On the heels of its loss in Matter of TransCanada Facility USA, Inc. DTA NO. 827332, on May 14, the New York State Department of Taxation and Finance proposed draft regulations addressing the Article 9-A Franchise Tax treatment of Qualified New York Manufacturers (“QNYMs”).[1]  These draft regulations, which are not currently in effect but which do shed light on the Department’s current thinking, amplify a position that the Department has taken in prior informal guidance and on audit regarding contract manufacturing arrangements and the scope of activities that constitute “manufacturing” that is not in the statute.  The position that a taxpayer that engages in contract manufacturing cannot qualify as a QNYM is contrary to prior New York authorities addressing “manufacturing” in the investment tax credit context and contrary to judicial authorities defining “manufacturing” under relevant federal tax law.  In addition, the draft regulations set out a new position—again, one not found in the statute—that “digital manufacturing” is not manufacturing, and that only manufacturing that results in the production of “tangible” goods will qualify for QNYM treatment.

These draft regulations would significantly narrow the scope of the application of the QNYM rate.  Although the Department is authorized to interpret ambiguous statutory provisions, it cannot usurp the Legislature’s authority by rewriting the statute.


By way of background, effective for tax years beginning on or after January 1, 2014, the New York Legislature enacted a special 0% tax rate on business income (and corresponding special rates on the capital base and fixed dollar minimum tax) available for corporations meeting the definition of a QNYM.[2]  Generally, to qualify as a QNYM, a taxpayer must meet two statutory tests—a “receipts test,” whereby it must derive more than 50% of its receipts from the sale of “goods” produced by manufacturing activities, and a “property test,” whereby it must have Investment Tax Credit-eligible property employed in New York with an adjusted basis of at least $1 million.  See N.Y. Tax Law §§ 210(1)(a)(vi); 210(1)(b)(2).[3]  Both the statute and accompanying legislative history reflect that, if the taxpayer meets these two tests (or an alternate employee/property tests), that taxpayer is by definition a QNYM.  See 2013 Legis. Bill Hist. NY S.B. 6359, Statement in Support of Bill Sponsor.

Contract Manufacturing

Not long after the 0% rate for QNYM went into effect, the Department publicly announced its position in a TSB-M that certain categories of companies—namely, companies that used contract manufacturers—should not qualify for QNYM treatment.  In a typical contract manufacturing arrangement, one company (generally, the company that designs and develops the products) outsources certain aspects of the manufacturing process (e.g., the mass assembly of the goods) to a third party, while retaining control over the overall manufacturing process (e.g., prototype development and testing, product inspection and quality control, and providing the materials, specifications, and oversight for the assembly process).  In TSB-M-15(3)C (Feb. 26, 2015), the Department advised that “[a] taxpayer that contracts out its production activities to another entity cannot consider those activities in determining its eligibility as a manufacturer. The contractor entity may include those activities when determining whether it meets the definition of a manufacturer.”  Thus, regardless of the actual facts and circumstances of the parties’ arrangement, including which party actually has title to the goods in progress and exerts control over critical aspects of the manufacturing process, merely outsourcing a portion of the mass replication and assembly process to a third party would seemingly disqualify a taxpayer from QNYM treatment.  However, the Department’s initial guidance implied that the contract manufacturer could potentially be treated as a QNYM and could include its contracting activities for purposes of determining its qualification as a QNYM.

The Department formulated its “anti-contract manufacturing” position notwithstanding the lack of any supporting authority in the statute or the accompanying legislative history, and in spite of the fact that, under a longstanding body of jurisprudence, companies hiring contract manufacturers can qualify as manufacturers for other tax purposes, including for purposes of New York’s Investment Tax Credit (a provision that is referenced in the QNYM statutory language) and the former Internal Revenue Code Section 199 domestic production activities deduction.  As a recent case addressing former Section 199 pointed out, “[t]he long-accepted proposition is that one can be a manufacturer for a variety of tax positions without being a ‘manufacturer’ in the lay sense.”  See Meredith Corp. v. United States, No. 4:17-cv-00385 (S.D. Iowa Mar. 20, 2020).

