State economic development initiatives.

Geographic competition across the nation has fostered the creation of a wide variety of incentives to improve and promote "friendly" local business climates. Their announced objective is to increase the number of jobs in the private sector by encouraging business to locate, expand, or sometimes just to make it possible for a troubled firm to continue to operate within a jurisdiction. Despite arguments by political opponents, economists, and others that they are corporate welfare, inefficient, costly, and ineffective, their availability continues to mushroom. [1]

Consistent with expanded opportunities, an increasing facet of the Corporate State & Local Tax function is to identify and capture the benefit of those incentives. Because they are so widespread, evaluating their effect should become an integral part of the financial study performed by companies planning capital investment or increased employment levels or investigating plant, warehouse, or office sites. Looking at the picture from another direction, a Tax Department would be derelict if it failed to aggressively pursue incentive takedowns.

Government incentives traditionally occupy a secondary role among the factors leading to a decision whether to proceed with a project. One reason is that the aggregate state tax burden constitutes less than one-half of one percent of the cost of doing business. [2] Nevertheless, upfront cost reductions together with their political and psychological appeal may significantly alter perceived investment strategies, especially for larger projects. Therefore, they may become a key factor leading to the choice of one location over another.

Two models exist--the first is the selective package targeted at a single project. The second is the generic intended to engineer specific economical or social behavior that rewards all businesses performing the favored activity.

Most incentives operate as tax reductions that are offset against payments that otherwise would be owed and their realization is contingent upon first incurring the tax liability. Targeted sponsorship also includes grants, real estate transfers and infrastructure improvements, direct expense reimbursement, and the funding of services, the most frequent of which are education and training. Incentives may be earmarked to build a manufacturing base, assist businesses experiencing difficulties, spur employment, or stimulate growth. They serve to reduce initial taxpayer outlays and continue for a fixed period of years. Thereafter they are phased out or end when the term expires and then the recipient is treated the same as all other taxpayers in the community.

Governments provide inducements today because to do so is politically correct: cash outlays are the exception and the real cost consists of short term revenue losses that are minor when weighed against the long term policy to boost economic activity. Development agencies aggressively scour the country and even overseas to pursue firms that may be considering relocation or establishing new facilities. More than 30 States have adopted Enterprise or Development Zone initiatives, approximately 35 offer hiring, job-creation, and investment credits and at ]east 25 provide research and development credits. [3] Many serve to stimulate socially responsible actions--environmental remediation and improvement, energy conservation, charitable giving, training, and child care--to name a few.

During the past two decades, the media have scrutinized the near cutthroat competition between States and localities that have vied for large facilities. The outcomes of many of these have been severely criticized as lush giveaways. For example, the package given by Alabama to attract Mercedes Benz has been estimated to cost taxpayers $165,000 per new job. A Congressional Research Service report published May 29, 1996, concluded that sports stadiums financed by tax-exempt bonds rarely generate enough economic benefits to justify the subsidies they receive from federal, state, and local governments. [4]

The following illustrate some 'trophy' contests:

* One of the earliest to receive notoriety was the bidding war during the mid 1970s for Volkswagen, which constructed its American plant in New Scranton, Pennsylvania. The tax abatement was $70 million for a plant originally projected to employ 6,000; the actual head count stopped at 1,500 and the plant closed a few years after opening. General Motors chose Springhill, Tennessee, as the site for its Saturn plant. Mercedes Benz opened a $300 million facility near Tuscaloosa, Alabama, which may employ 6,000. BMW built a 1.9 million square foot complex in South Carolina which was estimated to cost $400 million. Honda moved to Marysville, Ohio, and Toyota chose Elizabethtown, Kentucky. Large new auto plants were opened in numerous States, mostly scattered throughout the southeast and midwest.

* Michigan competes by offering attractive incentives to retain and expand existing auto manufacturing and supplier facilities. Legislation was adopted by Connecticut to retain United Aircraft units and assist SwissBank to relocate its New York City office and construct a new headquarters in Stamford. Massachusetts enacted legislation to assist' Raytheon, which is said to have asked for $30-40 million in incentives as part of its effort to cut operating costs; one part of this plan encouraged the State Legislature to revise the three-factor apportionment formula to one-factor consisting of sales. New York City revised its Corporation tax apportionment formula to keep Dreyfus and similarly situated financial companies and also provided $31 million to Kidder, Peabody & Company to stay in the city. [5] Illinois offered $61 million to build highways and make infrastructure improvements to benefit Sears.

