Which amounts paid to a third-party contractor counted as qualified costs for California's Manufacturers' Investment Credit?

Plain-English summary

Legal Ruling 2000-1 required a manufacturer to look through a third-party construction contract instead of treating the entire capitalized invoice as a qualified cost for California's Manufacturers' Investment Credit (MIC).

The contractor built one widget-stamping machine under a $1 million lump-sum contract. Although the manufacturer capitalized the full payment into the machine's basis, only two components qualified for the credit: $100,000 of parts and materials on which the contractor paid California sales tax, and $160,000 of direct labor items consisting of wages, sick leave, overtime, and payroll taxes.

The resulting qualified-cost base was $260,000. At the ruling's 6% MIC rate, the credit was $15,600.

The look-through rule

A taxpayer using a third-party contractor had to identify the contract costs that would have qualified if the taxpayer had constructed the property with its own employees. Capitalization alone was not enough.

The taxpayer could include:

• Amounts on which the contractor paid California sales or use tax, excluding the tax payment itself.

• Capitalized direct labor costs that met the MIC definition under the uniform capitalization allocation rules.

The taxpayer could not convert indirect labor, non-labor expenses, overhead, or profit into qualified direct labor merely by paying them through a capitalized contract.

The $1 million contract

The contractor's written invoice allocated the payment as follows:

• $100,000 for parts and materials on which the contractor paid California sales tax.

• $8,000 of California sales tax on those materials.

• $400,000 for 4,000 labor hours billed at $100 per hour, consisting of $160,000 in wages, sick leave, overtime, and payroll taxes; $120,000 in employee overhead such as retirement, health care, and fringe benefits; and a $120,000 contractor-profit component in the labor rate.

• $220,000 of miscellaneous costs: $50,000 insurance, $50,000 employee relocation, and $120,000 equipment rental.

• $272,000 of contractor profit on the contract as a whole.

What qualified

The ruling allowed $260,000:

• $100,000 for taxed parts and materials.

• $160,000 for direct labor items identifiable with the machine: wages, sick leave, overtime, and payroll taxes.

The ruling describes direct labor more generally as potentially including basic compensation, overtime, vacation pay, holiday pay, sick leave, shift differential, payroll taxes, and payments to a supplemental unemployment benefit plan when properly allocable to the qualified property.

What did not qualify

The other $740,000 did not enter the MIC base:

• The $8,000 sales-tax payment itself was excluded because the tax was not an amount on which sales tax was paid.

• Employee overhead for retirement, health care, and fringe benefits was indirect labor.

• Insurance, relocation, and equipment-rental costs were not qualified direct labor.

• The contractor's profit embedded in the labor rate and its profit on the contract as a whole did not qualify.

Those costs remained excluded even though they were capitalized into the machine and generally depreciable for California income or franchise tax purposes.

Substantiation matters

The taxpayer bore the burden of obtaining enough detail to apply the look-through method. The ruling expressly states that failure to obtain a breakdown did not make the full contract amount qualified. Inadequate substantiation could cause all or part of the claimed contract costs to be disallowed.

What this means for you

Manufacturers using contractors

A lump-sum invoice was not a sufficient MIC calculation. The contract and supporting records had to separate taxed property, direct employee labor components, indirect labor and benefits, other expenses, taxes, and profit.

Contractors preparing invoices

Detailed cost schedules could matter to the customer's ability to substantiate the historical credit. A single blended labor rate could contain both qualifying direct labor and excluded overhead or profit.

Accountants and tax professionals

The ruling used the section 263A uniform capitalization rules only to distinguish direct from indirect labor for MIC purposes. It did not say that every amount capitalized under section 263A became a qualified MIC cost.

Common questions

Q: Did the entire $1 million capitalized contract qualify?

A: No. Only $260,000 qualified under the stated facts.

Q: Why did the $100,000 of materials qualify?

A: The contractor paid California sales tax on those materials, satisfying the ruling's general taxed-cost requirement.

Q: Did the $8,000 of sales tax itself qualify?

A: No. The ruling excluded the tax payment itself from qualified costs.

Q: Did retirement, health-care, and fringe-benefit overhead qualify as direct labor?

A: No. The ruling treated those amounts as indirect labor costs.

Q: Could contractor profit qualify because it was capitalized into the equipment?

A: No. Neither the profit embedded in the labor rate nor the overall contract profit qualified.

