Appeals Settlement Guidelines—State and Local Location Tax Incentives, Mar. 2, 2011
In highly redacted Appeals Settlement Guidelines (ASG), IRS has set out its compliance conclusions, and explored taxpayers' contrary arguments, on the treatment of state or local location tax (SALT) incentives received by a corporation to induce it to expand, maintain or relocate its facilities.
Observation: As the “Settlement Guidelines” portion in the ASG is completely redacted, the ASG primarily serves to indicate the position IRS will take to challenge what it perceives to be corporations' erroneous treatment of SALT incentives.
Background. Under Code Sec. 118(a), a corporation generally doesn't include in gross income contributions to its capital. To be an excludable capital contribution, the Supreme Court has held that: (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. (U.S. v. Chicago, Burlington & Quincy R.R. Co (S Ct 1973), 32 AFTR 2d 73-5042, 412 US 401)
Under Code Sec. 362(c)(2), if money is received by a corporation as a contribution to capital by a nonshareholder, the basis of any property acquired with the money during the following 12 months is reduced by the amount of the contribution.
SALT incentives. Many state and local governments use tax incentives to induce businesses to relocate to the community or to expand existing operations and investment. SALT inducements may include one or more of the following: tax rate reductions, tax abatements, tax credits, exemptions from income or property tax, and tax credits for the creation of additional local jobs. Specific qualifications and application procedures vary with each incentive. Taxpayers generally treat such SALT incentives as reductions of state and local tax expense for federal income tax purposes.
The problem. Some corporate taxpayers have argued that a SALT incentive should be viewed as an incentive payment to the taxpayer, coupled with a payment of the tax by the taxpayer—i.e., payment of a tax liability that exists but for the performance of the corporation's activity. Accordingly, the corporation claims a tax deduction for the full, unreduced local tax liability under Code Sec. 164. It reports the tax reduction amount as income under Code Sec. 61, but excludes it as a contribution to capital under Code Sec. 118. The corporation then reduces the basis of its property in the amount of the Code Sec. 118 exclusion under Code Sec. 362(c).
In the case of land and other non-depreciable property, taxation of the deferred income could be postponed indefinitely since there's no offset resulting from the reduced basis until the property is disposed of in a taxable transaction. For buildings and other depreciable property, the tax benefit is recaptured over the depreciable life of the property, as the depreciation expense allowable each year is reduced due to the reduced basis in the property.
Under this approach:
• The SALT incentives are treated as consideration from the state or locality to induce the corporation to expand its operations and make significant capital investments within each state. The SALT incentive is income under Code Sec. 61 and Reg. §1.61-14(a) as another person's payment of the taxpayer's income taxes (relief from the payment of a tax liability is a realized accession to wealth that constitutes income).
• The SALT incentive is deductible as taxes paid or accrued since the payment of taxes includes the furnishing of cash and cash equivalents as well as the netting of offsetting accounts under Reg. §1.461-4(g)(1)(ii).
• The corporation excludes the SALT incentives included in its income as a contribution to capital under Code Sec. 118, and reduces the basis of its property in the amount of the exclusion under Code Sec. 362(c). The SALT incentives (unlike generic reductions in tax) are designed to obtain the investment commitment from the taxpayer to undertake certain activities. They represent the taxpayers' receipt of a capital contribution from the states and/or locality excludable under Code Sec. 118. The corporations argue that the five factors under the Supreme Court in Chicago, Burlington & Quincy R.R. Co are met because:
1. They must locate their operations within a specific jurisdiction to obtain the tax incentives; the incentives are in substance a reimbursement for the cost of land, buildings, and equipment in locating their operations there.
2. The benefit to the contributor is only indirect; rather, the principal purpose of the contribution is to benefit the community as a whole.
3. There is a choice as to taking the incentive or not where the incentives are offered by statute or on a formulary basis; the contribution isn't the result of a unilateral transfer.
4. The incentives are payments for separate consideration and are economically identical to the transfer of cash by the state or local government to the taxpayer.
5. The incentives induce the taxpayers to expand their operations and make further capital investment in various assets located within the states; these assets will materially contribute to the production of further income by taxpayers.
Observation: IRS notes that while this strategy was addressed by a Coordinated Issue Paper (CIP) “State and Local Location Tax Incentives,” effective May 23, 2008, neither the CIP nor the ASG address the treatment of credits that are refundable, transferable, or provided in return for specific consideration, such as services, property, or the use of property.
IRS's analysis. The ASG determines that a SALT incentive isn't deductible as tax paid or accrued in the tax year under Code Sec. 164 because a taxpayer doesn't pay, and isn't required to pay, any state or local taxes in excess of the amount remaining after all applicable abatements, credits, deductions, rate reductions, or exemptions.
The ASG concludes that a SALT or similar tax incentive (exclusive of refundable credits): (1) is not income under Code Sec. 61; (2) is not a contribution to capital under Code Sec. 118(a); and (3) so does not reduce a corporation's basis under Code Sec. 362(c). This is because these tax incentives, whether in the form of an abatement, credit, deduction, rate reduction or exemption, simply reduce the tax imposed by the state or local governments.
The ASG also concludes that a SALT incentive will not qualify for exclusion as a contribution to capital by a non-shareholder under Code Sec. 118(a), even if it were an item of gross income, because SALT incentives do not meet the five factors required to qualify for non-shareholder contribution to capital treatment as determined by the Supreme Court in Chicago, Burlington & Quincy R.R. Co: (1) even if a SALT incentive were treated as an amount paid to the taxpayer, it is generally not conditioned on the taxpayer's actual use of the amount to acquire capital assets, and so does not become a permanent part of working capital; (2) if the location or retention of a facility and/or the creation of a job is determined to be a type of service rendered, the taxpayer would have received the contribution as compensation for services rendered; (3) SALT incentives aren't necessarily bargained for, e.g., rate reductions and credit amounts are established by statute and are available to all companies meeting the specific requirements; (4) if classified as an operating expense, no asset exists and nothing is transferred and there is no value apart from the reduction of an operating expense; and (5) if the incentive is classified as an operating expense, no asset is transferred, and income cannot be produced.
References: For nonshareholder contributions of property to a corporation, see FTC 2d/FIN ¶F-1903.1; United States Tax Reporter ¶1184.01; TaxDesk ¶232,308; TG ¶11437. For property tax rebates, see FTC 2d/FIN ¶J-1394.1; TaxDesk ¶196,001.