June 13, 2016
Re: Appeal of Final Local Determination
Taxpayer: *****
Locality: *****
Business, Professional and Occupational License Tax
Dear *****:
This final state determination is issued upon the application for correction filed by you on behalf of ***** (the “Taxpayer”) with the Department of Taxation. You appeal assessments of the Business, Professional and Occupational License (BPOL) tax issued to the Taxpayer by the ***** (the “City”) for the 2009 through 2012 tax years.
The BPOL tax is imposed and administered by local officials. Virginia Code § 58.1-3703.1 authorizes the Department to issue determinations on taxpayer appeals of BPOL tax assessments. On appeal, a BPOL tax assessment is deemed prima facie correct, i.e., the local assessment will stand unless the taxpayer proves that it is incorrect.
The following determination is based on the facts presented to the Department summarized below. The Code of Virginia sections, regulations and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's web site.
FACTS
The Taxpayer, a wholly owned subsidiary of ***** (the “Parent”), had contracts with the federal government to rebuild ***** (Weapon System A) units and ***** (Weapon System B) components. The Taxpayer also had other contracts with the federal government to restore existing Weapon System A and B components to working order. In addition, the Taxpayer had a number of other contracts that did not involve either Weapon System A or B. The Taxpayer states that revenue from its Weapon System A and B contracts accounted for 58% of its gross receipts during the taxable years at issue. Of that portion, the Taxpayer states that approximately 78% came from contracts that involved rebuilding activities.
On its BPOL tax returns for the taxable years at issue, the Taxpayer classified itself as a wholesaler. Under audit, the City determined that the Taxpayer should have been classified as a service business and issued an assessment for additional taxes due. The Taxpayer appealed, contending that it was exempt from BPOL taxation as a manufacturer selling its goods at wholesale from the place of manufacture.
The City issued a final determination upholding the assessment on the basis that the Taxpayer's manufacturing activities were merely incidental to its service business and the Taxpayer had not made any wholesale sales.
The Taxpayer appealed to the Department, contending that it qualified for exemption as a manufacturer because its rebuilding activities constituted substantial manufacturing activities and it was selling its manufactured goods at wholesale.
ANALYSIS
BPOL - Manufacturing
Virginia localities are prohibited from imposing a license fee or tax on a manufacturer for the privilege of manufacturing and selling goods, wares and merchandise at wholesale at the place of manufacture. See Va. Code § 58.1-3703 C 4.
The BPOL statutes do not define the term “manufacturer” for purposes of the local business license tax. However, the Supreme Court of Virginia (the “Court”) has developed a test involving three essential elements in determining whether a manufacturing activity is being undertaken. These elements are: (1) original material, referred to as raw material; (2) a process whereby the original material is changed; and (3) a resulting product, which by reason of being subject to such processing, is different from the original material. See Title 23 of the Virginia Administrative Code (VAC) 10-500-520 B and County of Chesterfield v. BBC Brown Boveri, 238 Va. 64, 380 S.E.2d 890 (1989). As such, for BPOL tax purposes, a manufacturer means one engaged in a processing activity whereby the original materials are transformed into a product that is substantially different in character from the original materials.
Although the City acknowledged in its final determination that the Taxpayer manufactured some of the parts it used to repair or rebuild the weapon systems, it found that substantial service activities were occurring, with only limited manufacturing of the total amount of parts used.
The Taxpayer contends that its rebuilding activities satisfied all three elements of the manufacturing definition. The Taxpayer also contends that the complexity of the assembly processes used was more indicative of a manufacturer than a service business.
Original Material
In its final determination, the City seemed to suggest that manufacturing does not occur unless the original material is primarily raw material like the raw copper that was used to craft the copper replacement parts in BBC Brown Boveri. Although the Court in BBC Brown Boveri found that the processing of such raw material constituted manufacturing, the standard for manufacturing used by the Court and set forth in Title 23 VAC 10-500-520 refers more generally to “new material” or “original material,” respectively. As such, the manufacturing process does not necessarily have to begin with “raw material” in the traditional sense, such as metal ore. Whatever the starting material is, a manufacturing activity occurs as long as it is subjected to a process whereby it is changed into a substantially different material.
