Coordinated Issue Paper- Agriculture Industry
Effective Date: April 8, 2008
Coordinated Issue Paper
Section 118 - Characterization of Bioenergy Program Payments
ISSUE: Whether bioenergy program (BEP) payments received from the United States Department of Agriculture (USDA) are excluded from a taxpayer’s gross income as nonshareholder contributions to capital under section 118(a) of the Internal Revenue Code.
CONCLUSION: BEP payments are not designed to compensate the taxpayer for capital asset acquisition. Rather, BEP payments are intended to compensate the taxpayer for operating costs incurred as a result of purchases of commodities in the taxpayer’s bioenergy production process. Consequently, BEP payments do not qualify for the exclusion from gross income under IRC section 118(a), and thus fall within the definition of gross income under IRC section 61(a).
FACTS: The USDA’s Commodity Credit Corporation (CCC) administers the BEP, which provides for cash payments to U.S. commercial bioenergy producers based on each company’s annual increase in its bioenergy production from eligible commodities. Specifically, 7 U.S.C. section 8108(b) (Supp. IV 2004) provides that the BEP is designed to encourage increased purchases of eligible commodities for the purpose of expanding production of such bioenergy. Bioenergy is commercial fuel-grade ethanol and biodiesel made from program eligible commodities. Eligible commodities include barley, corn, grain sorghum, oats, rice, wheat, soybeans, sunflower seed, canola, crambe, rapeseed, safflower, sesame seed, flaxseed, mustard, and cellulosic crops such as switchgrass and hybrid poplars.
All commercial bioenergy producers meeting all program requirements are eligible to participate in the BEP. A commercial bioenergy producer does not have to own the production facility to qualify for the BEP payments. To participate, producers must complete a Bioenergy Program Agreement, Form CCC 850 (Agreement). The Agreement contains the terms, conditions, and eligibility requirements to participate in the BEP and is not negotiable. Once the Agreement is executed and accepted by the USDA, the producer is under an obligation to meet specific contract production levels, record keeping, and record submission requirements to obtain payment (see 24 C.F.R. section 1424.5).
The CCC pays eligible producers subsidy payments up to a congressional funding limit on a quarterly basis. The BEP does not require that the subsidy payments be used for any specific purpose. Payments to each producer are capped at 5 percent of the annual funding limit per year. USDA conditions payments on increases in bioenergy production as reported by a participating producer compared to the previous year’s production.
Under IRC section 61(a), except as otherwise provided in Subtitle A, gross income means all income from whatever source derived.
IRC section 118(a) provides, in the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.
Section 1.118-1 of the Income Tax Regulations provides, in part, that IRC section 118 applies to contributions to capital made by persons other than shareholders. For example, the exclusion applies to the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities. However, the exclusion does not apply to any money or property transferred to the corporation in consideration for goods or services rendered, or to subsidies paid for the purpose of inducing the taxpayer to limit production. (emphasis added).
The Supreme Court has provided guidance concerning the dichotomy between capital contributions and income received in exchange for the performance of services. In Detroit Edison v. Commissioner, 319 U.S. 98 (1943), the Court held that payments made by prospective customers to an electric utility to cover the cost of extending the utility’s facilities to the customers’ homes were part of the price of service and not contributions to capital. The Court found that the customers did not intend to make contributions to the taxpayer’s capital and regarded the payments as the price of services, stating, “it overtaxes imagination to regard the farmers and other customers who furnished these funds as makers either of donations or contributions to the Company.” Id. at 103.
In Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950), the Court held that payments to a corporation by community groups to induce a shoe company to locate or expand its factory operations in the community represented a nonshareholder contribution to capital. The Court concluded that the contributions made by the citizens were made without anticipation of any direct service or recompense but rather with the expectation that the contribution would prove advantageous to the community at large. Id. at 591. The Court reasoned:
Since in this case there are neither customers nor payments for service, we may infer a different purpose in the transactions between petitioner and the community groups. The contributions to petitioner were provided by citizens of the respective communities who neither sought nor could have anticipated any direct service or recompense whatever, their only expectation being that such contributions might prove advantageous to the community at large. Under these circumstances the transfers manifested a definite purpose to enlarge the working capital of the community. Id. at 591.
