Tier I Issue: IRC Section 118 Abuse Directive # 4
LMSB Control No: LMSB-4-0608-034
Impacted IRM 4.51.5
August 1, 2008
MEMORANDUM FOR INDUSTRY DIRECTORS
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
DIRECTOR, INTERNATIONAL COMPLIANCE STRATEGY AND
FROM: Patricia C. Chaback
Communications, Technology and Media
SUBJECT: Tier I Issue: IRC Section 118 Abuse Directive # 4
This memorandum provides field direction on the Section 118 Tier I Issue regarding non-refundable state and local tax incentives.
State and local governments routinely use tax incentives to induce businesses to remain in or relocate to a particular geographic area. These tax incentives reduce a company’s state and/or local tax liability, in exchange for the company’s commitment to establish, improve, or maintain its presence in the taxing jurisdiction, or to hire new employees or preserve employment opportunities for existing employees. The incentive may be separately negotiated with the taxpayer, or it may be available to any taxpayer that meets certain requirements. The incentives may include a reduction in the rate of tax, abatement of, credit against, deduction from, and/or exemption from income taxes, property taxes (real and/or personal), franchise taxes, and/or sales and use taxes. Generally, however, these tax incentives are nonrefundable, although some credits can be carried forward to offset future taxes.
In some situations, the taxpayer first pays its tax, without reduction by the amount of the incentive, and then receives the incentive in the form of a separate rebate or refund equaling all or a portion of the tax. The incentive may be in the form of a "refundable credit," meaning that the taxing jurisdiction will pay the taxpayer the amount of the credit that exceeds the tax liability. Refundable credits are not covered by this directive.
A state or local tax incentive for purposes of this directive means any tax reduction, whether by means of abatement, credit, deduction, rebate, refund (to the extent of tax obligation), or exemption, which is accorded a taxpayer who agrees to locate in, remain in, or expand its operations in a particular area, to create additional jobs in a particular area, or otherwise to invest in or remain in a particular area.
A corporate tax strategy has been marketed for the federal tax treatment of state and local tax incentives. Under this strategy, the corporation maintains that rather than following the form of the transaction and reducing its I.R.C. § 164 deduction by the amount of the incentive, for federal tax purposes, it should treat the incentive as a capital contribution from the state or local government coupled with a deemed payment of tax to the government. The corporation claims an I.R.C. § 164 deduction for the amount of taxes that would have been owed absent the incentive, and asserts that the incentive amount is an accession to wealth which is nevertheless excludable from income as a non-shareholder contribution to capital under I.R.C. § 118. The taxpayer then reduces its basis in property (which may be land) by the amount of the tax incentive under I.R.C. § 362(c).
This issue transcends industries and results in the improper application of I.R.C. §§ 164 and 118, which leads to an improper income deferral effected through I.R.C. § 362(c), particularly when a taxpayer reduces the bases of long-lived assets such as buildings. The improper application is compounded when the taxpayer reduces its basis in land, effectively deferring income recognition indefinitely.
UIL: 118.01-02 with a primary SAIN 517 and ITA C181.
Section 362(c) basis adjustment:
UIL: 118.01-03 with a primary SAIN 110 and ITA C186
Planning and Examination Guidance
The issue has been identified on claims filed at or near the end of an examination cycle.
Absent the filing of a claim, the issue may not be readily apparent upon review of a tax return, although in-depth examination of a taxpayer’s Schedule M or Schedules M-3 reconciling book to tax income should disclose the issue. Other means of identifying the issue on a tax return include the following:
Key words or phrases used on the tax return (i.e., contribution to capital, inducement, I.R.C. § 118)
A comparative analysis of the state and local tax expense
A review of fixed assets for basis reductions or negative assets
A review of Forms 10-K and annual reports
Through newspaper articles or news releases made by the company or by state or local authorities
Planning and Examination Risk Analysis
The issue should be identified and prioritized using materiality thresholds and other considerations, such as compliance, through the risk analysis process. If the issue is selected for examination, agents must contact a Retail Technical Advisor. The contact may be via e-mail (utilizing secure messaging), fax or telephone, and provide the name of the case, taxable periods involved, and the name of the examiner working the issue.
A guideline for an Information Document Request for the state and local tax incentive is available. See attachment for a list of information to request.
Direction and assistance on evaluating information gathered may be obtained by contacting a Retail Technical Advisor. The agent should identify and research the specific state and local taxing methodologies governing the local tax incentives at issue and obtain the taxpayer’s written position paper with respect to its claims for additional I.R.C. § 164 deductions. In addition, an in-depth review of the asserted correlative I.R.C. § 362(c) basis adjustments should be completed to determine the actual asset basis(es) decreased.
It is the Service’s position that state and local tax incentives (other than refundable credits) are not income under I.R.C. § 61 and do not give rise to additional deductions under I.R.C. § 164 or § 461. State and local tax incentives are reductions in liability and the only deduction allowed by the Code is the net liability due and payable after application of the incentive. Moreover, even if state and local tax incentives were to be construed as income, these incentives would likely not qualify as non-shareholder contributions to capital under I.R.C. §118(a), and accordingly, no basis adjustment under I.R.C. § 362(c) is appropriate. The Commissioner’s position on this issue is more fully set forth in the Coordinated Issue Paper (CIP) on State and Local Tax Incentives, with an effective date of May 23, 2008, and is available on the Industry Issue Focus website. Coordinated Issue Paper - State and Local Location Tax Incentives (Effective Date: May 23, 2008)
Taxing jurisdictions may offer taxpayers a wide variety of tax incentives. Each situation may be factually unique; however agents must contact a Retail Technical Advisor for additional guidance before consideration of any resolution other than full concession by the taxpayer.
Effect on Other Guidance:
Contact Name and Phone Number:
Dave Moser, Retail Technical Advisor, (636) 255-1246
Maria Montani, Retail Technical Advisor, (636) 255-1385
Carol McClure, Retail Counsel, (281) 721-7306
This Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.
cc: Commissioner, LMSB
Deputy Commissioner, Operations
Deputy Commissioner, International
Division Counsel, LMSB
Director, Performance, Quality, Analysis and Support