Process
The City stated that manufacturing typically involves the same process to create the same parts using the same manufacturing equipment. While this may be a characteristic of a traditional assembly line manufacturing process, Virginia law only requires that the process cause a change to the original material. See BBC Brown Boveri at 238 Va. 64, 69, 380 S.E. 2d 890, 893; Title 23 VAC 10-500-520 B 2. The manufacturing process does not necessarily need to involve the same process, the same parts or the same equipment repeated over and over again.
Resulting Product
The City observed that the resulting product came into the facility as a weapon system and left as a weapon system. The City found that substantial service activities were occurring, with only limited fabrication of parts to be installed in the Weapon System A unit or Weapon System B component. The City also found that the Taxpayer used parts already owned by the federal government, purchased from third-party vendors, or retrofitted parts that were fabricated, assembled or manufactured to refurbish the systems. The City, however, found that the rebuilt system was not different from the original product because it did not primarily consist of raw materials converted into a new item.
The main factual dispute in BBC Brown Boveri involved the taxpayer's rebuilding activities. In that case, the work involved services and repairs to defective equipment belonging to utility companies. See BBC Brown Boveri at 238 Va. 64, 67, 380 S.E.2d 890, 891. The taxpayer disassembled defective units, performed engineering tests, made appropriate design changes and reassembled them. When finished, the equipment, as a whole, retained the same character as it had when it first came to the facility. For the Court in BBC Brown Boveri, however, the rebuilding activities consisted of manufacturing because the taxpayer's fabrication of the copper replacement components was a transformation of new material into a product of substantially different character.
The City appeared to interpret BBC Brown Boveri to require that any rebuilding process must consist primarily of the conversion of raw materials into new replacement items in order to be a manufacturing activity. Under the unique facts of that case, the Court in BBC Brown Boveri found that manufacturing was occurring because copper replacement parts were being made from raw copper. Under Title 23 VAC 10-500-520 C 2, “[m]ere manipulation or rearrangement of the original materials is not sufficient; there must be a substantial, well-signified transformation in form, usability, quality and adaptability rendering the original material more valuable for use than it was before.”
Weapon System A
The Taxpayer explains that the process of rebuilding Weapon System A units was covered under four contracts. According to the Taxpayer, when a unit was brought to the facility, all of the old components were removed, leaving only the metal housing. Over the course of approximately 18 months, an upgraded unit was rebuilt. The process required the assembly of thousands of parts, many of which were new, and some of which were manufactured by the Taxpayer. Once finished, the new unit's functionality was improved because it was able to counter more threats than the previous system. It also received a new asset number.
It is clear that the process of upgrading the Weapon System A units involved far more than the mere manipulation or rearrangement of the original materials. These materials, i.e., the original metal casing and the vast array of new components used, were transformed into a new product that involved a substantial, well-signified transformation in form, usability, quality and adaptability rendering the original materials more valuable for use than they were before. See Title 23 VAC 10-500-520 C 2. In the Department's opinion, the process of fully rebuilding the Weapon System A units constituted a manufacturing activity.
This conclusion is supported by the Department's regulation distinguishing manufacturing from mere assembly. Factors that suggest a process is manufacturing include, but are not limited to, whether: (1) the assembly process is complex and uses numerous parts; (2) after assembly, the components cannot be recognized without previous knowledge; and (3) the components are not readily usable for any purpose other than incorporating into the finished product. See Title 23 VAC 10-500-520 C 4.
The process described was complex and used numerous parts. It was also likely that most of the components could only be recognized if the unit was disassembled and the individual components identified by someone with expertise in its manufacture. In addition, although some of the components may have been usable for other purposes, given the highly specialized nature of the system, it seems likely that a number of parts would only have been suited to its use alone. As such, it appears that the process more closely resembled manufacturing than mere assembly.
