EXPLANATION OF THE DISCUSSION DRAFT OF THE SECTION 25128 REGULATIONS
Attached is the preliminary draft of the Section 25128 regulations. These regulations primarily address two basic areas: (1) how to handle vertically integrated businesses; (2) what is included in the definitions of an extractive and agricultural business activities for purposes of the statute. As a subissue under the second area, there is also clarification of the language of Section 25128(d)(2) relating to the additional "more than one-half of the commodity so treated" test for certain agricultural activities.
With regard to vertical integration, the draft proposes that only the products sold to third parties be considered in determining whether the apportioning trade or business is engaged in an extractive or agricultural business activity. This is in keeping with the terms of the statute which excludes intercompany sales from "gross business receipts."
With regard to what is included in the definition of an extractive or agricultural business activity, the proposed regulations attempt to follow the terms of the statute as much as possible. The statute states that an extractive business activity means "activities relating to the production, refining, or processing of oil, natural gas or mineral ore." As the terms "relating to" and "refining or processing" can be interpreted very broadly, the regulations serve to limit the activities which would qualify. Following the language of the statute, it was decided to draw the line with businesses which produce, refine or process directly the oil, natural gas or mineral in its raw state and to limit the production, refining or processing to the first commercially viable stage (refining or processing of the raw materials only). However, after some research and input from industry, the staff recognized that it was very difficult to define exactly when the various stages ended. Therefore, the proposed regulations specifically list all the products and activities which would qualify. In compiling this list, the staff used as a reference the Standard Industrial Classification (SIC) Manual, which is used by federal agencies to define various types of businesses, and consulted some industry experts. Of the businesses listed in the SIC Manual, the staff adapted the definitions for Section 25128 purposes and picked those which were considered to be dealing directly with the raw materials and those which generally involve the first level or primary processing or refining. The IRC mining depletion regulations under 1.613-4(f) and (g) were also consulted. There is also an exception for "incidental" additions to qualifying products.
The statute defines agricultural business activity at Section 25128(d)(2). The terms of the statute by referencing the agricultural commodities themselves indicates that only the production of the commodities qualifies as an agricultural business activity. Furthermore, the statute contains terms such as cultivating, raising or harvesting, all of which generally denote production only. The statute also sets forth a production test. There is no indication in the statutory language or history that refining or processing would be included (in contrast to the extractive business activity definition). This is also generally in keeping with certain IRC definitions of farming and related terms from which the language of Section 25128 relating to "agricultural business activity" was apparently partially derived. Therefore, the draft regulation propose that only businesses which directly involve the production of agricultural or horticultural commodities (i.e. first level production without processing) should be included in the definition of "agricultural business activity" (unless otherwise provided by the statute itself.) Processing which is incidental to production (i.e. sorting, cleaning, packing), as defined under industry practices or standards, is included as a qualified business activity.
It was also believed that it would be better to list the specific businesses included in the definition of agricultural business activities rather than to provide a general definition, which would be extremely difficult. Again, in determining what is listed in the regulation, the starting point was the SIC Manual. Cooperatives are excluded because the association itself is not engaged in the production of an agricultural commodity. Patronage dividends received from cooperatives are not included as "gross business receipts" because such dividends are not directly from the production of agricultural products and often include amounts derived from other than the sale of the members own products.
The proposed regulations also provide that only an extractive business which itself produces, refines, or processes oil, natural gas or mineral ore and agricultural businesses which itself produces commodities are included. Businesses who purchase from others and merely sell the goods do not qualify. The legislative history indicates that the main articulated reason for allowing an exception for the extractive and agricultural business activities is to except businesses which are connected to the land and have little choice as to where to conduct its activities or sales. Given such history, mere resellers (e.g. wholesalers) should not be included. The exception to this provision is exchanges. This provision requires the taxpayer to trace sales which qualify (self-produced) and which do not (not self-produced) as from a qualified business activity. This may create some practical difficulties, and the department hopes for suggestions from industry on this point.
The regulations also deal with how services are treated. There are numerous businesses which conduct extractive or agricultural businesses on a contractual or fee basis and do not own any interest in the products themselves. The draft regulations proposes that services not be included. This proposal was made in light of the legislative history that businesses connected to the land should be allowed the exception from the general rule. Businesses which provide services generally do not have much connection to a specific land located in a certain jurisdiction. These businesses often provide services to numerous customers and often move around to provide services. They also generally do not have to be located in any particular area. Furthermore, the staff believed that the intent of the statute was to deal with businesses as a whole, not to any particular incremental task needed to be performed in the course of the business. If services are included, each of the tasks that could be contracted out may have to be considered as an extractive or agricultural business activity. This also creates enormous difficulties in determining which tasks are enough to allow the business to be categorized as a qualifying business activity. For example, should providing payroll services on a contract basis to a farm considered to be an agricultural business activity? Further, because the activities should be connected to the land, the main emphasis of the statute was the product produced from the land, not the services provided. In light of the above, it was felt that it would be best to generally exclude services from the definition of extractive and agricultural business activities except as specifically provided on a limited basis under Section 25128(d)(2).
The regulations also provide clarification of Section 25128(d)(2), which interjects an additional "more than one-half of the commodity so treated" test for specific agricultural activities set forth in the section. It is unclear from the language how this test should apply. The draft proposes that this test should be applied to only affect the classification of receipts from services to third parties outside the apportioning trade or business group. Otherwise, the apportioning trade or business self produced agricultural products will lose their status as from an agricultural business activity if the business produces less than 50% of the products stored, etc. This does not appear to be reasonable as these products are from a qualifying business activity and sales from such should qualify as agricultural "gross business receipts" regardless of other activities listed in the statute which are conducted by the business with respect to those products. There is also the question whether the last phrase in the second sentence of this section ("but only if the owner, tenant, or operator of the farm regularly produces more than one-half of the commodity so treated") applies to the entire sentence or merely to the last phrase preceding it. It was decided to interpret the phrase to apply to the entire sentence because there appears to be no reason to distinguish the various elements in each part of the sentence from others or to discriminate against the different activities mentioned.
It is important to note that the draft regulations are only preliminary and should be considered a work in progress. The department has attempted to fashion preliminary regulations for comment based on what it believes the statute provides and what was intended. However, it is recognized that the language and history of the statute may be somewhat unclear, and the department is only interested in providing guidance which is legal, equitable, and administrable, from both the taxpayers and the departments perspectives. To this end, the department is open to and encourages any input from industry and other members of the public as to any provision in the proposed regulations. For example, the staff would welcome suggestions as to alternative definitions, as well as additions and deletions from the list, of extractive and agricultural businesses along with justification and grounds for inclusion or exclusion. The staff is also hopeful that specific problems or concerns with implementation will be raised as well as reasonable alternatives. If there is enough interest, the department also intends to hold a public meeting or symposium on these regulations before the formal hearing process for approval of the regulations are commenced. Written comments should be addressed to : Beverly Moore, Franchise Tax Board Legal Division, P.O Box 1720, Sacramento, CA 95741-1720 or faxed at (916) 845-3648. For further information, you may also call Lorrie Inagaki at (916) 845-3361. Please submit any comments by October 15, 1997.