In United States v. Chicago, Burlington & Quincy R.R., 412 U.S. 401 (1973), the Court considered whether a taxpayer was entitled to depreciate the cost of certain improvements including highway undercrossings and overcrossings, crossing signals, signs, and floodlights, that had been funded by the federal government. The Court held that the government subsidies were not contributions to the taxpayer's capital. In considering the precedents of Brown Shoe and Detroit Edison, the Court identified from these cases the salient characteristics of a nonshareholder contribution to capital under the Internal Revenue Codes of 1939 and 1954:
It must become a permanent part of the transferee's working capital structure;
It may not be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee;
It must be bargained for;
The asset transferred must foreseeably result in benefit to the transferee in an amount commensurate with its value; and
The assets ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect.
In reaching its conclusion that the improvements at issue did not qualify as contributions to capital, the Court reasoned:
Although the assets were not payments for specific, quantifiable services performed by CB&Q for the government as a customer, other characteristics of the transaction lead us to the conclusion that, despite this, the assets did not qualify as contributions to capital. The facilities were not in any real sense bargained for by CB&Q. Indeed, except for the orders by state commissions and the government subsidies, the facilities would not have been constructed at all. Id. at 413-414.
The Supreme Court and lower courts have also addressed the proper treatment of payments received by taxpayers from the federal government as subsidies for performing services in the ordinary course of their businesses. In Texas & Pacific Railway Co. v. United States, 286 U.S. 285 (1932), the Supreme Court considered whether payments received by a railroad company from the federal government as a guarantee of minimum operating income constituted capital contributions. The Court noted the Transportation Act of 1920 provided for payments representing a guarantee of minimum operating income to compensate the railroad during the transition from federal control to private ownership. The Court reasoned, therefore, that the payments did not represent capital contributions:
Here they were to be measured by a deficiency in operating income, and might be used for the payment of dividends, of operating expenses, of capital charges, or for any other purpose . . . . The government’s payments were not in their nature bounties, but an addition to depleted operating revenue consequent upon a federal activity. Id. at 290.
In Deason v. Commissioner, 590 F.2d 1377 (5th Cir. 1979), the Fifth Circuit Court of Appeals considered whether payments received by the taxpayer from the Department of Labor for job training for hardcore unemployed individuals represented capital contributions. The court deferred to the reasoning of the Tax Court decision, which concluded that irrespective of the public benefit of reduced unemployment that occurred as a result of the payments, the payments constituted direct compensation for training services and thus could not be considered a contribution to capital.
In a recent district court decision in United States v. Coastal Utilities, Inc., 483 F.Supp.2d 1232 (S.D. Ga. 2007), aff’d, No. 07-12484 (11th Cir. January 23, 2008), the court held that universal service fund (USF) payments by the federal and state governments to a telecommunications provider for the reimbursement of telecommunication services provided in high cost areas constituted income and not a capital contribution under section 118(a). The court reasoned the payments constituted supplements to general revenue, rather than specific capital contributions. The court focused primarily on the motivation of the government entities in making the subsidies. Specifically, the court distinguished payments made as an incentive for providing a rate of return on the taxpayer’s investment (income) versus an investment in infrastructure (capital). In other words, instead of furnishing the payments directly for the capital investment, the USF government entities provide an enhanced return on investment to the telecommunication providers, taking into consideration actual investment, a range of expenses, and the allowable rate of return. Thus, the court concluded that governmental USF payments constitute income subsidies, not contributions to capital.
The court also rejected Coastal's argument that the subsidies are capital contributions because they serve a public purpose. The court reasoned:
At the highest level of generality, all government spending should, theoretically, and at least indirectly, be for the purpose of benefiting the community. To decide a case such as this based on the most generalized expressed purpose of Congress would make virtually all government subsidies contributions to capital, except where the government received specific goods and services in return for payments. Id. at 1245-1246.
In the case of the BEP, some taxpayers contend that BEP payments are contributions to capital and make the following arguments: 1) the motive of the USDA is to benefit the public good by enhancing bioenergy production throughout the United States; and 2) the USDA is not the actual consumer of the bioenergy production, therefore IRC section 118 capital contribution treatment is appropriate.
The USDA’s intent and motivation in making BEP payments is to supplement the operating income of the bioenergy producers for the increased purchase and use of agricultural commodities to expand bioenergy production. The BEP payments are not designed to compensate or reimburse the participant for capital asset acquisition. Indeed, a commercial bioenergy producer need not own the production facility to qualify for the payments. Further, a drop in production could result in the producer paying a portion of the BEP payments back to the government. If the producer received payments and subsequently ceased or curtailed operations, the producer may be required to return the support payments to the government. This clawback provision provides further evidence that the USDA’s motivation in making the BEP payments is to provide income subsidies, not capital contributions. As noted specifically in Texas Pacific and Coastal Utilities, government payments furnished as revenue supplements or subsidies to operating income constitute gross income, not capital contributions.
