, into a new product possessing a new name, nature and adapted to a new use.

In order to be treated as a Section 38 manufacturer, a corporation must meet two requirements. First, it must be engaged in manufacturing during the taxable year. Second, its manufacturing activity must be substantial.  For purposes of G.L. c. 63, § 38(l), it is not necessary that the corporation conduct its manufacturing activities in Massachusetts.  See Department of Revenue Apportionment of Income Regulation 830 CMR 63.38.1(10)(b)1.

The portion of the Department of Revenue’s Apportionment of Income regulation dealing with Section 38 manufacturers defines “substantial manufacturing” and details the requirements that a manufacturing corporation must meet in order to utilize single-sales-factor apportionment.  See 830 CMR 63.38.1(10) (b)2.  A corporation’s manufacturing activities will be considered substantial if the corporation meets one of five enumerated tests provided in G.L. c. 63, § 38(l)(1).  Under the first of these tests, a corporation’s manufacturing activities will be substantial if the corporation derives 25% or more of its receipts for the taxable year from the sale of manufactured goods that it manufactures.[1]  G.L. c. 63, § 38(l)(1)1; See also  830 CMR 63.38.1(10)(b)2.

Company asserts that its internal production of concentrate clearly constitutes manufacturing within the definition of G.L. c. 63, § 38(l).  However, this internal production by itself does not result in the generation of 25% or more of Company’s receipts.  Company asserts that the 25% gross receipts test for substantial manufacturing  would be met if the product being manufactured through third-party contractors is included in the calculation.  In that case, a majority of the Company’s receipts would be derived from the sale of manufactured goods that it manufactures.

It is well-settled that a process which does not produce a finished product may nonetheless constitute manufacturing if it is an essential and integral part of a total manufacturing process.  See 830 CMR 58.2.1(6)(b)(7).  Further, a process that is a practical and necessary step in the production of a finished product for sale is generally considered to be an essential and integral part of a total manufacturing process.  Id.  The provisions of 830 CMR 58.2.1(6)(b)(8) also provide that a process which produces intangible property, either in whole or in part, to be used in a manufacturing process may constitute manufacturing.  However, the process by which the intangible personal property is created must transcend the mere manipulation of the information and must be a substantial and integral step in the manufacturing process.  Moreover, the intangible property must have a physical application in the final manufacturing activity.

Thus, in cases where products are being produced through an outsourcing arrangement, such as here, the issue is whether Company’s activities are essential and integral to the overall manufacturing process such that its activities constitute manufacturing.  Company has cited a number of authorities which support a conclusion that Company’s activities should be considered manufacturing.  See, e.g., Letter Ruling 05-5 (a network storage company was a manufacturing corporation because it designed and developed software used by third parties to produce storage networking adaptors and switches);  Letter Ruling 07-1 (biopharmaceutical company was a manufacturing corporation because it produced “working cell banks” which were transferred to a contract manufacturer who used them to produce antibiotics);  The First Years, Inc. v. Commissioner of Revenue, A.T.B. Docket No. C267626 (2007); Commissioner of Revenue v. Houghton Mifflin Company, 423 Mass. 42 (1996) (book publisher engaged in manufacturing, although actual printing of the books was performed by a third party.)  We now examine these authorities in further detail.

In Department of Letter Ruling 05-5, the Commissioner analyzed whether a Company’s development of software and transmitting it by electronic means to a third party contractor for use in the production of storage net working host bus adaptors and embedded storage switches constituted manufacturing activity for purposes of being deemed a manufacturing corporation entitled to apportion its taxable net income based solely upon its sales factor pursuant to G.L. c. 63, § 38(l)(2)(v).  Although the company utilized third party contract manufacturers to ultimately fabricate the HBAs and switches, the Commissioner found that the company’s activities were an essential and integral step in the process of manufacturing based upon the standard enunciated in Commissioner of Revenue v. Houghton Mifflin Company, 423 Mass. 42(1996) (developing intangible content and transferring it to a third for physical application in manufacturing process qualifies as manufacturing activity).  Accordingly, the Commissioner concluded that the taxpayer was, in fact, engaged in manufacturing. 
          

Similarly, in Letter Ruling 07-1, the Commissioner ruled that a company that produced working cell banks which were then provided to third party contractors to produce an antibiotic drug for the treatment of bacterial and skin structure infections was a manufacturing corporation within the meaning of G.L. c. 63, § 38(l).  In so doing, the Commissioner looked to the Department’s Manufacturing Corporations regulation, 830 CMR 58.2.1(6), which provides guidelines for determining whether a corporation may be classified as a manufacturing corporation of purposes of G.L. c. 63, §§ 38C (now repealed) and 42B.  As in Letter Ruling 05-5, the Commissioner once again stated that these guidelines are also applicable by analogy to corporations that seek manufacturing corporation status for purposes of G.L. c. 63, § 38(l).

In his analysis, the Commissioner examined the company’s production of working cell banks in detail.  Applying the standards set forth in the Manufacturing Corporations regulation, and in particular, the provisions of 830 CMR 58.2.1(6)(b)2 (if a process involves chemical change to property rather than only physical change, it is more likely to be manufacturing) and 830 CMR 58.2.1(6)(b)7 (a process that does not produce a finished product, but constitutes an essential and integral part of the total manufacturing process, may constitute manufacturing; a process that is a practical and necessary step in the production of a finished product for sale is generally an essential and integral part of the total manufacturing process), the Commissioner concluded that the company was engaged in manufacturing as contemplated for purposes of G.L. c. 63, § 38(l).

