Editor: Mary Van Leuven, J.D., LL.M.
The 2017 tax reform law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, made a significant but generally overshadowed change to the tax treatment of grants received from governmental entities, including location incentives for relocating or expanding existing facilities. Historically, the package of negotiated incentives includes some combination of cash grants, tax abatements, government-funded infrastructure improvements, financing assistance, and other economic incentives. The 2017 changes to the tax law now must be considered by companies in negotiating for and assessing the economic benefits of these packages.
Prior to the TCJA, Sec. 118 allowed taxpayers to exclude from gross income location incentives structured as nonshareholder contributions to capital. Although the Code itself did not provide a definition of that term, the Supreme Court in 1973 articulated a five-factor test for determining whether a governmental grant qualified as a nontaxable capital contribution or instead was a taxable accession to wealth (the CB&Q factors) (Chicago, Burlington & Quincy R.R., 412 U.S. 401 (1973)).
Taxpayers and the IRS frequently disagreed as to whether a particular governmental grant qualified for exclusion under Sec. 118 or instead was taxable because it failed to satisfy one or more of the CB&Q factors. Taxpayers and the IRS also disagreed as to whether partnerships could exclude governmental grants from gross income either under Sec. 118 or alternatively under a common law analogue.
The TCJA may have ended much, but likely not all, of that uncertainty. Unfortunately for taxpayers, it did so by effectively repealing Sec. 118 as it applies to nonshareholder contributions to capital. Under Sec. 118 as amended, nontaxable capital contributions do not include either (1) any contribution in aid of construction or any other contribution as a customer or potential customer, or (2) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such). The second part of the new standard sweeps broadly and may result in unexpected tax bills for companies that are unaware of this significant change when negotiating location incentives.
The new rules apply to contributions made after Dec. 22, 2017 (the TCJA's enactment date). Significantly, however, the new rules do not apply to any contribution made by a governmental entity after Dec. 22, 2017, under a "master development plan" approved before that date. Neither the TCJA nor its legislative history clarifies the meaning of "master development plan" for this purpose. While the term "development plan" often connotes real estate developments (such as new industrial or office parks or residential subdivisions), nothing in the plain language of the statute or its legislative history restricts the term to a particular industry. Instead, given that governmental entities commonly undertake many types of development plans — including local or regional economic development — companies should consider whether they are receiving location incentives under a master development plan approved before Dec. 22, 2017.
Perhaps in response to historical disagreements as to whether Sec. 118 applies to partnerships or other businesses not structured as corporations, Congress made clear its view that it does not. Both the Conference Report and the JCT Blue Book state that "Section 118 applies only to corporations" (Joint Committee on Taxation, General Explanation of Public Law No. 115-97(JCS-1-18) (December 2018)). In light of the greatly diminished scope of Sec. 118, however, it likely provides little benefit to companies receiving nonshareholder contributions to capital, regardless of how the company is structured.
On the right facts, however, certain types of incentive payments might be excluded from income under the so-called inducement theory. The inducement theory is premised on the taxpayer's being unwilling to complete a transaction on the seller's stated terms. Another person having a vested interest in its consummation (such as a broker who would receive a sales commission), makes a payment directly to the taxpayer to "induce" it to agree to the deal on the seller's terms. Courts have held that the payment from the third party to the taxpayer functions as a purchase price adjustment from the taxpayer's perspective, reducing the taxpayer's tax basis in the acquired property but not requiring the payment to be included in the taxpayer's income (Freedom Newspapers, Inc., T.C. Memo. 1977-429).
The IRS generally takes the position that the inducement theory applies only if the payer and the payee are each parties to the transaction. The IRS has been less accepting of the inducement theory if the payment comes from someone who is not a direct party to the transaction itself (e.g., the buyer, seller, or broker). Not all courts have taken such a narrow view of the inducement theory, but a U.S. district court recently expressed considerable skepticism regarding its continued validity (Uniquest Delaware LLC, 294 F. Supp. 3d 107 (W.D.N.Y. 2018)).
The inducement theory now takes on much greater importance following Sec. 118's effective repeal as applied to nonshareholder contributions to capital. Its continuing applicability and scope likely will receive renewed scrutiny by taxpayers, the IRS, and ultimately the courts.
Companies negotiating location incentives with state and local governments may want to consider alternative routes to the same economic result. For example, the TCJA's legislative history makes clear that state or local tax abatements are not taxable. The IRS takes this view as well (IRS Legal Advice Issued by Field Attorneys 20085201F). Structuring location incentives as tax abatements rather than as cash grants may present an attractive tax alternative, albeit one that may not be as attractive to the recipient from a cash flow perspective.
Local jurisdictions also might be willing to substitute for cash grants various infrastructure improvements required by the relocation or expansion of the company's facilities and that the company might otherwise be responsible for funding. So long as the local jurisdiction retains ownership of the infrastructure improvements (which would be typical anyway), the tax answer is likely to be better while preserving the deal's economics.
If the state or local developmental authority is unwilling or unable to substitute one of these approaches for a cash grant (which is entirely possible, particularly if the various alternatives would need to be funded from different parts of the state or local budgets), companies with sufficient negotiating leverage should request taking into account the likely loss of a portion of the cash grant to federal taxes. If the company requires a bottom-line amount of cash to make the deal economically feasible or attractive, the development agency's budget (and desire for the project) might be strong enough to gross up the grant for the federal tax liability.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org..
Contributors are members of or associated with KPMG LLP. These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.