Weapon System B
The Taxpayer also states that it upgraded several components for Weapon System B under three contracts. The rebuilding process for these components was similar to the rebuilding process for Weapon System A, except on a smaller scale and with a shorter timeline. When the component arrived at the Taxpayer's facility, all of the old parts were stripped out of the housing. The Taxpayer was able to reuse some of the existing parts but also installed many new parts, some of which were manufactured by the Taxpayer. Each component took approximately two days to build. When finished, the new components gave Weapon System B more capabilities than it had before.
As with Weapon System A, it is clear that the Taxpayer's process in rebuilding the Weapon System B components involved more than the mere manipulation or rearrangement of the original materials, which consisted of both new and reused parts. Once the Taxpayer's work was finished, these materials were transformed in form, usability, quality and adaptability rendering the materials more valuable than they were before.
The process to rebuild the components for Weapon System B also involved the same type of complex assembly as Weapon System A. Each component involved many parts and took several days to build. After assembly, it was likely difficult to recognize the individual components without having specialized knowledge. It seems more likely, however, with the Weapon System B components that their parts could have been used for other purposes.
In addition, the Weapon System B components were essentially electronic devices. The assembly process described is comparable to the process at issue in P.D. 13-224 (12/13/2013), in which the Taxpayer built custom electronic devices for the military, the parts for which were purchased from unrelated manufacturers or produced at its facility. In that case, the Department compared the taxpayer's process of assembling component parts into integrated systems to the process of assembling computers in County of Fairfax v. DataComp Corp., 36 Va. Cir. 60 (1995) and P.D. 98154 (10/16/1998) and held that, as in those two cases, the Taxpayer's assembly process constituted manufacturing.
The City contends that P.D. 13-224 is not applicable, however, because the Taxpayer never owned the components, they were not sold back to the federal government and they did not create an entirely new device. While ownership and the details surrounding any sales may impact the question of whether wholesale sales were occurring, those factors are not relevant to the question of assembly. Based on the analysis above, it is the Department's opinion that a new product was created, one of a substantially different character than the original materials. Therefore, the process of rebuilding the Weapon System B components constituted a manufacturing activity.
Other Contracts
In addition to its Weapon System A and B rebuilding contracts, the Taxpayer also had a number of other contracts to restore certain Weapon System A and B components to working order. In addition, the Taxpayer also had a number of contracts that did not involve work on either Weapon System A or B. The descriptions of these contracts provided by the Taxpayer indicate that they may have involved either manufacturing or non-manufacturing activities or a combination of both.
Substantiality
In BBC Brown Boveri, the Court held that after it is determined that a taxpayer is engaged in a manufacturing activity, the taxpayer's manufacturing activities must meet the test of substantiality. “When a party is engaged in both manufacturing and non-manufacturing activities, it will nonetheless be classified as a manufacturer for tax purposes if the manufacturing portion of its business is substantial.”
The Court offered several constructive measures to be used in determining whether a business should be classified as a manufacturer for local business tax purposes. These are: (1) the manufacturing component's financial receipts or proportion of total corporate income; (2) the percentage that manufacturing equipment, inventory, etc., comprises of the total capital investment; (3) the number of employees working in the manufacturing component as compared with the total number of employees; or (4) the ratio of manufacturing activities to the entire business. Pursuant to Title 23 VAC 10-500-520 C, to be considered substantial, the manufacturing component of a business must not be de minimis, merely trivial, or only incidental to its principal business.
In its final determination, the City stated that it could not clearly identify the extent of the Taxpayer's manufacturing activities based on the four factors above because the Taxpayer was unable to provide sufficient information. The Taxpayer contends that its manufacturing activities were substantial based on the percentage of gross receipts attributable to the Weapon System A and B rebuilding contracts and the percentage of employees devoted to working on those systems. In support of its position, the Taxpayer prepared charts showing the amount of revenues derived from the Weapon System A and B contracts it claims involved manufacturing. The Taxpayer also claims that 79% of the Taxpayer's employees were involved in the manufacture of components for the systems. A list of employees provided, however, indicated that 60% of the Taxpayer's employees were devoted to manufacturing activities, and it is unclear how the Taxpayer arrived at this percentage.