Q: What if the taxpayer could not obtain a detailed contract breakdown?

A: The taxpayer still had the burden to establish the qualifying amounts. The ruling says a missing breakdown did not turn the entire contract into a qualified cost.

Citations and references

• Cal. Rev. & Tax. Code §§ 17053.49 and 23649
• Cal. Rev. & Tax. Code §§ 17265 and 17266; I.R.C. § 179
• I.R.C. §§ 263, 263A, and 1245(a)(3)(A)
• Treas. Reg. §§ 1.263A-1 and 1.263A-2
• Cal. Code Regs., tit. 18, §§ 17053.49-0 through 17053.49-11 and 23649-0 through 23649-11
• FTB Legal Ruling 98-1, clarified and superseded to the extent inconsistent

Source

• Landing page: California FTB Legal Rulings
• Official HTML: Legal Ruling 2000-1

Original ruling text

Home

Legal ruling 2000-1

Mail State of California
Franchise Tax Board - Legal Branch
PO Box 1720
Rancho Cordova CA
95741-1720 Phone 916-845-3309 Fax 916-845-3648

Kathleen Connell
Chair
Dean Andal
Member
B. Timothy Gage
Member

June 1, 2000

Manufacturers' investment credit capitalized costs under third-party contracts

This ruling is intended, in part, to clarify Legal Ruling 98-1, issued on February 2, 1998, regarding the qualification of capitalized labor costs directly allocable to qualified property for the California Manufacturers' Investment Credit (MIC), and supersedes that ruling to the extent of any inconsistency between the two rulings.

Issue

To what extent may capitalized labor costs paid or incurred by a qualified taxpayer to a third-party contractor for the construction, modification or installation of qualified property constitute qualified costs for purposes of the MIC?

Law

The MIC is allowed under Revenue and Taxation Code sections 17053.49 (Personal Income Tax (PIT) Law) and 23649 (Bank and Corporation Tax (B&CT) Law). Regulations for the MIC are at Title 18, California Code of Regulations, sections 17053.49-0 through 17053.49-11 (PIT) and 23649-0 through 23649-11 (B&CT). The MIC is allowable to qualified taxpayers who pay or incur qualified costs on or after January 1, 1994, for qualified property that is placed in service in California.

Generally, qualified property for the MIC is tangible personal property as defined in Internal Revenue Code section 1245(a)(3)(A) for use in an establishment of the qualified taxpayer that is properly classified under either Division D (Codes 2011 through 3999, inclusive) or Codes 7371 through 7373, inclusive, of the Standard Industrial Classification (SIC) Manual, published by the United States Office of Management and Budget, 1987 Edition, and is primarily used in a qualified activity. (Rev. & Tax. Code §§ 17053.49(d) & 23649(d); Cal. Code Regs., tit. 18, §§ 17053.49-5 & 23649-5.) Generally, qualified costs for the MIC are any amount upon which the qualified taxpayer has paid, directly or indirectly, sales or use tax under Part 1 (commencing with section 6001) of the Revenue & Taxation Code. (Rev. & Tax Code §§ 17053.49(b)(1)(B) & 23469(b)(1)(B); Cal. Code Regs., tit. 18, §§ 17053.49-4 & 23649-4.) Qualified costs do not include the amount of sales or use tax paid, directly or indirectly, by the qualified taxpayer. (Cal. Code Regs., tit. 18, §§ 17053.49-4(a) & 23649-4(a).)

The MIC is equal to six percent (6%) of all qualified costs. Generally, qualified costs for the MIC are costs paid or incurred by a qualified taxpayer on or after January 1, 1994, for the construction, reconstruction, or acquisition of qualified property upon which California sales or use tax is paid. (Rev. & Tax. Code §§ 17053.49(b)(1)(A) & (B) and 23649(b)(1)(A) & (B).) Qualified costs for the MIC are further limited to amounts that are properly chargeable to the capital account of the qualified taxpayer. (Rev. & Tax. Code §§ 17053.49(b)(1)(C) & 23649(b)(1)(C).)

Capitalized costs of labor that are "directly allocable to the construction or modification" of qualified property may also be included as qualified costs for purposes of the MIC. (Rev. & Tax. Code §§ 17053.49(d)(3) & 23649(d)(3).)1 While qualified costs for purposes of the MIC must generally be amounts upon which California sales or use tax is paid, capitalized direct costs of labor represent the one narrow exception to that requirement. (Rev. & Tax. Code §§ 17053.49(b)(1)(B) & 23649 (b)(1)(B).)

