Should Your Business Apply for California’s New Tax-Incentive Program?

News Updates
States are doing everything possible these days to lure businesses away from each other—and as a high-tax state, California is a major target of these efforts.
One high-profile competitor is Texas Gov. Rick Perry, who’s been trying to persuade California employers to flee the state’s “tax and spend” policies. In ads, media interviews and trips to the state, he tries to entice businesses with the prospect of lower taxes and minimal regulations.
To deal with the fierce competition, California took a bold step last year. The state enacted Assembly Bill (AB) 93, which aims to keep employers in California, attract new companies and create jobs. One component of the new law is the California Competes Tax Credit program, which will provide an estimated $780 million in credits by 2018. Under the program, applicants who pass certain hurdles proceed to negotiate contracts with state authorities. A newly created committee has the power to approve or deny those agreements.
The application process is rigorous, and lawyers advise businesses to weigh the potential risks and benefits to determine what makes sense for their situations.
How the Program Works
The California Competes Tax Credit program is open to businesses in any industry and of any size. To receive a tax credit, employers must show specifically how they can benefit the state’s economy.
The program is administered by the Governor’s Office of Business and Economic Development (GO-Biz). The agency expects to allocate $30 million in credits for fiscal year 2013-14, and $150 million for 2014-15. For the three fiscal years after that, the estimated amount is $200 million annually.
There’s no fee to apply. If they choose, employers may receive help from lawyers or consultants during the application process.
During a webinar hosted by GO-Biz, agency officials discussed efforts to help small businesses, which were described as the backbone of California’s economy. Each fiscal year, 25 percent of the total amount of credits will be reserved for small businesses—those with gross receipts of less than $2 million.
Although the initial application period has ended, there will be more opportunities to apply for the coming years. For the 2013-14 year, the deadline for applications was April 14. The agency says that it will provide information about the next application period before July 1.
The agency will consider 11 factors during the process:
*The number of jobs the employer will create or keep in California.
*Employee compensation, including wages and fringe benefits.
*The amount that the business is investing in California.
*The extent of unemployment or poverty in the area where the company is located.
*Other incentives available to the business in California, such as incentives from the local government.
*The incentives available to the company in other states.
*The duration of the proposed project and the amount of time the employer commits to stay in California.
*The company’s overall economic impact in the state.
*The employer’s strategic importance to the state, region or locality.
*The company’s opportunity for future growth and expansion in California.
*The extent to which the expected benefit to the state exceeds the tax-credit amount.
As part of the application, companies also need to disclose “material litigation.” This refers to litigation that is included in financial statements, or that should be disclosed to shareholders or potential investors.
The evaluation process for the program involves two phases. The first phase evaluates quantitative factors, such as job creation and the amount of credit requested. Using an automated system, this information is calculated and compared to other applicants.
Those with “the most advantageous cost-benefit ratio to the state” will move to the next stage, according to GO-Biz. In this second phase, the focus is on qualitative criteria, like the company’s strategic importance and the opportunity for future growth.
If a company executive provides written certification that the business is at risk of leaving California, GO-Biz has the authority to move that company directly to the second phase.
Businesses that get through these two phases have many steps ahead. At this point, GO-Biz and the applicant negotiate terms of the agreement. The topics include minimum employee compensation levels and retention periods; the credit-distribution period; and the program’s “recapture” provisions, which enable the committee to take back the tax credit from a company that violates its agreement.
At the end of this process, GO-Biz recommends a contract for approval by the committee, and the panel meets to make its decision. The committee consists of the state treasurer, the Department of Finance director, the GO-Biz director, an appointee from the Senate and an appointee of the Assembly.
The California Competes Tax Credit program is one of three tax incentives created by AB 93. The other two are a hiring tax credit and a manufacturing partial sales tax exemption. The three incentives replace the state’s Enterprise Zone system, which had many critics. There were questions about whether it encouraged economic growth or whether it was just a corporate giveaway, noted Marty Dakessian, a Los Angeles tax attorney at Reed Smith.
Potential Benefits and Risks
Businesses that are considering applying should evaluate all aspects of the program. Then they should determine if the program is a good fit for their specific needs and circumstances.
“There’s a huge potential upside, but there’s also a huge potential downside on the other end,” said employment attorney Rafael Nendel-Flores, of Ogletree Deakins’ Costa Mesa office.
The program offers the possibility of a large tax credit, which is extremely appealing to businesses. However, other factors to consider include the program’s public disclosure requirements, the recapture provisions and the time spent applying. In addition, there may be grounds for potential legal challenges to the program.