Further, the Taxpayer applied the substantiality test across all the tax years at issue. Because the annual license is based on each tax year's activities, the Taxpayer must meet the test each tax year. This approach is supported by BBC Brown Boveri's use of a range of percentages in its decision.
Citing P.D. 02-76 (5/2/2002), the Taxpayer also contends that the City must factor in parts manufactured by other business units of the Parent and provided to the Taxpayer for use in its manufacturing activities. In P.D. 02-76, the Department stated that because the taxpayer was a wholly-owned subsidiary, its relationship with its parent was such that its situation was analogous to BBC Brown Boveri. The decision in City of Winchester v. American Woodmark Corp., 250 Va. 451, 464 S.E.2d 148 (1995), concludes that the particular activities of a taxpayer in one jurisdiction cannot be separated from the company as a whole for purposes of determining local tax classifications.
The taxpayers in BBC Brown Boveri and American Woodmark were both single legal entities. In addition, in P.D. 07-191 (11/21/2007), the Department rejected a contention by a taxpayer that its corporate family constituted a vertically integrated manufacturer company, concluding the Taxpayer must be considered to be a separate taxable entity from the other members of its corporate family for business tangible personal property (BTPP) tax purposes. The Department applied this same standard to the classification of a manufacturer for BPOL tax purposes in P.D. 11-44 (3/23/2011). The Department has also required an evaluation of each separate legal entity with regard to BPOL business classification in P.D. 13-76 (10/3/2013). As such, the fact that the Parent may have manufactured and supplied parts to the Taxpayer has no bearing on the substantiality of the Taxpayer's own manufacturing activities in this case.
Sales of Goods, Wares and Merchandise at Wholesale
In order to be classified as a manufacturer for BPOL tax purposes, it is not enough that the business be conducting substantial manufacturing activities. An entity must be selling goods, wares or merchandise at wholesale. As it is the public policy of Virginia to encourage manufacturing, the words “selling goods, wares and merchandise at wholesale” must be liberally interpreted.
Sales to governmental entities are typically considered wholesale sales for BPOL tax purposes. See Title 23 VAC 10-500-350 C. Not all manufacturers sell at wholesale, however. For example, in P.D. 97-146 (3/27/1997), it was determined that manufacturers selling at retail are subject to license taxation. Also, in P.D. 99-14 (1/19/1999), it was determined that manufacturers that do not own original materials, works in progress or finished goods, and which only ship goods at the instruction of the title holder of the goods, do not sell goods at wholesale and are subject to license taxation. See also P.D. 99-311 (12/9/1999). These exceptions exist because Va. Code § 58.1-3703 C 4 only exempts a specific privilege undertaken by a manufacturer and does not provide a blanket exemption for manufacturers. See also P.D. 98-154 (10/16/1998).
In this case, the materials the Taxpayer used were furnished by the federal government, purchased from third-party vendors or manufactured by the Taxpayer. The Taxpayer states that title to any materials purchased from third-party vendors vested in the federal government pursuant to federal regulations when the materials were delivered to the Taxpayer. See Title 48 of the Code of Federal Regulations (CFR) § 45.402(b). The Taxpayer also states that title to parts manufactured by the Taxpayer vested in the federal government when the Taxpayer began to process the materials for use in fulfilling the contract. See Title 48 CFR § 52.245-1(e). As such, it appears that title to all of the parts used by the Taxpayer either was already held by, or became vested in, the federal government before the parts were utilized by the Taxpayer in its rebuilding activities. In addition, it appears that the Taxpayer never owned the work in progress or finished goods.
