Ruling Request No. 97-07

Declaratory Rulings

Ruling Request No. 97-07

Re: Request for Ruling Regarding the Application of the Investment Tax Credit

Request for Ruling

On behalf of your client, ("X Corp"), you request a ruling pursuant to R.I.G.L. 42-35-8 that certain property acquired by X Corp will qualify for investment tax credit under R.I.G.L. 44-31-1, as amended. The facts that follow summarizes the facts presented in your ruling request dated September 23, 1997, the supplement thereto dated October 17, 1997, as well as lease documents and invoices submitted October 6, 1997. All of the aforementioned documents are incorporated herein by reference and are made part of this ruling.

Facts

X Corp and the Rhode Island Economic Development Corporation ("EDC") a state agency created under Chapter 64, Title 42 R.I.G.L. (The "EDC Act") are expected to enter into a development agreement ("Development Agreement") to induce X Corp to develop and construct a national corporate headquarters on certain land owned by X Corp which will include the construction by X Corp of a new office building complex, the renovation of an existing office building complex, construction of certain infrastructure improvements and the acquisition and installation of substantial furniture, fixtures and equipment, including the acquisition of certain new computer hardware and software from various suppliers which will be assembled and integrated and will be used in controlling the inventory and other aspects of X Corp's wholesale pharmaceutical and non-pharmaceutical business, ("Computer System").

X Corp is a subsidiary of Parent Corporation ("Parent"). X Corp, itself, is the parent of numerous direct and indirectly owned subsidiary corporations which own numerous retail pharmacy stores throughout the country. X Corp is a wholesale distributor for the pharmaceutical and non-pharmaceutical products, including medical prescription drugs to its retail subsidiaries. More than ninety percent (90%) of its sales are to retail stores outside of Rhode Island.

In May, 1997, the X Corp group acquired another national pharmaceutical retailer in a tax-free merger. The acquisition increased the X Corp retail stores from 1,400 to 3,935. The X Corp group now operates in approximately 26 states.

In order to adequately service its wholesale delivery service to its 3,935 retail stores, X Corp has undertaken to create the Computer System consisting of its existing expanded mainframe computer system, client server systems, staging centers, upgrades, satellite terminals, laptop and specially designed software. The Computer System will allow X Corp to manage its own wholesale inventory as well as the inventory of its 3,935 retail stores to permit it lead time in ordering goods from its suppliers and supplying those products to the retail stores.

The Computer System is designed to provide X Corp with a consolidated, integrated electronic network supplying information to be used by management to provide among other things, client server systems, main frame systems, staging centers, satellite terminals, laptops and specially designed software which will enable X Corp to manage efficiently both the wholesale inventory as well as inventory of each of the 3,935 retail stores. Portions of the Computer System will be installed in phases beginning in the latter half of 1997 and throughout 1998. The Computer System was designed with the objective of providing X Corp with a comprehensive, integrated, consolidated information system for all of its 3,935 retail stores.

The first component (Rx 2000 OLTP) is designed to support the prescription filling process for all of X Corp's 3,935 retail stores. The elements of the Computer System relating to the Rx 2000 OLTP will not be able to receive any information or be useful for the purposes for which it was designed until March of 1998 at the earliest and may well not be Fully Operational until the final two quarters of 1998. (As used herein, the term "Fully Operational" means with respect to an item of equipment that such equipment is operating and performing the complete functions for which it was designed and thereby achieving the purpose for which it was acquired ("Fully Operational").

The second component (Rx Data Warehouse System) will be turned on in November, 1997 to begin receiving data input. By December 31, 1997 it is estimated that less than 70% of the consolidated data will be inputted into the Rx Warehouse System. X Corp estimates that the Rx Warehouse System will not be fully loaded with data and therefore not be Fully Operational until the fourth quarter of 1998.

The third component of the Computer System (Supply Chain Data Warehouse) is designed to enhance inventory management as well as provide assistance in pricing specific inventory items for each store. While the hardware will be completely installed and turned on in November, 1997 it will take several months for the data to be fully inputted into the computer. By December 31, 1997, it is estimated that less than 45% of the consolidated data will be inputted into the Supply Chain Data Warehouse. X Corp estimates that the Supply Chain Warehouse will not be fully loaded with data and therefore not be Fully Operational until March, 1998 at the earliest.

Although X Corp has or will install the second and third component system of the consolidated Computer System as well as certain related equipment and will have inputted a portion of the total universe of data to be inputted therein prior to December 31,1997, the Computer System and its related parts will not commence processing information on a consolidated basis and therefore will not be Fully Operational at the earliest before March, 1998 (and with respect to the Rx Warehouse component not before the fourth quarter of 1998). In the event the Computer System, or any component or related is not Fully Operational, X Corp will negotiate with the vendors to return and/or replace the pertinent hardware and/or software portions which are not accomplishing the intended tasks for which they were acquired.

The entire Computer System must operate as an integrated system in order to perform the required above described tasks. A failure of any component will result in the inability of the system to operate for the purpose intended. Consequently, although the Computer System is being configured and installed in stages, the efficiency and usefulness of the entire Computer System cannot be determined until each of the retail stores are brought on line. X Corp will not take depreciation charges for tax purposes in calendar year 1997 for the Computer System or any related component which is not Fully Operational by December 31, 1997.

X Corp has filed income tax returns in Rhode Island classifying itself as a wholesaler -- Industry Number 5129, Major Group 51, Standard Industrial Classification. It will remain as a wholesale supplier to the group's retail stores. In addition, since X Corp primarily supplies the accounting, bookkeeping and management services to the entire X Corp Consolidated Group, it also qualifies under Major Group 87 as well as Major Group 51.

