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State Incentive Grants to Corporation Were Not Nontaxable Contributions to Capital

(Parker Tax Publishing August 2020)

The Third Circuit reversed a Tax Court decision and held that $56 million in cash grants to members of a taxpayer's consolidated group under the State of New Jersey's Business Employment Incentive Program were not nontaxable contributions to capital. According to the Third Circuit, because New Jersey did not restrict how the recipients of the grants could use the cash, and because the grants were calculated based on the amount of income tax revenue that the new jobs would generate, the grants were taxable income. Comm'r v. Brokertec Holdings, Inc., 2020 PTC 224 (3d Cir. 2020).


States often provide economic incentives, such as tax breaks or grants, to businesses willing to relocate, with the understanding that these businesses will create new jobs and otherwise improve the state's economy. New Jersey had one such incentive program under which it provided cash grants, without any restrictions on how that cash could be used, to companies willing to relocate or expand there and create a certain number of high-paying jobs in the state.

Two subsidiaries of BrokerTec Holdings, Inc. - Garban Intercapital North America, Inc. (Garban) and First Brokers Holdings, Inc. (First Brokers) - applied for, and received, grants under the State of New Jersey's Business Employment Incentive Program (Incentive Program). For a company to be eligible for Incentive Program grants, three conditions had to be satisfied: (1) the relocation or expansion would create a net increase in employment in the state; (2) the project would be economically sound and of benefit to the people of New Jersey by increasing employment and strengthening the state's economy; and (3) the receipt of the grants would be material to the company's decision to undertake the relocation or expansion. But no restrictions were placed on how the company could use the grant money. The amount the company would receive was a set percentage of state income taxes withheld from the wages of the company's employees at the new location. That percentage varied from 30 percent to 80 percent of tax withholdings. Larger grants would be provided to businesses creating jobs in certain municipalities in particular need of investment as well as businesses in certain targeted industries. The grants would not be paid until the recipient had completed the project and begun to pay wages, and until it could be confirmed that the amount of state income tax withheld from those wages had met or exceeded the amount of the proposed grant. This ensured that the grants would generate more revenue for the state than they cost.

BrokerTec was relocating its offices to New Jersey and certified it would employ a combined 720 full-time workers at its relocated office spaces. It also noted that it would make more than $47 million in improvements to the raw office space it was leasing, as well as acquire more than $25 million in technology, furniture, and other equipment. But it was not required under the terms of the Incentive Program to make those expenditures to receive grants. What was required was that it create a minimum number of jobs, and hence a minimum amount of income tax revenue, for the state.

Over the next decade, under the Incentive Program, Garban received over $147 million, and First Brokers received $22 million, for a total of approximately $170 million. BrokerTec used those funds to purchase stock in a wholly owned subsidiary, ICAP Holdings (USA), Inc., as part of a series of transactions designed to expand its business into other trading markets.

During the four tax years at issue, 2010 to 2013, BrokerTec's tax returns (consolidated with the returns for its subsidiaries, Garban and First Brokers) excluded approximately $56 million in Incentive Program grant payments as non-taxable, non-shareholder contributions to capital under Code Sec. 118. The IRS concluded that the grants were taxable income and, accordingly, issued BrokerTec a deficiency notice for the difference in taxes. BrokerTec contested the deficiency and the case ended up before the Tax Court.

Contributions of capital to a corporation by a person other than a shareholder are excludable from the gross income of the corporation where the contributions are made before December 23, 2017. The exclusion applies to the value of property contributed before December 23, 2017, to a corporation by a government or civic group to:

(1) induce the corporation to locate its business in a particular community, or

(2) to enable the corporation to expand its business in the community in which it is currently located.

Observation: Under Code Sec. 118(b), for contributions after December 22, 2017, a corporation cannot exclude from income the value of land or other property contributed by a government or civic group to induce the corporation to locate its business in a particular community or to enable the corporation to expand its business in the community in which it is currently located.

The Tax Court decided the case in BrokerTec's favor. The court noted that Reg. Sec. 1.118-1 provides as an example of a contribution to capital, "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." The court added that, consistent with this regulation, the circumstances surrounding the incentive program grant payments were substantially similar to those in Brown Shoe Co. v. Comm'r, 339 U.S. 583 (1950), in which the Supreme Court held that payments to a corporation by community groups to induce the location of a factory in their community represented a contribution to capital. Thus, the Tax Court concluded, the Incentive Program grants manifested the definite purpose of enlarging the working capital of BrokerTec and were therefore contributions to capital, not taxable income. The IRS appealed to the Third Circuit.

Before the Third Circuit the IRS maintained that the Tax Court oversimplified the analysis of what constitutes a contribution to capital and that, while a relocation inducement provided by a state may be a contribution to capital, it is not necessarily so. The IRS argued that relocation-inducement payments must meet two tests: (1) the payments must, in some way, be restricted to use as capital, and not be available for the payment of operational expenses (like wages) or dividends; and (2) the payments may not be direct compensation for services rendered by the company. The IRS derived these two tests, respectively, from the first two "characteristics" of a non-shareholder contribution to capital set out by the Supreme Court in U.S. v. Chi., Burlington & Quincy R.R. Co., 412 U.S. 401 (1973) (CB&Q): (1) the contribution "certainly must become a permanent part of the transferee's working capital structure"; and (2) "[i]t may not be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee."


The Third Circuit reversed the Tax Court's decision and held that the grants received by Garban and First Brokers were taxable income and not nontaxable contributions to capital. The court agreed with the IRS that the Tax Court's finding was predicated on a misunderstanding of Code Sec. 118 as well as Reg. Sec. 1.118-1 and cases interpreting the statutory provision. Specifically, the court noted, the Tax Court appeared to have understood these authorities to hold that, where a government provides a company cash as a relocation inducement, its intent to contribute to the company's capital is shown - even where the government places no restrictions on how the cash can be used nor calculates the amount of cash provided on the basis of the company's investment in capital assets. In doing so, the court said, the Tax Court misperceived the law.

According to the Third Circuit, in determining whether a transfer is income or a contribution to capital, it's important to consider the intent or motive of the transferor, not the use to which the assets transferred were applied or the economic and business consequences for the transferee corporation. The court noted that, while the two parties agreed with this, they disagreed as to what circumstances indicate a transferor's intent to make a contribution to capital. The court agreed with the IRS and the holding in CB&Q that, to be a non-shareholder contribution to capital, even a relocation inducement must become a permanent part of the transferee's working capital structure and this is not so where, as in the instant case, cash grants were provided without any restrictions on their use. To constitute contributions to capital, the court said, government payments must, in some way, be restricted to use as capital and cannot be available for use in paying dividends or operating expenses.

Further, the court said, unrestricted government payments to a company reveal an intent to provide the company additional income rather than a contribution to the company's capital. Plus, calculating payments based on the company's income, rather than on the amount of some capital investment made by the company, further indicated to the court an intent to provide income rather than a contribution to capital.

For a discussion of the tax treatment of contributions to the capital of a corporation by a non-shareholder, see Parker Tax ¶77,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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