* Western States have treaded the same path. Arizona and New Mexico have adopted legislation to foster the growth of Intel and others in the electronics industry. Washington and Oregon encourage manufacturers and computer service firms. Lehi, Utah, offered Micron Technologies $125 million of property tax and other incentives to construct a $1.7 billion computer chip factory.

States have passed legislation promoting diverse activities--research and development, capital investment, job growth (sometimes targeted at economically distressed regions) and environmental enhancement. Some statutes focus upon economic sectors--manufacturing, warehousing, foreign trade, aircraft parts, chemical conversion, transportation, insurance, banking and financial operations, etc.

A study published by New York State in February 1996 commented on the effectiveness of the State Investment Credit and concluded that its 1TC was "once the most generous capital formation incentive in the nation, however, incentive programs of other States are now rivals." [6] Since the ITC was enacted in 1969, New York taxpayers claimed nearly $1.65 billion of investment credits. The study also reports that, since its inception, tax law changes, especially the minimum base tax, have undermined the value of the incentive.

Identifying and Qualifying for Incentives

State and local legislators have empowered Economic Development Agencies to boost business. Many publish slick brochures highlighting local advantages and chart detailed descriptions and comparisons between competing States. Representatives from these agencies invite initial contacts--they channel and coordinate inquiries with local business promotion groups, Chambers of Commerce, and Business Development Councils which are site specific. Economic development specialists will work closely with business to identify. a location and tailor a package to conform to company profiles. A new or expanded Enterprise Zone may be redrawn to accommodate a project or a previously vacant facility may be rehabilitated. These public groups will try to maintain the confidential nature of any inquiry or search as long as possible prior to a firm commitment.

Evaluating Alternatives

Corporations can weigh opportunities for major moves or business decisions but the prevalence, constant shift, and variety of public inducements also support facilities that have operated within a locality for many years. One alternative is to hire a specialist, either a full-time employee or an outside consultant, to track and match ongoing programs to potential projects. In a larger company, the staff member would be the State and Local Tax Executive, who would become a member of a team including operations, finance and human resources personnel who would pinpoint suitable geographic sites. A virtue of keeping this function in-house is the perspective of the overall tax situation of company units. The tax specialist would also be well versed in and monitor generic incentives that will be claimed on annual returns. In contrast, the outside consultant is likely to be proficient in program identification and technical criteria, and already to have nurtured personal contacts through the nation. The tax representative should also become directly involved in negotiating and drafting the incentive package.

Incentive management requires coordination between headquarters staff and local operating personnel to address and follow through once opportunities have been identified. Local personnel become the point men and women within their communities (with regard to negotiated programs). For example, the potential value of any state investment or research credit should be factored into the cost/benefit analysis on order to quantify both net company investment and change in the forecasted rate of return on an after tax basis. In theory, improved economics (and meeting the competition) provides a sound justification urging government to enact the incentive.

Types of Incentives

Direct tax offsets reduce income, property, or sales and use tax liabilities; very few of these amounts are refundable in the event the incentive exceeds the tax. Myriad diverse credits exists throughout the country though general frameworks are similar. Some States have enacted more than a dozen distinct incentive programs, each aimed at a different situation or economic bloc. All require identification of the existence and applicability of the program, data from operating units to ensure that qualifying actions have been completed, calculation of the amount, and offset against the tax liability. that otherwise would be incurred.

Categories of some of the most familiar incentives relate to:

* Relocation

* Research and development

* Capital Investment-Property, Plant & Equipment

* Property tax abatements-Freeport exclusions

* Job Credits

* Environmental Action

* Sales & Use tax reductions and exemptions

* Utility credits and rate reductions

* Defense Industry Conversions

* Formulas for computing the tax base

* Industry specific incentives

Several States have amended their property tax laws to decrease assessments during the early years of an asset's useful life and corresponding tax reductions may be achieved. Arizona, Connecticut, Iowa, and Ohio have eliminated or phased in lower assessment values for some newly acquired assets that otherwise would be taxable under standard valuation tables. These may be perceived as a means to equalize the tax structure of these States rather than incentives since many sister States have already repealed taxes on tangible personal property.

A mechanism adopted by Alabama, Kentucky, and Mississippi and under study by several other States is employment tax retention (also known as wage assessments). The employer retains a portion of employee wage withholding that otherwise would be paid to the state treasury. Each employee will receive full credit for tax withheld on his or her personal federal and state returns. These funds serve as a grant to the employer pursuant to the negotiated agreement.

