Background

On July 9, 2003, the California State Board of Equalization (SBE) issued a revised written opinion in the Appeal of California Steel Industries, Inc. (CSI), which may be cited as precedent in future cases [2003-SBE-001-A]. This case was originally argued on November 13, 2002, and an initial decision was published on January 9, 2003. However, the Franchise Tax Board (FTB) filed a petition for rehearing in the case, which had the effect of placing the original decision on hold until the matter was finally resolved.

The 5-0 ruling settled the fourth case involving the manufacturers' investment credit (MIC). The issue before the SBE was whether amounts paid to third-party contractors for capitalized labor were fully eligible for the MIC, or whether they needed to be bifurcated into "direct" and "indirect" costs of labor, as the FTB’s MIC Regulations require.

After oral argument by the taxpayer and FTB attorneys, the Board took the matter under submission at its November 13 hearing. Thereafter, a decision in favor of the taxpayer was rendered on December 4, 2002, with a written decision issued on January 9, 2003. However, a final opinion was adopted and published on July 9, 2003 (Board decisions can be obtained from its website at http://boe.ca.gov.)

California Steel Industries is based in Fontana, California, and invested over $43 million in its manufacturing process improvements. CSI currently employs almost 1,000 people at its facilities in the state. There was no dispute that CSI is a “qualified taxpayer” for purposes of claiming of the MIC. The issue before the SBE was one of first impression involving capitalized labor costs, one of the eligible forms of “qualified property” under the statute.

Applicable Laws

California Revenue & Taxation Code Section 23649(d)(3) provides that "qualified property" also includes "the value of any capitalized labor directly allocable to the construction or modification of qualified property."

On the other hand, FTB's Regulation Section 23649-4(d) provides that qualified property includes "direct costs of labor properly allocable to the construction or modification of qualified property." FTB based this limitation on the federal uniform capitalization (UNICAP) rules. However, under the UNICAP rules, producers must capitalize "direct materials costs," "direct labor costs," and specified "indirect labor costs."

In addition, FTB issued two legal rulings that impact the interpretation of this area of the MIC law. Legal Ruling 98-1 provides that engineering and design services are "direct costs of labor" (even though they are "indirect costs of labor" under federal law). Legal Ruling 2000-1 states that taxpayers are required to breakdown (called the "look-through" requirement) the costs of third-party contracts and divide the contracts into qualifying (direct labor) and non-qualifying (indirect labor) costs. (FTB Legal Rulings can be obtained from its website at http://ftb.ca.gov.)

Taxpayer’s Arguments

The taxpayer's arguments centered upon the conflict between the language of the statute and regulations. While the statute provides that the "value" of labor costs that are capitalized and directly allocable to "qualified property" are eligible for the MIC, the FTB’s regulations narrow the scope of capitalized labor costs.

In addition, CSI argued that the "look-through" requirement in Legal Ruling 2000-1 is not supported by the law or the federal UNICAP Regulations. There was also evidence presented from the June 1996 public hearing held by the FTB that "virtually all" design/engineering costs paid to third parties are eligible for the MIC. As a result, the taxpayer argued that there is no legal distinction between construction labor and design and engineering labor, and so construction labor costs paid to third parties should fully qualify.

Specifically, CSI argued that all costs paid to third party contractors should qualify for the MIC because the FTB’s own MIC Regulations never contemplated a taxpayer being required to document a distinction between direct and indirect costs for labor services provided by a third party. FTB’s “look through” position is an afterthought unsupported by statutory or regulatory authority.

In fact, Legal Ruling 2000-1 not only appears in conflict with FTB Regulation 23649-4(d), but also it appears in direct conflict with Example 3 of that Regulation, which is supposed to provide guidance to taxpayers in claiming the MIC. Moreover, the federal UNICAP regulations have no such requirement.

In addition, not only do the UNICAP regulations define direct labor to include the cost of independent contractors, but also such costs are specifically excluded from the definition of “indirect labor.” Both direct and indirect costs have to be capitalized under the UNICAP Regulations. Under the IRC Section 263A regulations, all of the costs attributable to property produced under contract are considered to be direct costs of production and, therefore, the entire labor component including any mark-up or employee benefit costs should be considered to be direct costs of production for such property.

