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Tax Court holds economic development grants tax-free to corporation

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Tax Hot Topics newsletterThe Tax Court in Brokertec Holdings, Inc. v. Commissioner (No. 3573-17) held that cash grants to a corporation from a state economic development program qualified as nontaxable contributions to capital under Section 118.

In Brokertec, a corporation (Garban) was a financial services company and the common parent of a consolidated group. Garban had offices in both towers of the World Trade Center in New York City and was displaced after Sept. 11, 2001. During its search for new office space, Garban applied for a grant under a New Jersey discretionary aid program that offered financial incentives to attract businesses to move to the state.

Specifically, the program awarded cash grants determined by the board of a New Jersey agency and was based on criteria including:  (i) number of eligible employees; (ii) expected duration of the employee positions; (iii) type of contribution the business could make to long-term growth of the New Jersey economy; (iv) the amount of other assistance that the business would receive; and (v) the total dollar investment the business was making in the project. The typical amount of a grant was 30%to 80% of employee state income tax withholdings, but the grant was only based on withholding tax paid by the employees and was not a rebate of tax paid. On Nov. 8, 2001, Garban was informed that it was approved for a grant over a 10-year period at the 80% level. Garban also acquired another company on April 30, 2002, which was also approved to receive a grant under the program.

New Jersey ultimately awarded Garban $169,780,735 in grants through the program with no restrictions on the use of money. Garban used approximately $40 million to move to New Jersey and spent the remaining amount to acquire the stock of another company. Garban filed its tax returns with a position that a portion of the grants qualified to be tax-free contributions to capital under Section 118. The IRS challenged that position, objecting on grounds that Garban used only $40 million of the total grants to move to New Jersey.

Prior to the Tax Cuts and Jobs Act, Section 118(a) provided that a corporation does not include a contribution to its capital in its gross income. Furthermore, Treas. Reg. Sec. 1.118-1 provided that Section 118 even applied to a contribution to capital made by a nonshareholder. For example, property contributed to a corporation by a governmental unit for the purposes of enabling the corporation to expand its operating facilities could have qualified as a contribution to capital under Treas. Reg. Sec. 1.118-1, and would not be included in the gross income of such corporation. There is an abundance of case law related to contributions to capital, including, as cited by the Tax Court in Brokertec, Commissioner v. McKay Products Corp., (178 F.2d 639 (3rd Cir. 1949)) and Brown Shoe Co. v. Commissioner (339 U.S. 583 (1950)). In Brown Shoe, the taxpayer received cash and property from community groups to induce it to locate its operations to certain municipalities. The Supreme Court held that such cash and property qualified as contributions to capital.

In Brokertec, the Tax Court held that the grants qualified as contributions to capital under the former version of Section 118(a) because they were substantially similar to the facts in Brown Shoe.

Contact:
Jeff Borghino
Partner, Washington National Tax Office
T +1 202 521 1532

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