With regard to the second requirement that the company’s manufacturing activities must be substantial, the Commissioner examined whether the company met the requirement that a corporation must derive 25% or more of its receipts for the taxable year from the sale of manufactured goods “that the corporation manufactures”, as required by G.L. c. 63, § 38(l)(1).  Although the company utilized third-party contract manufacturers to ultimately produce the antibiotic drug, the Commissioner found that the activities of the company constituted an essential and integral step in the process of manufacturing based on the standard enunciated in Commissioner of Revenue v. Houghton Mifflin Company, 423 Mass. 42 (1996).  Based on this analysis, and coupled with the company’s projection that 95% of its gross receipts for the 2007 taxable year would be from the sale of the drug product, the Commissioner ruled that the company would qualify as a manufacturing corporation as defined in G.L. c. 63, § 38(l)(1) and would therefore be required to apportion its taxable net income based solely upon its sales factor pursuant to G.L. c. 63, § 38(l)(2)(v) for the period at issue.

The Massachusetts Appellate Tax Board (Board) and the Massachusetts Supreme Judicial Court have also considered whether a taxpayer that outsources its manufacturing activities to a third party is engaged in manufacturing.  See, e.g., Onex Communications Corp. v. Commissioner of Revenue, A.T.B. Docket No. C271834 (2007), aff’d by Onex Communication Corp v. Commissioner of Revenue, 457 Mass. 419, 930 N.E. 2d 733 (2010); The First Years, Inc. v. Commissioner of Revenue, A.T.B. Docket No. C26726 (2007).

Onex was a foreign corporation with a principal place of business in Bedford, Massachusetts that was engaged in the development and production of integrated circuits for data and voice transmissions for the telecommunications industry.  After development of its flagship product (the OMNI chip), Onex outsourced the production of the chip to a third party, which exactly followed the instructions of OMNI’s research and development “blueprint”.  On the facts before it, the SJC found that the creation of the “blueprint” for the production of the OMNI chip for release to the third party manufacturer was an essential and integral step in the manufacture of the chip.  Citing the Commissioner’s Manufacturing Corporations regulation 830 CMR 58.2.1 (6)(b)(7) (a process that is a practical and necessary step in the production of a finished product for sale is generally considered an essential and integral part of a manufacturing process), the SJC concluded that Onex was engaged in manufacturing for Massachusetts sales and use tax purposes. 

In The First Years, Inc. v. Commissioner of Revenue, A.T.B. Docket No. C267626 (2007), the Board considered whether a child-care related products company was engaged in manufacturing for purposes of G.L. c. 63, § 38C, and, therefore, was entitled to classification as a manufacturing corporation under G.L. c. 58, § 2.[2]  In that case, the taxpayer created and designed its products, but utilized third-party contractors to mass-manufacture the products.

The Board concluded that the taxpayer was a manufacturer because it was “integrally involved in every step of the product creation process.”  In reaching its conclusion, the Board pointed to activities such as product development, establishing testing protocols, overseeing the production of tooling and molds, and conducting quality assurance testing.  The Board found that the taxpayer transformed “ideas, art, information and photographs, by application of human knowledge and skill, into [designs, models, molds and tooling], ready for use by independent [manufacturers], containing an immense amount of information in a highly organized form.”

The Board found that the design specifications developed by The First Years and the custom tooling and molds owned by The First Years, which it sent to the third-party contract manufacturers located in Asia, had physical application in the manufacturing process.  The fact that the tooling and molds were produced by third parties was found to be irrelevant, because they were produced under the taxpayer’s oversight and to its exact specifications and became the property of the taxpayer upon completion.

Here, Company is integrally involved in the creation of the product from start to finish.  Company invented the product formula, manufacturing processes and testing procedures for both blending concentrate and finishing.  Company also developed the Straw Assembly and spray can designs.  Company owns the molds for the Smart Straw and spray can components.  The formula, processes, testing procedures, designs and manufacturing assets, including molds, which Company provides to the contract manufacturers have direct physical application in the manufacturing process.

Company also controls the overall manufacturing process.  There are numerous third parties involved in production of the product, including a blender, a spray can manufacturer, a Straw manufacturer, and a number of different finishers.  Company manages all of these parties and coordinates the collective manufacturing effort.  For example, Company procures raw materials for the blender, manages the flow of product from the blender to finisher, and negotiates volume discounts with the tin plate supplier to the spray can manufacturer.  Company also mandates specific quality requirements and testing procedures for each activity.

 

IV.  Conclusion/Ruling

Based on the facts presented and authorities discussed in this ruling, we rule that Company is engaged in manufacturing which is substantial within the meaning of the G.L. c. 63, § 38(l) and therefore is required to use a single sales factor for purposes of apportioning its net taxable income to Massachusetts.

Very truly yours,

/s/ Amy Pitter

Amy Pitter
Commissioner of Revenue

AP:MTF:wrd

LR-11-8

 

[1]  You have indicated that Company would not meet the tangible personal property and payroll tests set forth in the statute.

[2]  The Manufacturing Corporations Regulation, 830 CMR 58.2.1, provides guidelines for determining whether a corporation may be classified as a manufacturing corporation.  The Commissioner has ruled that these guidelines are “applicable by analogy to corporations seeking manufacturing corporation status for purposes of G.L. c. 63, § 38(1),” Letter Ruling 05-5.