Finally, the contractor’s costs are all directly identified with qualified property. Therefore, all such costs are direct labor costs as to the taxpayer. CSI did not pay employee benefit costs to its independent contractors’ employees. Rather, the contractors paid their employees all the employee benefit costs. CSI paid its contractors for the “value” of labor, which it capitalized, and which was directly allocable to its qualified property. The law makes that cost a qualified cost for purposes of the MIC, according to the taxpayer.

FTB’s Arguments

The FTB argued that the statutory language requires bifurcation of labor costs paid to third parties, as well as in-house employees, into direct and indirect costs of labor. Moreover, employee benefit costs are properly excluded because they cannot be specifically identified with units or groups of property. FTB also argued that the taxpayer could not claim these costs themselves and, therefore, both in-house employees and third-party contractors should be treated equally.

Specifically, the FTB argued that Legal Ruling 2000-1 requires taxpayers to breakdown the costs of third-party contractors into a direct labor component (qualified cost) and an indirect labor component (non-qualified cost). Under the MIC statute, it is clear that not all labor costs constitute qualified costs because the statute specifically provides that only capitalized labor costs that are directly allocable to an item of qualified property constitute qualified costs.

Moreover, under the MIC law and federal regulations, employee benefit costs are specifically excluded from the definition of direct labor costs. The allocation under the FTB’s Legal Ruling is required because indirect labor costs, by definition, cannot be specifically identified with units or groups of property.

Finally, FTB argued that CSI is attempting to obtain the MIC credit indirectly for component costs that would not qualify on their own. For example, had CSI written separate checks for these component items, they would not qualify for the MIC. A lump-sum payment to a third-party contractor does not change the underlying nature of these charges, nor should it.

Essentially, then, FTB’s goal was to equalize the treatment for MIC purposes between a taxpayer self-constructing MIC assets using its own employees and a taxpayer utilizing independent contractor labor to construct the same asset.

The Final Written Decision

According to the SBE, "[t]he issue presented by this appeal is whether [CSI]’s payments to an independent contractor for construction of qualified property represent 'capitalized labor costs that are directly allocable to the construction' of qualified property, and thus constitute qualified costs for purposes of the MIC."

After reviewing the applicable legal authorities, the SBE wrote that CSI "presents a simple argument in favor of its position. The taxpayer contends it engaged various independent contractors to construct ... specific items of qualified property. As the independent contractors completed work on the qualified property, [CSI] paid contractually specified sums to the independent contractors, and capitalized such payments.

"Thus, [CSI] contends, all payments to the independent contractors represented capitalized labor costs directly allocable to the construction of a specific item or items of qualified property and qualify under the MIC." CSI cited to the actual language of Legal Ruling 98-1, Regulation Sections 23649-2(b), and 23649-4(d), the language of CRTC Sections 23649 (b)(1) and (d)(3), and IRC Section 263A in support of its position.

CSI also argued that FTB had erroneously disallowed miscellaneous costs for items such as rental equipment, materials, and other miscellaneous costs because CSI had failed to show that sales tax was paid on these items.

On the other hand, the opinion noted the FTB argued that CSI's position ignores the approach adopted by [FTB] from Treasury Regulation Section 1.263A-1(e). The FTB also alleged that CSI was seeking to obtain the MIC indirectly on costs it could not qualify for if it incurred such costs.

However, the SBE rejected the arguments set forth by the FTB. The opinion states, "Upon review of the language of section 23649, subdivisions (b)(1) and (d)(3), Regulation sections 23649-2, subdivision (b), and 23649-4, subdivision (d), Legal Ruling 98-1, and IRC section 263A, we agree with much, but not all, of [CSI]’s argument."

In another important holding, the SBE reiterated its position that "underlying our approach to the MIC is our belief that the MIC should be interpreted liberally in favor of taxpayers." (see Appeal of Save Mart Supermarkets & Subsidiary, 2002-SBE-002, Feb. 6, 2002.)

Specifically, the SBE stated that it "disagreed" with the FTB's arguments that a self-constructing taxpayer and a taxpayer hiring an independent contractor are similarly situated with respect to construction of qualified property. In so finding, the SBE stated, "The very fact that one taxpayer maintains employees to design and/or construct qualified property distinguishes that taxpayer from another taxpayer which does not, cannot, or will not incur the ongoing costs of maintaining employees to design and/or construct qualified property. Thus, we do not find [FTB]'s tax parity argument persuasive and believe [FTB] can properly apply the direct versus indirect labor cost differentiation to self-constructing taxpayers, while not applying them to taxpayers hiring independent third-party contractors."