Ruling Requested

  1. X Corp as a wholesaler of drugs, drug properties and druggists' sundries is a "qualified taxpayer" for purposes of Section 44-31-1, R.I.G.L.
  2. For purposes of subsection 44-31-1(b)(3) more than one-half of its gross revenues are a result of sales to retail establishments outside of Rhode Island.
  3. Because the Computer System, being designed for a specific assigned use will not have any components depreciated before 1998, and will not have completed testing to ensure that it is capable of performing the tasks for which it was designed until 1998, such Computer System will be treated as acquired or constructed after January 1, 1998, despite the fact that the most of the Computer System will be delivered and either payments made for purchases or initial lease rentals will commence in the last quarter of 1997.

Discussion

Significant changes were made to the Rhode Island investment tax credit law (R.I.G.L. 44-31-1, et seq) by enactment of PL 97-030. Among the major changes is the provision of a ten percent (10%) credit of the cost or other basis for Federal income tax purposes, and the qualified amounts for leased assets, including computer hardware and software, acquired, constructed, reconstructed or erected after January 1, 1998 by a qualified taxpayer.

The expanded credit is limited to property used by qualified taxpayers engaging in businesses described in certain Major Groups described in the Standard Industrial Classification Manual ("SIC Code"), one of which is Major Group 51 - "Wholesale Trade." Another pertinent provision of the amended statute is that more than one-half of its gross revenue of a wholesaler are a result of sales to customers outside the state.

The issue of X Corp as a "qualified taxpayer" as it relates to a wholesaler of drugs cannot be resolved. X Corp is a corporation subject to the business corporation tax. On its corporation tax return it has used industry number 5129 which is a subdivision of Major Group 51. X Corp is clearly a wholesaler. However, no ruling can be made regarding its status as a "qualified taxpayer" for purposes of R.I.G.L. 44-31-1 since there are other factors which have to be considered such as the level of wages paid by X Corp and no such information was provided. In any event, it appears that the statute requires wage certification from the Department of Labor and Training. The requirement that more than fifty percent (50%) of its gross revenues are the result of sales to customers outside the state can be resolved. X Corp's wholesale sales to retail stores outside Rhode Island are approximately ninety percent (90%) of its sales, clearly exceeding the statutory requirement.1

The more difficult question is whether the described integrated Computer System is acquired or constructed after January 1, 1998 even though the components of the system will have been installed prior to December 31, 1997, but not fully operational until after January 1, 1998.

In order to determine the date of acquisition or installation of the Computer System it must first be determined "what" is being constructed or acquired. Are the several components of the integrated Computer System to be viewed separately or treated as a whole. In LTV Corporation v. Comm'r, 63 T.C. 39 (1974) the taxpayer acquired a complicated computer system. In that case, as here, the tax court had to determine when the computer system was acquired, before or after December 31, 1961. The court therein stated that the "what" in that case was an installed and operating computer, one that is available "for the use by the petitioner for the purpose for which it was purchased." It held that the computer which was delivered and partially installed in December 1961 was acquired after January 1, 1962 when it became available for the use for which it was purchased.

In Siskiyou Communications, Inc. v. Comm'r, 60 T.C.M. 475 (1990), a communications company contracted for installation of a digital telephone switching system. It was installed and title passed to Siskiyou in 1984. When title passed, the system was fully capable of performing designed functions but additional tests and outside wiring, as well as training for employees, was required. The tax court found that the system was a component part of an integrated operation which was not in operation until January 1985.

In Revenue Rulings 76-238, 1976-1 and 73-518, 1973-2, the IRS was called upon to determine whether individual units of production machinery and equipment were placed in service when installed in a production line or when the entire production line was completed. The IRS ruled that components are not to be considered placed in service separately from the system of which they are an essential part. 2

When applying the reasoning of the tax court cases and the IRS Rulings it becomes apparent that the "what" in the instant matter is a fully operational computer system; one that is available for use for the purpose for which it was acquired. The purpose for which this Computer System was acquired is to provide X Corp with an integrated information system for all of its 3,935 retail stores. That will not occur until after January 1, 1998 when all the required data is loaded, the systems are fully integrated and tested, and all the stores are brought on line.

1 There are many other statutory requirements in the investment tax credit law, but since the ruling request does not ask for a determination that X Corp meets the other requirements of the statute they need not be discussed.

2The issue in this ruling request is date of acquisition or construction and not the placed in service date. However, these concepts are sufficiently similar to serve as an analogue for either test. Sealy Power Ltd v. Comm'r, 46 F3d 382 (1995), footnote no. 40.

Ruling

  1. X Corp is a wholesaler of drugs, drug proprieties and druggists' sundries.
  2. For purposes of subsection 44-31-1(b)(3) more than one-half of its gross revenues are a result of sales to retail establishments outside of Rhode Island.
  3. To the extent that the three (3) components of the Computer System do not become fully operational until January 1, 1998 or thereafter, said Computer System shall be treated as acquired or installed after January 1, 1998.

Excluded from this Ruling are certain items and leases that X Corp has acknowledged in its supplemental ruling request dated October 17, 1997 will be fully operational by December 31, 1997 and therefore ineligible for the investment tax credit.

This ruling may be relied upon by this taxpayer and shall be valid until applicable statutory provisions are amended in a manner requiring a different result or until the underlying factual presentation changes.

R. Gary Clark

Tax Administrator

October 21, 1997