The Department recognizes that such regulations exist to protect the federal government's interests in property used in government contracts, and they should not necessarily be controlling in a BPOL tax case. Also, unlike the taxpayers in P.D. 99-14 and 99-311 who never owned any of the materials at any point in time, the Taxpayer in this case appears to have owned at least some of the parts prior to the time when the regulations transferred title to the federal government. Provided that the federal government did not already own all of the property at issue regardless of the federal regulations, the Taxpayer's sales could be considered to be wholesale sales to the extent the governing contracts stipulated that a manufactured product was being sold to the federal government.
The Weapon System A contract states that the Taxpayer “shall provide all necessary personnel, materials . . . and services required to overhaul, repair, modify, upgrade and/or maintain parts, items and components of [Weapon System A].” The contract also provides that “[p]erformance of such overhaul/repair services” must conform with certain technical requirements (emphasis supplied). The contract then lists a number of “services” required to be completed. Based on the wording of the contract, the Taxpayer was compensated primarily for its service activities rather than any wholesale sale of goods, wares or merchandise. In addition, the fact that parts were supplied to complete such services does not change the result. Parts are generally required to complete repair and refurbishment services. See P.D. 99-88 (4/23/1999).
The Taxpayer has provided only a portion of a contract with regard to Weapon System B. In addition, the Taxpayer was working several contracts for both weapon systems and numerous other government contracts for other programs during the tax years at issue. Without examining all of the programs and contracts, it is not possible to determine whether wholesale sales were being made. Two contracts provided by the Taxpayer, however, one for the ***** (Program A) one for the ***** (Program B), suggest that sales of goods to the government may have occurred to some extent.
The Taxpayer argues that the “true object” test should be applied to determine the proper tax treatment. The Taxpayer implies that, because the true objects of the rebuilding contracts were the upgraded Weapon System A units and Weapon System B components, the contracts involved the sale of such units or components, not services. Pursuant to Title 23 VAC 10-210-693 B, “where a transaction between a government entity and a contractor involves both the rendering of a service and the provision of tangible personal property . . . the true object of the transaction must be examined to determine the taxability of the transaction.” This test is used to determine the taxability of such transactions for sales and use tax purposes. The BPOL tax, however, is a local tax that is separate and distinct from the Commonwealth's retail sales and use tax. Consequently, sales and use tax regulations are not authoritative in BPOL tax cases. See P.D. 09-139 (9/21/2009). Because the true object test is expressly used to determine the tax treatment of mixed contracts for sales and use tax purposes, it has no bearing on the Taxpayer's classification for BPOL tax purposes, and the Department has declined to apply it in BPOL cases. See P.D. 09-93 (6/11/2009).
Ancillary Receipts
In P.D. 98-154, the Department ruled that a manufacturer was exempt from BPOL tax on receipts attributable to products sold at wholesale from the place of manufacturer, but not on any retail receipts or other licensed activities. Under Title 23 VAC 10-500-520 C 1, however, any receipts that are ancillary to a manufacturer's sales at wholesale at the place of manufacture are also exempt. Therefore, only receipts that were ancillary to the Taxpayer's sales of manufactured products at wholesale would be exempt in this case. Any receipts that were ancillary to manufacturing activities that did not result in wholesale sales would not be exempt. In addition, any receipts that were not ancillary to any part of the Taxpayer's manufacturing business could be subject to BPOL taxation under a separate business license.
Multiple Businesses
Virginia Code § 58.1-3703.1 A 1 provides that a separate license shall be required for each definite place of business and for each business a taxpayer is operating. Local tax officials are responsible for making the determination as to whether a taxpayer is engaged in a single business or in two businesses, each of which could operate independently of the other. In order to make this determination, the local tax official must be provided with documentation demonstrating the substantiality of each business. See 1994 Op. Va. Att'y Gen. 99.
