A. Introduction

On July 30, 2010 the Massachusetts Supreme Judicial Court ("SJC") issued a Decision in favor of Onex Communications Corporation ("Onex" or "Taxpayer") relative to the sales/use tax periods beginning August 1, 1999 through September 2001. Affirming the decisions of the Appellate Tax Board ("Board") and Appeals Court, the SJC ruled that for the tax periods in question the Taxpayer was "engaged in manufacturing", and was therefore entitled to sales and use tax exemptions available under G.L. c. 64H, § 6 (r), (s) and G.L. c. 64I, § 7 (b) for purchases of tangible personal property used directly and exclusively in research and development by a manufacturing corporation. See Onex Communications Corporation v. Commissioner of Revenue, 457 Mass. 419; 930 N.E. 2d 733 (July 30, 2010). The purpose of this Technical Information Release (TIR) is to explain the effect of this decision on the Commissioner's interpretation of the phrase "engaged in manufacturing" for purposes of determining whether a taxpayer qualifies as a manufacturing corporation for the Massachusetts sales and use tax exemptions set forth in G.L. c. 64H, § 6(r), (s), and c. 64I, § 7(b).

B. Facts of the case

Onex, a foreign corporation with a principal place of business in Bedford, Massachusetts, was engaged in the development and production of integrated circuits for data and voice transmissions for the telecommunications industry. It was formed to develop application-specific integrated circuits to enable switching, routing, and transmission of multiple types of voice and data traffic. Onex' activities centered on taking its flagship product, an application-specific integrated circuit chip set (the OMNI chip), from abstract concept to production and commercial sale. Onex lacked the equipment needed to make the chip itself. After development of the OMNI chip, Onex outsourced the production of the OMNI chip to IBM, which exactly followed the instructions of OMNI's research and development "blueprint" (a computer-aided design including technical specifications for hardware and software components, as well as detailed manufacturing instructions). After producing an initial run of early stage chips, the chips were tested and analyzed at the Onex laboratory. The blueprint was then refined and sent to IBM, which proceeded to manufacture and ship production quantities of the OMNI chip to Onex. The chips were not commercially produced by Onex or another party during the periods in question.

Onex sought an abatement of use tax pursuant to G.L. c. 64I, § 7(b), for certain items it purchased. The items were exempt from sales/use tax under G.L. c. 64H, § 6(r), (s) and c. 64I, § 7(b) if either: (1) Onex qualified as a research and development (R&D) corporation under G.L. c. 63, section 42B ("section 42B"), or (2) Onex qualified as a manufacturing corporation, also under section 42B.

The SJC addressed Onex' argument that its purchases were exempt from use tax during the above period because it was "engaged in manufacturing" and thus qualified as a "manufacturing corporation" under G.L. c. 63, section 42B. The Commissioner argued that when it made the purchases at issue, Onex was engaged only in R&D and the production of prototypes, and that neither Onex nor any other entity manufactured any production-quality chips during this period. The Commissioner contended that to be engaged in manufacturing, a company must have produced at least one finished product or the company's inputs must have resulted in the fabrication of a finished product by some other entity. Because neither Onex nor any other entity had yet produced commercially marketable OMNI chips during the periods in question, the Commissioner concluded that Onex was not engaged in manufacturing.

C. Discussion

1. General

Purchases of personal property are generally subject to Massachusetts sales tax under G.L. c. 64H, § 2, or Massachusetts use tax under G.L. c. 64I, § 2, at the time the purchase is made. Taxpayers engaged in research and development (R&D) or manufacturing, however, may be exempt from payment of sales or use tax for materials, tools, fuel, machinery, and replacement parts that are used directly and exclusively in R&D or manufacturing. See G.L. c. 63, § 42B; G.L. c. 64H, §§ 6(r) & (s); G.L. c. 64I, § 7(b). With limited exceptions not relevant to this case, the exemptions for use tax, see G.L. c. 64I, § 7(b), are the same as those for sales tax; the provision setting forth the use tax exemptions refers to and incorporates the statutory exemptions for sales tax.

2. SJC's Analysis of "Engaged in Manufacturing"

In analyzing whether Onex was "engaged in manufacturing" for sales/use tax purposes, the SJC pointed out that it has construed the phrase "engaged in manufacturing" as having a "flexible meaning that should not be narrowly restricted." Onex at 425, citing William F. Sullivan & Co. v. Commissioner of Revenue, 413 Mass. 576, 579 (1992). The SJC began its analysis by applying the traditional tests for being a "manufacturing corporation" under G.L. c. 58, § 2; G.L. c. 63, § 42B. "To be a 'manufacturing company' a company must be "engaged in manufacturing." Onex at 424. "To qualify as a manufacturing company, a company's activities must be an 'essential and integral' part in the manufacturing process." Id. at 424, citing Joseph T. Rossi Corp. v. State Tax Comm'n, 369 Mass., 178, at 181-182 (1975). 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." Onex at 429, citing Department of Revenue Manufacturing Corporations regulation 830 CMR 58.2.1(6)(b)(7).

The SJC addressed the Commissioner's argument concerning the necessity of having a finished, marketable product in order to be engaged in manufacturing. It found that a company is not required to have built and distributed a finished product in order to be engaged in manufacturing. Id.at 426, citing Sullivan at 579-580, quoting Rossi at 181-182. ("Determination of whether a company is engaged in manufacturing has not been based on a final product theory.") Such an approach, it stated, was contrary to the statutory purpose of encouraging new manufacturing industries to locate in Massachusetts and encouraging existing companies to develop and expand within the Commonwealth. Onex at 428, citing Commissioner of Revenue v. Houghton Mifflin Co., 423 Mass. 42, 46-48 (1996). The SJC further noted that such a policy "[w]ould place new companies in a disadvantageous tax position compared to existing companies, [and] would tend to discourage the location of start-up companies in Massachusetts." Id. at 428.

