Government relocation payments and Section 118
Government payments to induce a company to relocate had to be reported as taxable income, a US appeals court said in late July.
Brokertec moved 720 employees to New Jersey in 2002 after its offices in the World Trade Center were destroyed on September 11, 2001.
New Jersey had adopted an economic incentive program to induce companies to relocate to the state and bring jobs or expand existing facilities in a manner that adds to employment.
Companies had to apply to the state Economic Development Authority. Grants were discretionary. Applicants had to promise to maintain a minimum number of employees at the new location for a certain period of time. There were no restrictions on how money would be used.
The state made payments over time that were a fixed percentage of state income taxes withheld from wages on company employees at the new location.
The percentage varied from 30% to 80% depending on whether the company was in a targeted industry or investing in a location where the state felt a greater need to bring jobs.
The state would not start making payments until a project was completed and the company had begun paying wages. The state income taxes withheld on wages had to exceed the amount of the grant so that the jobs would generate more revenue than they cost.
Two Brokertec subsidiaries that relocated to New Jersey received a total of $170 million in payments over 10 years. The IRS said tax should have been paid on the payments, but did not catch the issue on audit until the last four years of the period the company was receiving payments. During that period, the subsidiaries received a total of $56 million in payments.
Section 118 of the US tax code at the time spared corporations from having to report government payments as taxable income that are an inducement to the company to do something without adding to the company’s wealth. An example is where a town pays the cost for a freight railroad whose trains block traffic to put the tracks on an overpass.
A US appeals court said the payments in the case had to be reported as income because they supplement income. They reimbursed the subsidiaries for part of their wages costs, thereby giving them more income.
The court said Brokertec might have avoided tax under section 118 if the state had calculated the payments as a percentage of invested capital.
Congress changed section 118 in late 2017. The section now says that payments by governments and civic groups to corporations must be reported as income unless they are made by the government or civic group in the capacity as a shareholder.
The case is Commissioner v. Brokertec Holdings, Inc.