Thus, while the Department itself has previously approved the use of third parties to conduct certain aspects of the manufacturing process in the context of the Investment Tax Credit and relevant federal tax authorities generally use a facts and circumstances analysis to arrive at a determination of which party in a contract manufacturing arrangement should be considered the “manufacturer” of the product, the Department has taken a hard line stance against companies engaging contract manufacturers for purposes of the QNYM provisions.  The Department’s position is echoed and amplified in the draft regulations.  Specifically, in the draft regulations, the Department expressly provides that, for purposes of the “property” and “employee” tests, the company engaging with the contract manufacturer (the “contracting company”) can consider the assets and employees used in the production activities only if the contracting company owns the assets being used by the contract manufacturer (the “production company”) in the production activities and only if its employees operate or use those assets.  See Draft Reg. Section 10-1.3(b)(1).  Similarly, for purposes of the “receipts” test, the draft regulations provide that receipts earned by the contracting company from the sale of goods produced by the production company on behalf of the contracting company are not receipts from the sale of goods produced by manufacturing activities.  See Draft Reg. Section 10-1.3(b)(2).  In addition, the draft regulations lay out a host of activities, such as prototype development, making items more attractive for sale without substantially altering the product, and the performing of a service, that would not qualify as “manufacturing activities” at all.  See Draft Reg. Section 10-1.2(b).  Given that in a typical contract manufacturing arrangement, the production company is the party that mass produces the goods sold by the contracting company, while the contracting entity engages in a number of activities that appear in the Department’s list of “non-qualifying” activities, the Department’s regulations would result in the contracting party failing the receipts test in many cases.

In addition, while the Department noted in the 2015 TSB-M that the production company could consider its contract manufacturing activities in determining whether it qualified as a QNYM, the draft regulations now provide that a production company may only consider assets and employees used in the production process for purposes of the property and employee tests if the production company owns the assets and only its employees operate the assets in the production process, and that any receipts paid to the production company by the contracting company cannot be considered for purposes of the receipts test unless the production company is actually transferring title to the goods to the contracting company.  Because, in many contract manufacturing arrangements, the contracting company maintains ownership of the goods throughout the production process, the Department’s regulations would also result in the contract manufacturer being excluded from QNYM treatment.  Thus, the Department’s draft regulations seemingly lead to the inevitable and troubling result that neither party in a contract manufacturing arrangement will qualify for QNYM treatment, even if the arrangement unquestionably results in the production of goods by manufacturing.

Digital Activity

Separately, the Department attempts to rewrite the QNYM statute to exclude digital activity.  The statute provides that a taxpayer must be “principally engaged in the production of goods by manufacturing . . .”  See N.Y. Tax Law § 210(1)(a)(iv) (emphasis added).  The Department, however, provides in the draft regulations that a QNYM is defined as a corporation or combined group “engaged in the production of tangible goods by manufacturing . . .”  See Draft Reg. Section 10-1.2(a) (emphasis added).  The draft regulations also provide that “the creation of a digital product” is not a manufacturing activity.  See Draft Reg. Section 10-1.2(b)(7).  Finally, the statute provides that the rate is applicable to the sale of goods, but the draft regulations provide that “sale” excludes “licensing” of goods.  As many digital products are licensed, this appears to be an attempt to exclude digital activity even further.  In addition to rewriting the statute, the Department’s position arguably violates the Internet Tax Freedom Act (“ITFA”).  See 47 U.S.C. § 151.  ITFA prohibits a state or locality from discriminating against electronic commerce by taxing electronic commerce more than it taxes physical commerce.  By allowing the reduced rate for “tangible“ goods but not for digital goods, the Department clearly discriminates against electronic commerce in violation of ITFA.


The draft regulations appear to be an attempt by the Department to “legislate” by crafting exclusions from the scope of the QNYM statute that were not contemplated by the Legislature.  For example, as noted above, the plain language of the statute sets forth a receipts test and a property test.  Whether a corporation engages in contract manufacturing is not relevant to the question of whether or not that corporation derives more than 50% of its receipts from “the sale of goods produced by manufacturing” or whether or not the corporation owns the threshold level of ITC-eligible property in New York State.  Moreover, by narrowly defining the term “manufacturing,” the Department has attempted to rewrite the statute to apply to a more limited category of taxpayers.

