James Crowley, Esq.
DLS, Bureau of Municipal Finance Law

The Supreme Judicial Court has upheld a use tax exemption for a start-up corporation located in Bedford on the grounds that it was a manufacturing corporation. The manufacturing classification was granted even though the corporation had not produced even one finished product. The Court's decision in Onex Communications Corp. v. Commissioner of Revenue, 457 Mass. 419 (2010) has an impact on local personal property taxes, as well as state tax revenues.

Between the period of August 1, 1999 and September 21, 2001, Onex purchased computer hardware and software, lab equipment and fixtures to assist it in developing a new computer chip, the OMNI chip, for the telecommunications industry. Generally, any purchases of personal property are subject to sales tax under M.G.L. Ch. 64H or use tax under M.G.L. Ch. 64I. Onex did not pay a use tax when it filed its annual tax returns with the Commonwealth. The Department of Revenue performed an audit in July 2001 for nonpayment of the use tax over the 1999-2001 period. The Department concluded that Onex was not eligible for a use tax exemption since it did not qualify either as a research and development corporation or as a manufacturing corporation. Use taxes were then assessed by the Commissioner of Revenue. Onex failed to pay the taxes; filed an abatement application which the Commissioner denied, and then the corporation appealed to the Appellate Tax Board (ATB).

The ATB ruled that Onex was entitled to a total abatement of use tax on these qualified personal property purchases as a manufacturing corporation. The ATB found it unnecessary to reach the issue whether Onex was also a research and development corporation over that same audit period. The Commissioner then appealed to the Appeals Court, which affirmed the decision of the ATB. A further appeal was made by the Commissioner to the Supreme Judicial Court.

The Commissioner argued that Onex did not manufacture any marketable computer chips during the audit period. Onex merely produced prototypes. The Commissioner contended that manufacturing status could only be attained if Onex produced at least one finished product or if another entity, using Onex's specifications, fabricated the computer chip. The Supreme Judicial Court, however, did not adopt the finished products test advanced by the Commissioner. Instead, the Court stated that the proper test was whether a taxpayer is engaged in an "essential and integral" step in the manufacturing process. In prior decisions the Court had found that a company was engaged in manufacturing where there was a transformative process on raw materials. For example, a company which cut up scrap metal into specified lengths for sale to steel mills was engaged in manufacturing. William F. Sullivan & Co. v. Commissioner of Revenue, 413 Mass. 576 (1992). In like manner, a company was engaged in manufacturing where it cut down raw timber and produced lumber of various sizes to make it marketable. Joseph T. Rossi Corp. v. State Tax Commission, 369 Mass. 178 (1975). In a more recent case, the Court had ruled a company was engaged in manufacturing where it developed computer discs that were sent to third parties for book publication. The creation of the computer discs was found to be an integral step in the manufacturing process. Commissioner of Revenue v. Houghton Mifflin Co., 423 Mass. 42 (1996). In these and other cases, the Court has ruled that corporations were engaged in manufacturing even though the finished product test was not satisfied.

More importantly, according to the Court, adopting the finished product test would defeat the purpose of the manufacturing exemption statute which is to encourage new manufacturing companies to locate in Massachusetts. In the Court's view, the finished product test would place start-up companies at a tax disadvantage compared to companies presently doing business in the Commonwealth. In effect, the Court is saying that manufacturing should be given a broad definition and should not be limited to making products on an assembly line. Manufacturing then would include conceptual and design work which could last years but would ultimately result in a market-ready product.

In the case at hand, Onex used the equipment it purchased to create a blueprint for the Omni chip which was then fabricated by IBM at its plant. The blueprint developed by Onex was akin to the computer discs which were used to produce books in the Houghton Mifflin case. According to the Court, the creation of the blueprint was an integral step in the manufacturing process. From the evidence presented, it was apparent to the Court that Onex was making production computer chips during the two year audit period for testing purposes before full scale production.

Accordingly, the Supreme Judicial Court in agreement with the ATB and the Appeals Court held that Onex was engaged in manufacturing and therefore was exempt from the use tax. In that case, the company would likely qualify, after application to the Commissioner, for classification as a manufacturing corporation. That designation has important consequences on local taxes since the company's machinery would also be exempt from local personal property taxes. For this reason, the Commissioner had argued that it would be administratively difficult to determine which companies should receive the manufacturing designation unless the Court adopted a final product rule. The Court, however, did not agree. In any event, this start-up company was considered to be engaged in manufacturing and did not have to pay almost $300,000 in taxes to the Commonwealth.