In order to obtain multiple licenses, a business must be engaged in clearly identifiable separate business activities and not merely activities ancillary to the primary business. In P. D. 97-257 (6/11/1997), the Department concluded that the term “ancillary” refers to business activities that are subordinate, subservient, auxiliary, or in aid of the business’ principal business activity. Distinguishing between an ancillary activity and an activity that rises to the level of a separate business can often be accomplished by determining if the activity under scrutiny exists independently of the principal business. In general, an activity for which no separate charge is made will be presumed to be ancillary to the activity for which a charge is made, but separately stating charges for different activities will not create a presumption that each such activity is a separate business. See Title 23 VAC 10-500-110 B.
Several factors strongly suggest that the Taxpayer may have been operating multiple businesses. First, the Taxpayer had a number of separate contracts with the federal government, some of which involved manufacturing and others of which involved non-manufacturing activities. With respect to Weapon System A and B, even if the Taxpayer did not have the contracts to fully rebuild the systems and components, the Taxpayer likely could have performed the other contracts that merely involved restoring existing systems and components to working order and thus appear to have been contracts for repair, not manufacturing. Such non-manufacturing activities, therefore, may have existed independently of any manufacturing activities. In addition, to some extent different activities were confined to separate areas of the facility. This included certain areas designated for work on Weapon System A and B, respectively, and areas set aside for other programs as well. For example, part of the facility was designated as warehouse space under a contract whereby the Taxpayer was required to store certain equipment for a government agency and ship parts when ordered. Having separate areas for activities conducted under separate contracts would support a finding that the activities existed independently and, thus, may have constituted separate licensable businesses.
DETERMINATION
The process whereby the Taxpayer rebuilt Weapon System A units constituted manufacturing and such manufacturing activities were substantial. The contract supplied for Weapon System A, however, indicates that services were being rendered in rebuilding the Weapon System A units. Therefore, it does not appear that Taxpayer was selling the Weapon System A units at wholesale. Accordingly, the Taxpayer did not qualify for the manufacturing exemption under Va. Code § 58.1-3703 C 4 with respect to its Weapon System A activities. The Taxpayer also appears to have been engaged in repair services with respect to Weapon System A. These repair services appear to be ancillary to Weapon System A rebuilds and would be subject to BPOL tax based on the non-exempt status of the Taxpayer's Weapon System A activities.
The Taxpayer's process for rebuilding Weapon System B components also involved substantial manufacturing activities. Because only part of the contract for the Weapon System B components was provided, it is unclear whether wholesale sales of those components were occurring. The Taxpayer also appears to have been engaged in repair services with respect to Weapon System B. Again, such repair services appear to be ancillary to the Weapon System B rebuilding activities and would be either exempt as manufacturing or subject to tax as a business service based on the exemption status of such rebuilding activities.
In addition, sufficient information has not been provided to determine whether the Taxpayer's other contracts involving manufacturing or other business activities were ancillary to either Weapon System A or B activities or whether they rose to the level of a separate business. To the extent they were separate businesses, the Taxpayer and the City would have to determine the correct classification and the tax rates for these businesses.
Accordingly, I am remanding the case to the City with instruction to consider any evidence the Taxpayer can provide concerning the following issues: (1) the extent the Taxpayer conducted manufacturing activities under contracts not involving Weapon System A and B; (2) whether wholesale sales were being made under any Weapon System B contract or any other contract involving manufacturing; (3) to the extent there were wholesale sales of manufactured products, what portion of the receipts from the Taxpayer's non-manufacturing activities were ancillary to such sales at wholesale. Any receipts attributable to wholesale sales of manufactured products and any receipts ancillary to such sales would be exempt. Any receipts ancillary to manufacturing activities that did not result in wholesale sales would not be exempt. In addition, any receipts that were not ancillary to the Taxpayer's manufacturing business at all would be subject to BPOL taxation under a separate business license.
The Taxpayer must provide sufficient documentation, including portions of contracts sufficient to identify the work performed at the facility. Any new documentation must be submitted within 60 days of the date of this letter. If the documentation is not received within the time provided, the City's assessment will be considered correct.
If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/1-5897434772.M