The SJC affirmed that the proper test for determining whether a company is engaged in manufacturing is whether the company was engaged in an essential and integral step in the manufacturing process. Onex at 425. In Houghton Mifflin, the SJC held that a company that developed computer disks and tapes containing text graphics and layout information that were designed to be distributed to third parties who would use the disks to print and bind new books or to create marketable CD-ROM tapes, was engaged in manufacturing. It further held that the creation of computer disks alone was sufficient because the disks were an essential and integrated step in the manufacturing process. Houghton Mifflin at 49-50.

In Onex, the SJC focused on the fact that the Taxpayer had devoted most of its efforts to creating a "blueprint" for the production of the OMNI chip. The SJC found that it had moved beyond the production of prototypes and had entered into a licensing agreement with a third-party customer, which provided for a reduced per-chip price in return for final testing of the production chips prior to full scale production. The Court found this process of testing and improving the product design to be similar to the processes followed for the development of infant products in The First Years, Inc. v. Commissioner of Revenue, 33 Mass. App. Tax Bd. Rep. 208, 214 (2007), and the development of improved batteries in Duracell Inc. v. Commissioner of Revenue, 33 Mass. App. Tax Bd. Rep. 166, 172 - 173 (2007). During this same period Onex sold small numbers of chips to its third party customer, which the Board determined was the last step in testing the product before a full commercial rollout. The SJC also analyzed the percentage of employees, floor space, and computer hardware and software that were dedicated to the development of the "blueprint" for the chip in making its determination that Onex qualified as a manufacturing corporation.

On the facts before it, the SJC found that the creation of the "blueprint" for the production of the OMNI chip for release to IBM was an essential and integral step in the manufacture of the chip. Although the chip was to be produced by means of the third-party contract with IBM, production of the chip was entirely dependent on the "blueprint," and IBM was required to follow the blueprint exactly in producing the OMNI chip. The SJC found this to be virtually identical to the development of the compact discs containing the information for creating the physical books in Houghton Mifflin at 43-44, 48. The SJC also found that creation of the first fifty to one hundred production chips in early 2001, and refinement of the "blueprint" and the manufacturing process after analysis of the chips' quality, were also essential and integral steps in testing the new chip before full-scale production, as was its use by Taxpayer's customer.

3. Commissioner's Application of SJC Decision

The SJC continues to recognize that whether a particular company is engaged in manufacturing is a fact-based inquiry. Id. , at 430, citing William F. Sullivan & Co. v. Commissioner of Revenue, 413 Mass. 576, 581(1992) ("undefinable nature of the operative terms in these cases necessitates case-by-case, analogical development of their meaning"). While discussing the Commissioner's long-standing publicly announced rule in the Commissioner's Manufacturing Corporations regulation 830 CMR 58.2.1(6)(b)5 that the design and creation of prototypes are not, in and of themselves, manufacturing, the SJC found that Onex had moved beyond the mere design of prototypes and was making production chips that had been sold to a third party client and marketed to other potential clients. In addition, the Court found that another provision of the 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 the manufacturing process), was applicable to Onex's activities.

With the decision of the SJC in Onex, the Commissioner is now incorporating the analysis and holding of the SJC in that case in determining whether a company is engaged in manufacturing for purposes of G.L. c. 63, § 42B [1] and, accordingly, for purposes of applying the sales and use tax exemptions in G.L. chs. 64H and 64I. [2] In particular, in cases where, as in Onex, a company's activities are essential and integral steps in the overall manufacturing process ( i.e., where the activity in question is a practical and necessary step in the production of a finished product for sale) the Commissioner will determine that a company is engaged in manufacturing, whether or not the taxpayer or another entity has yet produced a finished product during the relevant period. Thus, in cases where a company designs and creates a prototype, and where that activity is an essential and integral step in the production of a product for ultimate sale, a company will be deemed to be engaged in manufacturing. As the SJC found in Onex and in Houghton Mifflin, the Commissioner will treat a company's design and creation of items such as a blueprint or computer disk necessary to the production of a product for ultimate sale as being an integral and necessary step in the manufacturing process.

/s/Navjeet K. Bal
Navjeet K. Bal
Commissioner of Revenue

NKB:MTF:wrd

October 18, 2010

TIR 10-19



[1] See also TIR 08-2, in which the Commissioner announced that she would adopt and apply in future cases the holdings of the Appellate Tax Board in The First Years and Duracell on the question of whether a company is engaged in manufacturing. That TIR described the activities that supported the Board's conclusion that those companies were engaged in manufacturing.

[2] While a corporation that is engaged in manufacturing within the meaning of G.L. c. 63, § 42B will be treated as having manufacturing corporation "status" allowing it to be eligible for the sales and use tax exemptions in G.L. c. 64H, §§ 6(r) and (s), the Commissioner emphasizes that a corporation must meet additional requirements in order to receive certain other tax benefits. In particular, only those corporations that apply for and are granted manufacturing corporation "classification" are entitled to the local property tax exemption on machinery used in the conduct of their business under G.L. c. 59, § 5, cl. Sixteenth (5). A corporation seeking a local property tax exemption continues to be required to follow the procedures in the Manufacturing Corporations regulation, 830 CMR 58.2.1(6)(7). See generally 830 CMR 58.2.1(3), (4), (5).