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Recently enacted federal tax reform is expected to generate $6.5 billion in additional federal revenue through 2027 by increasing corporate tax liability for certain state and local incentives. In this article, Eversheds Sutherland (US) LLP's Timothy A. Gustafson and Hanish S. Patel discuss the change and opportunities to minimize its impact.
By Timothy A. Gustafson and Hanish S. Patel
Tim Gustafson is a Counsel in Eversheds Sutherland's State and Local Tax Practice Group, located in Sacramento, California, and counsels clients on all aspects of state and local tax controversy, including audits, administrative appeals and litigation. He is extensively experienced on issues and matters before California's tax agencies. Hanish Patel is an Associate in Eversheds Sutherland's State and Local Tax Practice Group, located in Atlanta, Georgia, and counsels clients on state and local tax controversy, planning and policy matters. He advises on multistate tax nexus issues and on all tax types, including income, franchise, property, and sales and use tax.
On December 22, 2017, the President signed into law H.R. 1, the bill formerly known as the Tax Cuts and Job Act (the “Act”), enacting the largest restructuring of the federal tax code since the Tax Reform Act of 1986. Pub. L. 115-97, 131 Stat. 2054 (Dec. 22, 2017). Among its sweeping reforms, the legislation contains a significant change to the treatment of certain incentives offered to corporate taxpayers by state and local governments. Specifically, a wide array of governmental incentives may now constitute taxable gross income to the recipient for federal income tax purposes. Taxpayers should consider these federal tax changes related to their existing and future state tax incentives, including cash grants, no-cost land or equipment, “public” infrastructure and improvements, or other similar transfers of money or property to a corporation.
Gross income is defined broadly for federal tax purposes as all income from whatever source derived. Internal Revenue Code (“IRC”) §61(a). Generally, for corporations, former IRC §118 excluded from gross income “any contribution to the capital of the taxpayer.” IRC §118 (2017). Historically, this “contribution to capital” exclusion extended to contributions to capital made by persons other than shareholders, including contributions made by a “governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities.”Treas. Reg. §1.118-1. Therefore, if a contribution of money or property from a governmental entity constituted a “contribution to capital” under IRC §118(a), it was excluded from a corporate taxpayer's gross income.
In U.S. v. Chicago, Burlington & Quincy R.R. Co. (“ CB&Q”), 412 U.S. 401 (1973), the United States Supreme Court held that a corporate taxpayer's receipt of a capital contribution from a non-shareholder must satisfy a five factor test in order for the contribution to be excluded from gross income under IRC §118(a). The five factors are:
1. The contribution must become a permanent part of the corporation's working capital structure.
2. The payment cannot be in exchange for a direct benefit to the transferor, such as a payment for a service provided by the corporation.
3. The contribution must be bargained for.
4. The asset transferred must result in a benefit to the corporation in an amount commensurate with its value.
5. The contributed property ordinarily will be used in a manner that ultimately generates income for the corporation.
CB&Q, 412 U.S. at 413. Consequently, only those incentives that satisfied the five factors under CB&Q were excluded as a contribution to capital by a non-shareholder under former IRC §118. See, e.g., Sprint Nextel Corp. v. United States, 779 F. Supp. 2d 1184 (D. Kan. 2011) (holding payments from the Federal Communications Commission's Universal Service Fund did not satisfy the test for exclusion as non-shareholder contributions to capital and, instead, constituted taxable supplements to gross income).
Under the Act, IRC §118 is amended to expressly provide that the term “contribution to the capital of the taxpayer” does not include “any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such).” H.R. 1, §13312; IRC §118(b)(2) (2018). Accordingly, contributions of money or property to a corporation by a governmental entity will be includible in gross income (unless another exclusion applies). By its terms, the legislative amendments to IRC §118 apply “to contributions made after the enactment date” of the bill — i.e., contributions made after December 22, 2017. H.R. 1, §13312(b)(1). However, the amended IRC §118 will not apply to any contributions made by a governmental entity pursuant to a master development plan approved by that governmental entity prior to the enactment date. Id. §13312(b)(2).
According to the Joint Committee on Taxation, the new provision is estimated to generate approximately $6.5 billion between 2018 and 2027. This revenue increase is not surprising, considering that the new legislation will impact a broad range of state and local incentives that corporate recipients traditionally have not treated as taxable income for federal purposes. Most notably, the legislation would affect incentives such as cash grants, no-cost land, equipment, “public” infrastructure and improvements, reimbursements, refunds, or other similar transfers of money or property to a corporation.