For purposes of the MIC, the term "capitalized labor" means all direct costs of labor that can be identified or associated with and are properly allocable to the construction, modification, or installation of specific items of qualified property. (Cal. Code Regs., tit. 18, §§ 17053.49-2(b) & 23649-2(b).) In determining whether direct costs of labor are properly allocable to the construction, modification, or installation of a specific item of qualified property, the qualified taxpayer is required to use the same method of allocation that is required to be used by the qualified taxpayer for California income or franchise tax purposes under the uniform capitalization (UNICAP) allocation rules in Treasury Regulation section 1.263A-1. (Cal. Code Regs., tit. 18, §§ 17053.49-2(b)(3) & 23649-2(b)(3).)

The UNICAP rules contained in Internal Revenue Code section 263A ² generally address the capitalization of costs associated with real and tangible personal property produced by the taxpayer and property acquired for resale (i.e., inventory).³ For purposes of the MIC only, the UNICAP allocation rules of Internal Revenue Code section 263A are used to determine whether capitalized costs of labor associated with the construction, modification, or installation of qualified property for the MIC are direct costs of labor (as distinguished from indirect costs of labor). (Cal. Code Regs., tit. 18, §§ 17053.49-2(b) & 23649-2(b).) Accordingly, if costs of labor would be properly treated as direct costs of labor capitalized to an item of property produced by the taxpayer under Internal Revenue Code section 263A under the method of inventory accounting used by that taxpayer, then such costs of labor would also be properly treated as direct costs of labor for purposes of the MIC.

Treasury Regulation section 1.263A-1(e) provides in general that taxpayers "must capitalize all direct costs and certain indirect costs . . . ." Direct costs of labor include costs of labor that can be identified or associated with particular units or groups of units of specified property. (Treas. Reg. § 1.263A-1(e).) Elements of direct costs of labor include basic compensation, overtime pay, vacation pay, holiday pay, sick leave pay, shift differential, payroll taxes, and payments to a supplemental unemployment benefit plan. (Treas. Reg. § 1.263A-1(e)(2)(i)(B); Cal. Code Regs., tit. 18, §§ 17053.49-2(b)(1) & 23649-2(b)(1).) Indirect costs are defined as all costs other than direct material costs and direct costs of labor. (Treas. Reg. § 1.263A-1(e)(3)(i); Cal. Code Regs., tit. 18, §§ 17053.49-2(b)(2) & 23649-2(b)(2).)

Internal Revenue Code section 263A(g)(2) provides generally that a taxpayer is treated as producing any property produced for the taxpayer by a third party under a contract with the taxpayer. (See Treas. Reg. § 1.263A-2(a)(1) & (2).) Costs paid to or incurred with respect to third-party contractors, to the extent that those costs would be properly treated as direct costs of labor capitalized to an item of qualified property produced by the taxpayer under Internal Revenue Code section 263A under the method of inventory accounting used by that taxpayer, may also be qualified capitalized direct costs of labor for purposes of the MIC. (See Treas. Reg. § 1.263A-1(e)(2)(i)(B).)

Facts and analysis

Assume the following facts:

The business activities of each taxpayer are properly assigned to SIC Codes, as published in the SIC Manual, under Division D, Manufacturing (Codes 2011 through 3999, inclusive), or Codes 7371 through 7373, inclusive, and each taxpayer is a qualified taxpayer for purposes of the MIC. Each taxpayer is not doing business in an Enterprise Zone, a Targeted Tax Area, a Local Area Military Base Recovery Area, or a Manufacturing Enhancement Area. Unless otherwise specified, all property discussed is qualified property for the MIC. Assume that no election is made to currently expense any portion of the costs incurred with respect to any items of qualified property under Revenue and Taxation Code sections 17265 or 17266 (Internal Revenue Code section 179) or any other similar provision, such as the accelerated expensing provisions provided to taxpayers doing business in an economic incentive zone. Each taxpayer uses the same method of allocation for the MIC as is used by that taxpayer for purposes of determining whether costs of labor would be properly treated as direct costs capitalized to an item of property under Internal Revenue Code section 263A for California franchise and income tax accounting purposes.