Even where incentives are formalized and contracts are in place, there may be practical difficulties to capturing the proposed benefit. Taxing districts mandate strict reporting and recordkeeping requirements, applications, progress reports, and timely communication with local officials. Utilization of a Texas Enterprise Zone benefit requires reporting payroll, head count, continued proof of employee qualification and job durations, detail of capital acquisitions, and verification to support sales and use tax outlays for which a refund may be obtained. Property tax abatement applications must be filed annually during the entire term that the project qualifies under the Enterprise Zone designation.

State income tax offsets may not be realized when a taxpayer suffers a loss for the year (or over an entire NOL carryover period). Complexities and conflicts may also occur owing to corporate reorganizations, transfers, dispositions or uncertainties about the appropriate formula used to calculate the incentive amount. They may also surface where a company fails to attain measurements such as a specified number of jobs or aggregate capita] expenditures. Sometimes the difficulties may be resolved where the problem was created by unforeseen circumstances and future operations rebound. Many agreements contain recapture clauses. [7]

Relocation and Expansion

Plant location and expansion incentives cover site selection, infrastructure development (roads, utilities, transportation, etc.), grants, land and building purchase or lease, training moneys, and similar actions. They traditionally provide long-term reductions (5 to 10 or even as many as 20 years). Legal procedures are formalized and require public hearings, publication, and approval by local or state legislative bodies.

The optimum time to pursue a relocation incentive search is as early as possible. This is when a project goes on the drawing board and competition between geographic areas will be most intense. Obviously, the uniquely situated large taxpayer has the best bargaining posture. Language and conditions of special interest legislation limit the benefit to one taxpayer since no other firm can fulfill the statutory criteria. (8)

Industrial Development Bond Financing

Industrial Revenue Bond (IDB) financings have been possible for many years but their use has been sharply curtailed by federal caps and restrictions on private use projects. Many of the more recent IDBs are either small issues or large projects falling within categories specifically enumerated by section 103 of the Internal Revenue Code. Where feasible, IDBs still present a superb financial inducement to expand within a selected community owing to increased financing opportunities and reduction in interest costs, especially when interest paid to bond holders qualifies as tax exempt. From a state perspective, legal ownership of a project through a tax-exempt entity usually serves to minimize property taxes, use taxes on fixed asset acquisitions and construction, and sometimes other local costs.

Federal Reporting

Section 118(a) of the Interne Revenue Code describes incentives that are deemed non-taxable non-shareholder contributions to capital for the purpose of inducing the corporation to locate its business in the community. This definition excludes payments earmarked for deductible operating expenses unless they were incurred during the start up period and required to be capitalized. Taxpayers should examine their agreements to verify whether the statutory provision applies. Most may be traced to infrastructure and utility construction but the scope could cover other fact patterns including employment tax retentions. Companies with such projects should also be aware of and refer to the basis adjustment requirements contained in section 362(c)(2) of the Code.

Recent Litigation 

The validity of incentives limited to a small group or just one taxpayer is under review in various courts, and a surge of litigation can be anticipated during the coming decade. [9]

Gulf States Steel Company challenged the grant of incentives by the Alabama State Industrial Development Authority to one of the company's competitors. [10] At issue was the latitude that government has to decide which company should be subsidized and which should not. In Louisiana, the statute conditioned exemption upon meeting a minimum percentage of local labor, materials, and suppliers. [11] Earlier this year, a federal district court found that the rules discriminated against interstate commence and were unconstitutional. In a different case, the North Carolina Supreme Court reversed a lower state court decision and upheld the right of localities to provide economic inducements. [12]

These contests raise broad implications concerning constitutionality of targeted benefits and differences between taxation of domestic compared with foreign entities. Must all taxpayers be treated uniformly or may some be favored by the legislature? Are incentive programs discriminatory and thus unconstitutional? Similar issues are also present with respect to franchise taxation of domiciliaries versus non-domiciliaries and domestic versus foreign companies in Alabama and Kentucky. Will the judiciary continue to uphold the increasing emphasis upon weighted apportionment formulas, the Michigan capital acquisition deduction, or procedures that are designed to favor home-based multistate taxpayers at the expense of out-of-state competitors marketing their products and services to customers within the State? [13]

Conclusion

Corporate tax personnel need to become increasingly familiar with the full spectrum of economic development incentives. Because of the proliferation and rapidly evolving incentive landscape, they can be easily overlooked. Savings attributable to economic incentives are substantial and devoting time and attention to this area should provide an attractive return for many companies.

