The IRS said in a coordinated issue paper that a location tax incentive paid or credited to a business by a unit of state or local government is not included in the business’s gross income but rather reduces its tax expense. A location tax incentive is a tax reduction by abatement, credit, deduction, rate reduction or exemption given to a taxpayer as an incentive to locate in, remain in or expand its operations in a particular area. These incentives are not considered purchases from the taxpayer because they do not require the taxpayer to provide any services or property to the taxing jurisdiction. They benefit the taxpayer but are provided primarily for the economic benefit of the community at large. The taxpayer also does not realize an accession to wealth resulting in gross income.
Some corporate taxpayers have argued that such rebates should be treated as an exclusion from taxable income as a nonshareholder contribution to capital under IRC § 118, while they also include them in the full amount of tax expense deductible under section 164, the IRS said. These taxpayers would then reduce their basis of property under section 362(c) by the amount of the purported nonshareholder capital contribution. IRC § 118(a) does allow the money or value of property given to the corporation by the government or a civic group to be excluded from gross income (IRC § 61) as a nonshareholder contribution to capital. However, since a tax rebate is more like a discount on a liability than new incoming money or property, it is not a nonshareholder contribution to capital, the IRS said.
Even if such incentives were otherwise deemed to be gross income, they still generally would not be eligible for IRC § 118 treatment, which requires taxpayers to meet five factors, the IRS said, citing U.S. v. Chicago, Burlington & Quincy R.R. Co. (412 U.S. 401, 413 (1973)): (1) The contribution must become a permanent part of the transferee’s working capital structure; (2) the contribution must not be compensation for specific, quantifiable services provided by the transferee to the transferor; (3) the contribution must be bargained for; (4) the asset transferred must result in a benefit to the transferee commensurate with its value; and (5) the asset transferred ordinarily, if not always, will be used to produce additional income. (For treatment of a state location incentive grant analyzed by these factors and deemed to qualify as a contribution to capital, see Private Letter Ruling 200901018 issued Jan. 2.)
Under the Chicago, Burlington & Quincy R.R. rules, a tax incentive is a planned recovery of operating expenses, not a new contribution to the taxpayer’s working capital. A factual inquiry would have to be done to determine whether the contribution was made for specific, quantifiable services, in which case the transaction would be (taxable) sales revenue. Usually, tax incentives are not bargained for but are instead the result of state or local statutory tax provisions. A company would also have to show factually that the benefit enhanced the company by more than the amount of the payment deemed as income. If the benefit is used for operating expenses, it is not a longterm investment consistent with owners’ equity accounts, and it will not be considered to produce additional income for the company.
Also, since location tax incentives are not ordinarily used to purchase property but instead simply to reduce state and local tax liability, they are not capital expenditures. Instead, they lower the periodic expense of paying state and local taxes. As such, the basis of corporate assets would not be reduced as a nonshareholder capital contribution under IRC § 362(c)(1) or (2), the Service said.
The incentive is also not deductible under IRC § 164 for local, state or foreign taxes paid or accrued during the tax year. The “all-events test” under IRC § 461 allows for a deduction in the tax year in which all the events occurred that determine the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred. See Treas. Reg. §§ 1.461-1(a)(2) and 1.461-4(a)(1). Consequently, since location tax incentives are a reduction of state and local tax expense, only the tax liability net of the rebate is deductible for federal tax purposes.
Coordinated Issue Paper LMSB-04-0408-023, State and Local Location Tax Incentives (effective May 23, 2008)
By Brian Elzweig, J.D., LL.M., assistant professor of business law, and Valrie Chambers, CPA, Ph.D., associate professor of accounting, both of Texas A&M University–Corpus Christi.