X is a company that manufactures widgets at its manufacturing plant in Anytown, California. After January 1, 1994, X enters into a contract with an independent third-party contractor, Y, to engineer, design and construct a new widget-stamping machine for X's widget factory.4

Under the terms of the contract between X and Y, the new stamper is the only item of property for which Y is to provide design, engineering and construction services. All of X's payments under the contract to Y are properly capitalized to the cost basis of the new stamper for federal and state tax purposes.

X pays Y under the contract a lump-sum payment of $1,000,000 on or after January 1, 1994. The lump-sum payment is made under a written invoice that is broken down as follows:

$100,000 for parts and materials upon which California sales tax was paid by Y.

$8,000 for sales tax on item (1) at the rate of 8%.

$400,000 for 4,000 hours of labor at the rate of $100 per hour, broken down as follows:
$160,000 for wages, sick leave, overtime, and payroll taxes paid to or on behalf of Y's employees at the rate of $40 per hour;

$120,000 for Y's employee overhead costs, such as retirement, health care and fringe benefit costs; and

$120,000 for Y's profit component of the labor rate charged to X with respect to Y's employees.

$220,000 for miscellaneous items that include:
$50,000 insurance expenses;

$50,000 employee relocation expenses; and

$120,000 equipment rental.

$272,000 for Y's profit on the contract as a whole.

Analysis

X may include those costs upon which Y paid California sales or use tax as qualified costs for purposes of the MIC. Thus, the component of the lump-sum payment for parts and materials equal to $100,000 can be included as qualified costs for the MIC. X may not claim the billed California sales tax in the amount of $8,000 as qualified costs for the MIC because the amount of sales tax itself is not an amount upon which sales tax is paid.

With respect to the remaining costs, the primary issue is what costs paid to Y for the new stamper would be properly treated as direct costs of labor capitalized to an item of qualified property under Internal Revenue Code section 263A. As discussed above, the UNICAP rules contained in Internal Revenue Code section 263A are generally applicable to property produced by the taxpayer and property acquired for resale. While these rules provide that the taxpayer is treated as producing any property produced for the taxpayer by a third party under contract with the taxpayer, these rules do not specifically address the allocation of direct and indirect costs, including labor costs, with respect to property that is constructed by a third-party contractor for a qualified taxpayer. However, for definitional purposes only, the MIC regulations mandate that the UNICAP rules be used to determine whether costs of labor are properly treated as "direct" or "indirect" costs capitalized to an item of property within the meaning of Revenue and Taxation Code sections 17053.49(d)(3) and 23649(d)(3).5 Only capitalized direct costs of labor may be qualified costs for purposes of the MIC. For third-party contracts, X is only allowed to include those costs that X could include if X itself had constructed the new stamper using its own employees. In other words, to determine whether any of the cost items billed to X can be included as capitalized direct costs of labor for the MIC, X is required to look through its contract with Y, and in effect put itself in the shoes of Y for purposes of computing its qualified costs for the MIC.

Qualified costs for the MIC, as a general rule, are amounts upon which California sales or use tax is paid. Qualified capitalized direct costs of labor for the MIC are an exception to this general rule because labor costs are amounts upon which no sales or use tax is generally due where such labor amounts are separately stated. Thus, the statutory and regulatory provisions allowing the MIC for qualified capitalized labor costs must properly be narrowly construed as an exception to the general statutory rule that California sales or use tax be directly or indirectly paid in order for a cost to qualify for the MIC.

There is no provision in the MIC statutes or regulations that authorizes a credit for amounts paid to a third-party contractor based solely upon the fact that they are capitalized to and are paid or incurred for qualified property. First and foremost, such capitalized costs must either be costs upon which the third-party contractor has paid California sales or use tax or they must be labor costs, not costs paid or incurred for something other than labor. Qualified capitalized labor costs for the MIC must also meet the definition of capitalized direct costs of labor as if the item of qualified property were constructed by the qualified taxpayer. (Treas. Reg. § 1.263A-1(e)(2)(B); Cal. Code Regs., tit. 18, §§ 17053.49-2(b) & 23649-2(b).)

