Ohio investment tax credit struck down.

States often try to lure businesses Pinto their borders by offering attractive tax breaks. But beware: The Constitution gave Congress the power to regulate commerce between the states, and the U.S. Supreme Court has interpreted this to mean the states' power to regulate interstate commerce is limited. Aggressive tax incentive schemes often run afoul of this limitation.

One such situation arose in Ohio. DaimlerChrysler agreed to expand its Jeep assembly plant in Toledo, a project worth approximately $1.2 billion. In exchange, the company would have been entitled to an investment tax credit against its Ohio franchise tax liability in the amount of 13.5% of the cost of newly installed manufacturing machinery and equipment. DaimlerChrysler also would have received a 10-year, 100% property tax abatement based on its commitment to create and preserve existing jobs. The total value of the incentive package was estimated at $280 million.

A group of residents and small businesses who said they would be subsidizing the company's expansion sued the city, the state and Daimler-Chrysler. They argued that the tax incentives were invalid under the commerce clause of the U.S. Constitution and the equal protection clauses of both the U.S. and Ohio constitutions. The district court upheld both the investment tax credit and the property tax abatement, and the plaintiffs appealed to the Sixth Circuit Court of Appeals.

Result. Partially for the plaintiffs. On September 2, 2004, the Sixth Circuit held that Ohio's investment tax credit violated the commerce clause and reversed the portion of the district court's opinion that upheld it. However, the appeals court affirmed the lower court's decision that the property tax abatement was proper.

In Complete Auto Transit, Inc. v. Brady, the Supreme Court announced the four-pronged test against which all subsequent Commerce Clause cases have been analyzed. A state statute satisfies the clause if (1) the activity taxed has substantial nexus with the taxing state; (2) the tax is fairly apportioned to reflect the degree of activity within the state; (3) the tax does not discriminate against interstate commerce; and (4) the tax is fairly related to benefits provided by the state. There was no dispute that the Ohio investment tax credit and property tax abatement satisfied the first, second and fourth prongs. However, the plaintiffs claimed the incentives discriminated against interstate commerce.

The Supreme Court has not directly addressed the constitutionality of subsidies such as these. It has made clear, however, that state statutes that provide a commercial advantage to local businesses by burdening out-of-state businesses discriminate against interstate commerce. The plaintiffs argued the Ohio investment tax credit was unconstitutional because it induced businesses subject to the Ohio franchise tax to invest in Ohio rather than in another state. Businesses that expanded locally enjoyed a reduction in their Ohio taxes by virtue of the credit while those that expanded outside of Ohio did not. It was the plaintiff's contention that this disincentive to invest outside of Ohio hindered economic development in other states and, therefore, discriminated against interstate commerce.

The defendants took the position that state economic incentives favoring the local economy were constitutional as long as they did not penalize activities that took place out of state. While the Ohio investment tax credit did benefit local interests, it placed no burden on out-of-state activities and therefore, defendants argued, was constitutionally sound. The Sixth Circuit rejected this narrow view. Noting that "economically speaking, the effect of a tax benefit or burden is the same," the court agreed with the plaintiffs and held the investment tax credit discriminated against interstate commerce.

No such discrimination was found, however, with regard to the property tax abatement. The court said a business that located in Ohio and received an abatement of property tax was in no better position than a business that chose to locate outside of Ohio; neither would owe property tax in Ohio. The abatement did not favor local investment at the expense of out-of-state investment, as the investment tax credit did. That a business investing outside of Ohio may owe property taxes in another state did not invalidate the Ohio statute. Finally, the plaintiffs' arguments that the incentives were invalid on equal protection grounds were unsuccessful.

This case serves as a warning to other states. Unless the Supreme Court grants certiorari and says other wise, investment tax credits based on the location of an investment are constitutionally impermissible.

* Cuno v. DaimlerChrysler, Inc., 2004 US App. LEXIS 18550, CA-6.

Prepared by Laura Lee Mannino, CPA, LLM, assistant professor of accounting and taxation, St. John's University, Jamaica, New York.