General incentives that are claimed on income, franchise, sales and use, property and other return filings also offer significant paybacks by reducing direct cash outlays. Because of the diversity of existing measures, taxpayers should become familiar with the background for all return lines captioned "credits" that may be subtracted from a preliminary tax or tax base. These include references to supplementary schedules, instructions, rules, regulations and, of course, the underlying statutes.

Some state incentives have been closely patterned upon legislation enacted by Congress--for example, the research tax and investment credits. Federal formats, however, have repeatedly been revised, discontinued, and reenacted in changed forms (most recently this summer). Federal reporting has also been consolidated on a nationwide level whereas state credits are invariably limited to spending within each jurisdiction.

The mission of a State's Economic Development Agencies is to join with business in a creative manner to ensure that an incentive will perform as intended. In this way both the public and the private sector will profit from their mutual cooperation.

1. See Robert G. Lynch, Do State and Local Tax Incentives Work (1996). The study reports that according to 1992 tax expenditure reports for the following selected States, corporate tax breaks were: California - $1,736 million; Florida - $195 million; Louisiana - $231 million; Maryland - $38 million; Massachusetts - $420 million; Michigan - $1,218 million; Missouri - $270 million; Ohio - $324 million; Pennsylvania - $750 million; Washington - $956 million; and Wisconsin - $232 million. New York reported tax expenditures of about $1,000 million for years before and after 1992.

2. Lynch, supra note 1, at 4.

3. Summaries of these programs have been published in various publications, including "State Tax Credit and Incentives" in the Tax Management Tax Portfolio Series (Income Taxes), and Panel Publishers' "Multistate Corporate Tax Guide 1995" (Volume 1: Corporate Income Tax).

4. Dennis Zimmerman, Tax-Exempt Bonds and the Economics of Professional Sports Stadiums (96-460E). A synopsis of this study was printed in the BNA Daily Tax Report on May 30, 1996.

5 The New York Times reported on October 30, 1993, that Kidder agreed to keep 3,000 workers in the city for 15 years as its part of the bargain.

6. Office of Tax Policy Analysis, New York State Department of Taxation and Finance, The Effectiveness of the ITC: An Evaluation of New York's Investment Tax Credit (.Feb. 1996) (Report to the Governor and the Legislature).

7. On June 26, 1996, The Wall Street Journal reported that States and cities are taking steps to protect themselves against broken corporate promises. One example was Ypsilanti Township, Michigan which granted $1.3 billion dollars in tax abatements to General Motors with the understanding that GM would maintain jobs at the Willow Run car assembly plant. The town sued when the plant was shut and 4,000 jobs were lost. Under a New York City policy instituted by Major Rudolph Giuliani, the City can recoup double the value of the tax break when a company moves jobs out of town.

8. See Conn. Act 433 C.S.B. 1095 (1993), allowing R&D credits against Corporate Business Tax. A portion of this law, which also contained work force and other restrictions, was limited to aerospace companies whose research and development expenditures exceeded $200 million. This is only one portion of the 'United Aircraft' package.

9. See Morrison & Foerster, Constitutionality of State Tax Incentives: A Warning Bell from Louisiana in STATE & Local TAX INSIGHTS (Dec. 1995). See also Walter Hellerstein, Permissible Tax Incentives Versus Impossible Discrimination, California Tax Policy Conference (Nov. 2, 1995).

10. Gulf States Steel, Inc. v. Alabama State Indus. Dev. Auth. (Montgomery Cty Cir. Ct., June 15. 1995).

11. Pelican Chapter Assoc. Builders & Contractors v. Edwards, No. 92-481-A (M.D. LA. Oct. 3, 1995).

12. Maready v. City of Winston-Salem (1995). A discussion of this case appears in the April 1996 issue of Property Tax Alert, which is published by the State Taxation Institute in Atlanta, Georgia.

13. See R.J. Reynolds Tobacco Co. v. New York Dep't of Finance, No. 118236/94 (N.Y. Sup. Ct., Dec. 18, 1995), where the City (and State) decoupled depreciation of out of "state" assets from federal ACRS/MACRS. The New York court held that the same depreciation rules apply regardless of the location of the asset.