The test for whether costs of labor are direct costs of labor under Internal Revenue Code section 263A is whether these costs "can be identified or associated with particular units or groups of units of specific property produced." (Treas. Reg. § 1.263A-1(e)(2)(B); Cal. Code Regs., tit. 18, §§ 17053.49-2(b) & 23649-2(b).) For purposes of the MIC, these direct costs of labor include basic compensation, overtime pay, vacation pay, holiday pay, sick leave pay, shift differential, payroll taxes, and payments to a supplemental unemployment benefit plan. (Treas. Reg. § 1.263A-1(e)(2)(i)(B); Cal. Code Regs., tit. 18, §§ 17053.49-2(b)(1) & 23649-2(b)(1).) Direct costs of labor do not include training costs, officers' compensation, pension and other related costs, and employee benefit expenses (including payments pursuant to a wage continuation plan under Internal Revenue Code section 105(d) as it existed prior to its repeal in 1983). (Treas. Reg. § 1.263A-1(e)(3)(ii); Cal. Code Regs., tit. 18, §§ 17053.49-2(b)(2) & 23649-2(b)(2).)

Holding

X may not include the entire $1,000,000 lump sum paid to Y for the engineering, design and construction of the new stamper as qualified costs in computing X's MIC. Instead, X may only include as qualified costs for the MIC those items that X would be able to include had X itself constructed the stamper rather than paying Y to do it. Thus, X may only include those amounts billed to X that represent qualified amounts upon which California sales or use tax was paid and capitalized direct costs of labor, such as basic compensation, overtime pay, vacation pay, holiday pay, sick leave pay, shift differential, payroll taxes, and payments to a supplemental unemployment benefit plan.

Under the facts of this ruling, X may only include the following amounts paid to Y as qualified costs for the MIC:

$100,000 for parts and materials upon which California sales tax was paid;

$160,000 for wages, sick leave, overtime, and payroll taxes paid to or on behalf of Y's employees.

Therefore, the total qualified costs X may include for the MIC equal $260,000. X's MIC would thus equal $15,600 ($260,000 X 6%).

All of the other costs paid by X to Y for the new widget stamper are not qualified costs for purposes of the MIC, despite the fact that they are capitalized to the cost of the new stamper and would generally be depreciable for California franchise and income tax purposes. These costs are either California sales tax payment amounts or amounts that are properly treated as either non-labor costs or indirect costs of labor paid by X to Y under the contract. Therefore, these other costs do not qualify for the MIC. Thus, for example, X may not include as qualified costs for the MIC the portion of the payments to Y that represents Y's profit or overhead on the contract with X, nor may X include the indirect costs of labor for Y's employee overhead costs such as retirement, health care, and fringe benefits.6

Drafting information

The principal author of this ruling as originally drafted was Elliott Scott Ewing, formerly of the Franchise Tax Board Legal Branch. For further information regarding this ruling, contact Geoff Way at the Franchise Tax Board Legal Branch, P.O. Box 1720, Rancho Cordova, CA 95741-1720, 916-845-6351.

See also Revenue and Taxation Code sections 17053.49(d)(4)(B) and 23649(d)(4)(B) regarding capitalized direct costs of labor paid or incurred in connection with the construction, modification, or installation of certain special purpose buildings.

All references in this Legal Ruling to Internal Revenue Code section 263A incorporate by reference the regulations thereunder. Discussion or application in this Legal Ruling of federal or state statutes or regulations dealing with capitalization of property is only for purposes of defining direct costs of labor for purposes of the MIC.

For a discussion of the general scope of Internal Revenue Code section 263A, see Treasury Regulation section 1.263A-1(a)(3).

For purposes of this Legal Ruling, assume that X must capitalize its costs for the stamper under the general authority of Internal Revenue Code section 263.

See also Revenue and Taxation Code sections 17053.49(d)(4)(B) and 23649(d)(4)(B) regarding capitalized direct costs of labor paid or incurred in connection with the construction, modification, or installation of certain special purpose buildings.

The failure by a taxpayer, such as X, to obtain the necessary breakdown of the costs within a third-party contract does not therefore permit such taxpayer to claim that the entire amount of the contract becomes a "qualified cost" for purposes of the MIC. Instead, the taxpayer bears the burden of clearly establishing the amounts within such contract that are "qualified costs" by applying the "look through" methodology described in this ruling to the contract. (See generally Cal. Code Regs., tit. 18, §§ 17053.49-10 & 23649-10.) Failure to adequately substantiate those costs within the third-party contract that represent "qualified costs" for the MIC will result in disallowance of all or a portion of such costs as "qualified costs."

Last updated: 09/24/2025