From the standpoint of the legislature, the strict procedures will protect the interests of the entire state, including all taxpayers.
Possibility of Tax Relief—with Flexibility
During the GO-Biz webinar, agency officials emphasized that applicants request the amount they believe is right for them. That feature shows that California is being innovative and flexible in helping businesses with their needs, according to the agency.
In addition, any unused tax credits can be carried over for six years.
“For a lot of companies, this is a really great opportunity to get a tax credit to help subsidize their investment,” said Palo Alto tax attorney William Gorrod, of Morgan, Lewis & Bockius.
Public Disclosure
Applicants need to be comfortable with the level of public disclosure required, Gorrod said.
Under the program, the negotiated agreement becomes public before the committee meets to make a decision.
If an agreement receives approval, GO-Biz will post on its website certain information related to the award. This includes the name of the recipient, the credit amount allocated, and the estimated number of jobs retained or created.
However, GO-Biz says that it will protect confidential information such as trade secrets. The agency says that it won’t publicly disclose this type of information unless required to do so for some reason, like a court order. In that case, the agency would notify the applicant at least five business days before releasing the information, to enable the applicant to seek an injunction.
Another issue: Receiving a tax credit potentially could be used against the company in future litigation, according to Nendel-Flores. For instance, a plaintiff’s lawyer might state that not only is a business violating wage and hour regulations, but it’s also being subsidized by the government. “That adds some color to a lawsuit,” Nendel-Flores said.
He added: “Plaintiffs’ lawyers may be trolling around on the website looking for potential defendants.”
Recapture Provisions
If a company receives a tax credit but later breaches the agreement, the committee has the authority to take back the credit.
For instance, if a business receives a $100,000 tax credit—but later violates the terms of its agreement—the state could add $100,000 in back taxes, plus interest and penalties, Dakessian said.
In addition, GO-Biz would post online the amount of the tax credit that was recaptured.
Companies should evaluate whether they have a good case for receiving a tax credit, advised Michael Cataldo, a San Francisco tax attorney at Pillsbury Winthrop Shaw Pittman. Those that decide to apply should make honest and realistic proposals, he added. Applicants should be confident about their predictions, but not overly optimistic.
“Nobody has a crystal ball to know exactly what’s going to happen in the future,” Cataldo said.
Application Process
During the webinar, GO-Biz stated that the application process may seem daunting. To help ease the process, the agency advised employers to take it one step at a time and carefully follow instructions.
Nevertheless, applicants might end up going through a lengthy application process with nothing to show for it.
“You’re potentially wasting time and money going through the application process and not being picked,” Nendel-Flores said.
Legal Issues
Dakessian sees several grounds for potential legal challenges to the program.
The first one relates to the Commerce Clause of the U.S. Constitution, he said. In a number of cases, courts have ruled that these types of pro-growth incentives violate the Commerce Clause. By favoring companies that do business in a particular state, the incentives discriminate against out-of-state companies, the courts have determined.
Dakessian litigated one of these cases. In Cutler v. Franchise Tax Board, he represented Frank Cutler, who failed to qualify for a tax-incentive program. In 2012, the California Court of Appeal ruled that certain provisions of the incentive program in this case violated the Commerce Clause.
Second, this potentially could be an unlawful delegation of legislative authority, in violation of the separation of powers, according to Dakessian.
And third, the program potentially could violate a section of the state constitution, which states that the power to tax may not be surrendered by grant or contract, he said.
In the event of a successful legal challenge to the California Competes Tax Credit program, it’s unclear what would happen to businesses that had already received tax credits, Dakessian said.
In the Cutler case, the Franchise Tax Board interpreted the court’s decision to mean that the entire tax-incentive program was invalid and that the recipients of these tax breaks could be retroactively taxed.
Dakessian helped form a business coalition to challenge the Franchise Tax Board’s interpretation in the Cutler case. Ultimately, the California legislature stepped in and overturned the tax board’s determination.
When asked via e-mail about potential legal challenges, a GO-Biz spokesman didn't provide any comments on the issue.
Legislature’s Aims
The process is demanding, but the state legislature says the system is designed to protect the needs of everyone in California. According to legislators, the program is a tool to attract and retain high-value employers—and to do so in a responsible way.
“The program created by this act will allow businesses to publicly apply for tax credits allowed on the basis of job creation and retention standards,” states the text of AB 93.
“This program is intended to be a model of transparency and accountability for the state’s job creation efforts in that performance measurements will ensure that the effective use of taxpayer dollars is maximized.”
Toni Vranjes is a freelance business writer in San Pedro, Calif.
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