Treas. Reg. section 1.118-1 not only precludes compensation for services from qualifying as a capital contribution, but the regulation also provides that governmental subsidies paid to a producer to limit production does not warrant capital contribution treatment. Such governmental payments provided are clearly given to producers to compensate for the shortfall in income that would thereby result. Despite the existence of a public benefit derived from such a subsidy payment, a compelling public purpose does not negate the fundamental principle under IRC section 118(a) and Treas. Reg. section 1.118-1 that governmental subsidy payments designed to offset operating income shortfalls incurred by a taxpayer constitute income, not capital contributions.
A close review of court decisions analyzing governmental support payments in cases such as Texas Pacific, Deason, and Coastal Utilities indicates that a crucial factor in analyzing the tax characterization of governmental payments is the motivation of the transferor in making the payment; and, this motivation must be deduced from a review of all of the facts surrounding the payment. These cases do not support the contention that a public purpose is an overriding factor mandating characterization of a payment as a capital contribution. For example, in Texas Pacific, the federal government provided payments to fulfill a statutory public purpose, and yet because of the inherent nature of the transaction as reimbursement for deficiencies in operating income, the payment did not warrant capital contribution treatment.
Similarly, in Deason, the federal government made payments that served the public goal of reducing unemployment. Nevertheless, the court focused its analysis on whether the payments represented compensation for services, and in view of an affirmative determination that the payments were indeed for services, the payments did not qualify as contributions to capital.
In summary, the clear meaning of Treas. Reg. section 1.118-1, and the consistent body of judicial decisions considering the issue of governmental subsidy payments, all overwhelmingly support the Service’s position that BEP payments paid to program participants for purchasing and using agricultural commodities in the production of bioenergy constitute gross income, not capital contributions, despite an underlying public purpose.
Some taxpayers argue that the federal government must be the actual recipient of the services performed by the bioenergy providers in order for the BEP payments to be included in gross income. Treas. Reg. section 1.118-1 provides that a nonshareholder contribution to the capital of a corporation does not apply to money or property transferred to the corporation in consideration for goods or services rendered or to subsidies paid for the purpose of inducing the taxpayer to limit production. The regulation clearly does not limit the prohibition to the case where the contributor is the recipient of the services rendered. The prohibition is equally applicable in the case where the contributor’s payments are given to the corporation to provide services to a third party. This was the same reasoning used by the court in Deason, where the court held that a payment by the government to a taxpayer to provide job training for unemployed individuals constituted compensation for training services and thus ineligible for capital contribution treatment.
This was also the conclusion of both the district court and court of appeals in Coastal Utilities, where the court emphasized that the government did not receive any direct benefit in return for the universal service funds paid to the taxpayer. Nevertheless, the court reasoned that the payments were income based on the motivation of the government in making payments to supplement the taxpayer’s income and thereby to create an incentive for the provision of telecommunication services in high cost areas. Similarly, the government’s motivation in the case of BEP payments is similarly to furnish an economic incentive to bioenergy producers for the increased use of agricultural commodities, and the expansion of the bioenergy market, without direct benefit. Consequently, we believe the taxpayer’s assertion that the government must be the direct beneficiary of the BEP payments is wholly without merit.
Additionally, the BEP payments also do not satisfy the five characteristics of a nonshareholder contribution to capital set forth in Chicago, Burlington & Quincy R.R., supra, because the BEP payments: (1) do not become a permanent part of the bioenergy producer’s working capital because the BEP payments are not limited to the acquisition of capital assets and can be used to pay current expenses; (2) are made for specific, quantifiable increases in bioenergy production; (3) are not bargained for because the BEP payments are prescribed unilaterally by the USDA; (4) do not benefit the bioenergy producer commensurate with the value of the subsidy payments because BEP payments subsidize operations; and (5) do not generate additional income for the bioenergy producer because the incentive payments are not limited to the acquisition of capital assets that will generate additional income for the bioenergy producer, but can be used to pay current expenses.
Finally, additional evidence that the BEP payments represent gross income appears through the issuance of Form 1099-G by the USDA to all BEP participants. The USDA’s issuance of Form 1099-G to bioenergy producers reflects the USDA’s consistent intent to treat the BEP payments as income subsidies, not contributions to capital.
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