Similarly, the plain language of the QNYM statute provides that a taxpayer must be engaged in the production of “goods” to qualify as a manufacturer.  Wholly on its own accord, the Department has attempted to redraft the statute to provide that the taxpayer must produce “tangible” goods and that the production of a digital product is not a manufacturing activity.  These changes represent a clear attempt by the Department to legislate—a role that is not within the purview of an administrative agency.

The Department’s attempt to narrow the scope of QNYM eligibility to less than what the statute allows is especially troubling in light of a recent New York State Tax Appeals Tribunal decision, Matter of TransCanada Facility USA, Inc., DTA NO. 827332 (NYS Tax App. Trib. May 1, 2020).  The question in TransCanada was whether the Department could “read into” the QNYM statute (here, whether or not the taxpayer qualified for the “cap” on the capital base tax applicable to QNYMs) an exclusion related to the generation of electricity when such exclusion was not in the plain language of the statute.  Holding in favor of the taxpayer, the Tribunal pointed out that because the capital base QNYM “cap” was a tax imposition statute, rather than an exemption or exclusion from tax, all ambiguities had to be resolved in favor of the taxpayer.  Furthermore, the Tribunal explained that because the issue of whether or not the taxpayer qualified as a QNYM was one of pure statutory construction, deference to the Department’s interpretation was not necessary or warranted, and it refused to read an exclusion into the statute that wasn’t apparent in the statutory language.

The same logic could be applied to the Department’s attempt to create a blanket exclusion for all companies engaged in contract manufacturing, to narrowly interpret the types of activities that qualify as “manufacturing” (which notably continue to exclude the generation and distribution of electricity notwithstanding the contrary holding in TransCanada) and to exclude the manufacturing of digital products.  No such exclusions should be inferred from the statutory language, and any attempt to create such exclusions via regulation should not be entitled to deference.  Indeed, when determining the weight to give to the Department’s draft regulations (if formally proposed and finalized), one should keep in mind that the Legislature did not grant the Department specific authority to issue regulations interpreting the QNYM statute when it enacted the 0% rate—in other words, the Legislature did not expressly recognize that its statute was ambiguous and in need of interpretation by the Department.  Rather, the Department’s authority to promulgate regulations interpreting the QNYM statute can only be found in the general grant of authority under Tax Law § 171(First) (“The commissioner of taxation and finance shall . . . [m]ake such reasonable rules and regulations, not inconsistent with law, as may be necessary for the exercise of its powers and the performance of its duties under this chapter[.]”).  The lack of any directive by the Legislature for the Department to promulgate interpretive regulations lends credence to the argument that the statutory definition of “manufacturing” is not ambiguous and the Department has no authority to exclude by regulation the types of “manufacturers” that it believes should not qualify for the QNYM 0% rate.

Finally, by effectively excluding all parties engaged in a contract manufacturing arrangement from the scope of the QNYM statute, the Department has eliminated a large group of modern manufacturers from being treated as manufacturers for Article 9-A Franchise Tax purposes.  Outsourcing portions of the manufacturing process—namely, mass assembly following a detailed design, development and testing phase—to third parties is a common activity that is done for cost and efficiency (not tax) reasons.  Federal courts have realized this and have chosen not to punish companies that engage in modern manufacturing processes, such as contract manufacturing.  Furthermore, in the modern economy, a great deal of manufacturing activity results in the production of digital goods that are treated, for many tax purposes, as the equivalent of their tangible counterparts.  Given that the New York Legislature had the stated goal of retaining manufacturing jobs and attracting new manufacturing companies to the state (see 2013 Legis. Bill Hist. NY S.B. 6359, Statement in Support of Bill Sponsor), the Department’s attempt to exclude contract manufacturers, certain manufacturing activities, and producers of digital products from the scope of the QNYM treatment is troubling and, should the draft regulations be finalized, would be ripe for challenge.

[1] The draft regulations also address other types of entities, including S-corporations, REITs, and RICs, though we focus on the manufacturing regulations here.

[2] Before 2014, QNYMs were subject to Franchise Tax at a lower rate than general non-manufacturing corporations.

[3] Alternatively, a taxpayer may qualify for QNYM status if it has at least 2,500 employees in manufacturing in New York and the taxpayer or the combined group has property in the state used in manufacturing with an adjusted basis of at least $100 million.

Contact the Authors: Maria Eberle, Lindsay LaCava, Mark Yopp, Niki Ford