Whether Onex was a manufacturing corporation pursuant to G.L. c. 63 § 42B, and therefore entitled to a sales and use tax exemption, during a period when it was developing specifications for a microchip but had not yet ordered it manufactured.

Between August 1, 1999 and September 21, 2001 (the “audit period”), Onex designed the hardware and software of a microchip and related systems. The result was a blueprint containing technical specifications of hardware and software components and detailed manufacturing instructions.

Since Onex lacked the sophisticated equipment necessary to produce the microchip internally, Onex outsourced production to IBM. Under the contract, IBM did not have any input into the design of the microchip and had to follow the exact instructions of the blueprint. Onex directed IBM in all facets of production and manufactured microchips became Onex’s property. Onex did not commercially distribute the microchips until after the audit period, in 2002. 

During the audit period, Onex made purchases totaling $2,723,510 on which no sales and use tax was paid. The Commissioner of Revenue assessed unpaid tax, Onex appealed, and the Appellate Tax Board ruled that no tax was owed.

A corporation that qualifies as either a “manufacturing corporation” or a “research and development corporation” under G.L. c. 63 § 42B is exempt from sales and use tax on purchases used for research and development within the Commonwealth. See G.L. c. 64I § 7(b) and c. 64H §§ 6(r) and (s).

1. Qualification as a Manufacturing Corporation. The Appellate Tax Board determined that Onex was a manufacturing corporation, even though commercial production did not begin until after the audit period, because creation of “technical blueprints capable of minutely directing the manufacture of the [microchips]” was an essential and integral part of the overall manufacturing process. The Commissioner argues that research and development purchases by a “manufacturing corporation” are exempt from sales and use tax only if the corporation is also engaged in actual manufacturing at the time of the purchase. 
2. Qualification as a Research and Development Corporation. A foreign corporation that derives more than two-thirds of its receipts, or that incurs more than two-thirds of its expenditures, from research and development activities within the Commonwealth is a research and development corporation. If the SJC agrees that Onex was not a manufacturing corporation, the Commissioner argues that the case must be remanded to decide whether Onex’s venture capital funding and bartered services qualify as “receipts.”

Although prototypes were developed during the audit period, commercial production did not occur until afterward.  The regulations specifically provide that “[m]arket research, research and development, and design and creation of a prototype, although prerequisites to manufacturing, are not manufacturing.” 830 C.M.R.§ 58.2.1(6)(b)(5). Therefore, it is unlikely that the SJC will affirm the Board’s conclusion that Onex is a manufacturing corporation during the audit period. The Commissioner is likely correct that the SJC must remand the case to the Board to make the necessary findings of fact as to whether Onex qualifies as a research and development corporation.

Retroactive qualification as a manufacturing corporation has implications beyond the area of sales and use tax. For example, the Commissioner argues that the Board’s decision could retroactively exempt corporations from property tax, causing disruption to the annual assessment scheme in a manner not anticipated by the Legislature.