Statutory definitions often carry ambiguous terms and subtle distinctions. However small these distinctions may seem, their interpretation can mean millions in state tax. In Massachusetts, for example, multistate corporations generally apportion their business income using a three-factor formula based on a property factor, a payroll factor, and a double-weighted sales factor. However, certain out-of-state corporations, like “manufacturing corporations” or “mutual fund service corporations,” may be required to apportion their business income using Massachusetts’s single-sales factor apportionment formula. In the event a single-sales factor apportionment formula applies, an out-of-state company’s Massachusetts corporate excise tax liability may increase, as none of that company’s out-of-state property and payroll expenses are accounted for in apportioning income.
On January 12, 2017, the Supreme Judicial Court of Massachusetts held that Genentech, Inc., a biotechnology company that develops drugs from proteins produced by living cells, qualified as a manufacturer for Massachusetts corporate excise tax purposes. For tax years 1998 through 2004 (the “Tax Years at Issue”), Genentech attempted to employ Massachusetts’s general three-factor apportionment formula. However, the Massachusetts Commissioner of Revenue rejected this approach, claiming that Genentech was engaged in substantial manufacturing activity and, therefore, was subject to Massachusetts’s statutory single-factor apportionment formula prescribed for manufacturers. The Commissioner then issued several assessments, which were later affirmed by the Massachusetts Appellate Tax Board.
Genentech appealed the Board’s ruling using three alternative arguments–(1) Genentech did not qualify as a manufacturer for corporate excise tax purposes; (2) even if Genentech engaged in manufacturing, it did not satisfy the necessary test for engaging in “substantial” manufacturing due to a significant portion of its gross receipts arising from short-term investments; and (3) application of the single-factor apportionment formula to out-of-state “manufacturing” companies like Genentech violates the dormant Commerce Clause of the U.S. Constitution.
Genentech’s “Manufacturing” Operations
During the Tax Years at Issue, Massachusetts defined “manufacturing corporation,” for corporate excise tax purposes as a corporation:
engaged, in substantial part, in transforming raw or finished physical materials by hand or machinery, and through human skill and knowledge, into a new product possessing a new name, nature and adapted to a new use.
Through a four-step process, Genentech employees (1) altered selected cells to produce a specific “protein of interest;” (2) facilitated the growth of the protein by placing cells in the proper environment; (3) purified the protein; and then (4) extracted the protein from the cells and formulated it into a bulk drug. Genentech argued that through this four-step process, its employees did not change the cell’s character as required to qualify as manufacturing under Massachusetts’s law. Instead, Genentech argued its employees reduced the cells to smaller, commercially usable sizes, similar to an earlier Massachusetts Supreme Judicial Court ruling that held the extraction and mining of rocks into smaller commercially usable fragments did not qualify as manufacturing. However, the Court rejected this analogy, finding that Genentech altered “the original cell in a most fundamental way,” thus qualifying as manufacturer under Massachusetts’s law.
Genentech’s Financial Transactions
In the alternative, Genentech argued that even if did engage in manufacturing, it was not “engaged in substantial part” in such activity. In Massachusetts, five alternative tests are used to measure whether a corporation’s manufacturing work qualifies as “substantial.” Under the first alternative test, which both parties agreed was the applicable test for Genentech, “manufacturing activities” would be considered “substantial” if 25% or more “of the corporation’s gross receipts are derived from the sale of manufactured goods that it manufactures.” In this case, the majority of Genentech’s gross receipts were derived “from the redemption or return at maturity of funds invested in short-term securities,” rather than from the sale of its drugs and other ordinary business income. For instance, during the 2004 tax year, Genentech “generated $39,226,839,298 in gross receipts, of which only $4,578,096,817 came from ordinary business income […].”
The Court found that including gross receipts from Genentech’s short-term investments would be “distortive” and thus, including these receipts in its “substantial” manufacturing analysis “runs counter to the reality of Genentech’s business and essentially makes no sense.” It is interesting to query whether the Court’s reasoning on distortion would have been applied if being a “manufacturer” would have instead benefitted Genentech–for example, if manufacturers in Massachusetts were subject to a lower tax rate.
As a last alternative, Genentech argued Massachusetts’s apportionment rules, as applied to out-of-state manufacturers, violated the dormant Commerce Clause of the U.S. Constitution. During the Tax Years at Issue, Massachusetts offered “manufacturing [tax] credits” to taxpayers whose manufacturing activities took place within the state. Genentech asserted “that by requiring the company to use [the] single-factor apportionment formula based only on sales while simultaneously denying it the benefit” of the applicable manufacturing tax credits, Massachusetts law “discriminates against the company as a foreign corporation” whose manufacturing activities take place outside the state and, “therefore unconstitutionally burdens interstate commerce.”
The Massachusetts Supreme Judicial again was not persuaded. Instead, it found that the purpose of the single-sales factor apportionment formula was “to encourage manufacturers to increase the level of investment in manufacturing operations in the Commonwealth by removing a tax ‘disincentive’ created by the three-factor formula.” In accordance with U.S. Supreme Court precedent, “business investment encouragement” is a “constitutionally appropriate goal.” In this case, however, the change in apportionment method, resulted in a decrease in the amount of income apportioned to Massachusetts for corporations with manufacturing operations in the state, while having the opposite effect on out-of-state corporations like Genentech with manufacturing activities based elsewhere. Nonetheless, the Court held that “the formula treats the income from every sales transaction involving manufactured goods exactly the same, no matter where the corporation’s manufacturing operations would be located.” Moreover, with respect to the in-state manufacturing tax credits, “[d]irect subsidization of domestic industry does not ordinarily run afoul” of the dormant Commerce Clause, even though out-of-state manufacturers disproportionately do not receive the same benefits.
The Genentech case is another example of state revenue agencies implementing arguments to expand their revenue base at the expense of out-of-state companies. This case also shows how ambiguous terms and subtle statutory distinctions can have drastic implications for state taxpayers. Furthermore, Genentech exemplifies the lengths state’s will go to recharacterize out-of-companies and justify increased tax assessments–in this case using an interpretation of their statutory definitions to do so. Corporate taxpayers should carefully evaluate how their business activities are defined by various states’ statutes and consult with their advisors where appropriate.