In addition, the SBE determined that the FTB's "approach ignores business reality with respect to a taxpayer’s hiring of an independent contractor. First, as argued by [CSI], a taxpayer is not concerned with how an independent contractor categorizes various costs of a project as long as the costs to the taxpayer are justified, reasonable, and represent the best value to the taxpayer.

“Second, [FTB]'s approach imposes a potentially impractical burden on taxpayers to obtain labor cost information from independent contractors. In particular, some independent contractors may not wish to divulge such information, others may not keep accurate records of such information, while others may increase the costs of the project to reflect the additional service provided. We do not believe this result to be appropriate tax policy."

Furthermore, the SBE held that "a taxpayer which hires and pays an independent contractor for construction of qualified property may correctly attribute the amounts paid to the independent contractor to the specific items of qualified property; thus satisfying the requirements for qualified costs." The SBE said, "[w]e find support for this view in [FTB]’s Legal Ruling 98-1."

In addition, the SBE determined that the record in this case "suggests" that CSI "can identify or associate the construction costs paid to the independent contractor with particular units or groups of units of specified property. Thus, [CSI] meets the criteria set forth in the legal ruling." In addition, the legal ruling language "comports" with Regulation Section 23649-4(d), Example 3. Again, the SBE’s opinion cited the FTB’s own regulations in support of the taxpayer’s position.

However, the SBE did not agree to allow all costs paid to independent contractors to qualify for the MIC. The SBE stated, "Although we generally concur with [CSI] that its payments to an independent contractor constitute qualified costs, we do not believe amounts paid to an independent contractor attributable to non-labor costs constitute capitalized costs of labor for purposes of section 23649, subdivision (d)(3).”

The opinion goes on to provide a detailed definition for taxpayers and the FTB to follow. “With respect to independent contractors, labor costs are all costs paid or incurred for services rendered in connection with the construction or modification of qualified property, including any overhead and profit attributable to such services. For the union labor costs incurred by [CSI], labor costs include all of the component costs that comprise the total wage rates under master labor agreements.

“Non-labor costs are all other contract costs, including, for example, materials, equipment purchases and/or rentals, small tools and consumables, and all other non-service charges and reimbursable costs, including overhead and profit attributable to such non-labor costs. If, however, a taxpayer can verify payment of sales or use tax on these items, then these non-labor costs may qualify under the general rule of section 23649, subdivision (b).”

As a result of these modifications to the original opinion, taxpayers can claim the MIC on the labor components of payments made to third parties under the “capitalized labor” provisions of the “qualified property” definition of the MIC statute. However, non-labor costs will not qualify under this section of the law. Nonetheless, those non-labor costs may otherwise qualify for the MIC under the general “qualified property” criteria.

The final holding of the SBE's opinion dealt with the Cohan v. Commissioner rule (39 F.2d 540). CSI argued that substantiating 92 percent of its claimed costs is sufficient for the FTB to proceed as if adequate documentation has been provided for the remaining costs. However, the SBE held that, "Given no independent facts have been provided to us, we refuse to alter [FTB]’s determination regarding unsubstantiated costs."

The SBE concluded its revised written opinion with the statement that "a taxpayer which hires and pays an independent contractor for construction of qualified property and which can attribute the labor costs paid to the independent contractor with particular units or groups of units of specified property, may claim the amounts paid to the independent contractor for labor costs as qualified costs.

“We do not conclude, however, that amounts paid to an independent contractor attributable to non-labor costs, such as materials, equipment purchases and/or rentals, small tools and consumables, and all other non-service charges and reimbursable costs, including overhead and profit attributable to such non-labor costs constitute capitalized costs of labor for purposes of section 23649, subdivision (d)(3). If a taxpayer can verify payment of sales or use tax on these items, then these costs may qualify under section 23649, subdivision (b). Therefore, in the present case, [CSI] may take the MIC amount for payments to the independent contractor for labor costs as defined herein, but may not include unsubstantiated costs.”

Representing the taxpayer was Douglas Bramhall of KPMG in Los Angeles; Michael Cataldo, Tax Counsel, represented the FTB.