To incent businesses to relocate or expand in a state, many states offer cash grants based on a project meeting certain employment or investment requirements. For example, Connecticut's “First Five Plus Program” offers grants to projects that are expected to create at least 200 new jobs and require an investment of $25 million. Conn. Gen. Stat. §32-4l. Since 2012, total grants under the First Five Plus Program have ranged between $8.5 to $48 million to various businesses, including manufacturing, media, and financial service companies. Under the new legislation, grants under the First Five Plus Program may give rise to taxable income.
Similarly, many local governments offer land or public infrastructure improvements at no-cost as inducements to invest locally. For example, in 2012, local development authorities in Georgia offered hundreds of acres of land, as well as substantial road, water, and sewer improvements, to a heavy equipment manufacturer for locating a new manufacturing facility in the state. In total, the land and improvements were valued at approximately $20 million. Under the Act, the receipt of these types of grants from local development authorities could now be subject to federal income tax, depending on how the incentives are structured.
While the new provision applies to contributions made after the date of enactment, taxpayers with existing incentive agreements may still be affected. For example, a business may have an existing incentive agreement in 2016, but may not receive the underlying incentive until 2019. In such case, the contribution likely may be treated as having been made in 2019.
Generally, the receipt of state and local tax incentives such as state and local tax credits, deductions, abatements, rate reductions, and exemptions do not constitute taxable income for federal tax purposes. Instead, the Internal Revenue Service (“IRS”) (currently) views these incentives as a reduction (or potential reduction) in a taxpayer's outstanding state or local tax liability. See, e.g., IRS NSAR 20085201F (Dec. 26, 2008) (treating receipt of Michigan state tax credit as reduction of business tax liability). Under the IRS' view, tax credits may be treated as income if they are refundable or transferable, and to the extent the credits offset tax that was previously paid by the taxpayer and for which a federal tax deduction was claimed. Id.
Accordingly, there may be opportunities to restructure the receipt of an existing incentive to minimize the risk it will qualify as a taxable contribution under the new legislation. For example, a locality's contribution of land at no-cost to a corporation very likely will be taxable, while a locality's lease of land to the corporation, and corresponding abatement of any property taxes on the leasehold interest, likely would not be considered taxable income. Moreover, states and localities may respond to the amendments to IRC §118 by offering new credits, exemptions, and other incentives that would not be excluded from the definition of “contribution to capital”. Taxpayers would be wise to watch for any new offerings.
In addition to incentives from state and local governments, the legislation also will affect various incentives or grants from federal entities. As an example, in Revenue Ruling 93-16, 1993-1 C.B. 26, the IRS ruled that a grant by the Federal Aviation Administration (“FAA”) to a corporate owner of a public-use airport under the Airport Improvement Program was a nontaxable, non-shareholder contribution to the capital of the corporation under former IRC §118(a). However, under the Act, the grant now likely would be includible as gross income.
We also expect to see increased activity by the IRS in examining incentives and related contributions occurring prior to the change in law. As part of its Large Business & International (“LB&I”) Compliance Campaigns, and prior to the Act, the IRS announced a new initiative on “Economic Development Incentives” to ensure compliance with the IRC §118 exclusion. Press Release, IRS Announces Rollout of 11 Large Business and International Compliance Campaigns (Nov. 3, 2017) . The LB&I Compliance Campaigns provide an overview of the issues where the IRS will be focusing its efforts. The LB&I Campaign on Economic Development Incentives suggests that the IRS will be focusing not only on the legislative change, but also on the legal sufficiency of exclusions under the former IRC §118. In addition, the IRS states that the compliance treatment for the campaign will be “issue based examination,” rather than soft letters, voluntary self-correction, practitioner outreach, or published guidance, suggesting a more active review of prior exclusions.
Although the ultimate impact of tax reform under the Act remains to be seen, the legislation will reduce the value of certain state and local incentives by including those incentives in federal taxable income. There are, however, opportunities to minimize the federal tax impact while maintaining the same net economic benefit of the particular incentive. In addition, taxpayers should re-examine their federal income tax treatment for incentives received in prior years to support exclusion under former IRC §118.
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