Valid cash incentive or illegal tax rebate?

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Tyler Mulligan

Tyler Mulligan is a School of Government faculty member focusing on community development, economic development, public-private partnerships for revitalization, and development finance.

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Tyler Mulligan is a School of Government faculty member.

One news outlet reported that in exchange for constructing a data center in North Carolina, Apple Inc. will be reimbursed by North Carolina local governments for “50 percent of tax revenue on real estate property — buildings and land — and 85 percent of tax revenue on business property — computers and other equipment — for the next 10 years.” How do we determine whether this is an improper tax exemption or a valid incentive? I’m afraid there’s no “app for that.”

It is not uncommon for local governments to calculate cash incentives for a business as a percentage of property taxes paid. Cash incentives awarded in this way tend to be prospective in nature; in other words, a business is eligible to receive a cash incentive each year for some number of years, provided it pays its taxes and meets other criteria during each eligible year. There are several practical reasons for using this format, primarily to ensure that the business pays property taxes first and that the incentives awarded never exceed a set percentage of the tax revenue it generates.

One school of thought, however, suggests that local governments should avoid calculating the incentive as a percentage of tax revenue received, lest the incentive be viewed as an illegal tax rebate prohibited by G.S. 105-380. Furthermore, the North Carolina Constitution establishes in Section 2 of Article V that only the General Assembly may classify or exempt property for taxation. Taken together, the concern is that poorly designed incentives could be construed as an improper attempt by a local government to classify or exempt property for taxation. How substantial is this risk?

The question can be avoided entirely if incentives are awarded without direct or indirect reference to property taxes paid. This can be accomplished, for example, by offering a fixed cash incentive per year or by calculating the incentive with reference to some other factor such as a fee certain for each job created. However, if the incentive is not capped by the amount of property taxes paid, then there is a separate risk that the local government will pay out more than it intended as a percentage of the tax revenues it receives.

In an attempt to balance these concerns, local governments often calculate incentives on the basis of a factor which serves as a close (sometimes identical) substitute for the tax revenue actually received. Examples of such proxy factors include total capital investment made or taxable value of capital investment made. Although these proxies are employed to distance an incentive from the tax classification problem, they could be susceptible to a “form over substance” argument in that they typically have the same effect as calculating incentives by tax revenues directly. An additional risk, and a counter-argument to the form over substance problem, is that these proxy factors occasionally do a poor job of measuring expected tax revenue. They fail to track actual property tax revenues when capital investments are counted for purposes of calculating an incentive but are later exempted from tax (e.g., the business applies for a tax exemption for its pollution control equipment). This problem can be corrected through careful drafting of incentive agreements, but as those agreements get better at accurately tying incentives to tax revenues, the “form over substance” argument resurfaces.

Case law does not clear up the issue either, but it is worth mentioning that the North Carolina Supreme Court let stand a court of appeals ruling regarding Dell Inc.’s incentives in Blinson v. State, 186 N.C. App. 328 (2007). The plaintiffs’ brief pointed out that the local government incentives package “reflects the projected property tax to be paid by Dell,” and “Dell will essentially not pay property taxes for the next fifteen years by virtue of the cash grants or reimbursements from the local governments.” Plaintiffs raised the tax classification issue, but that claim was dismissed for lack of standing. The issue was therefore never resolved, except to highlight the practical difficulties of mounting a legal attack on that basis.

Perhaps this suggests taking a different approach to the problem. A focus on what incentives should not do—namely classifying or exempting property from taxation—may not be as important as what incentives should strive to be. As discussed below, an argument can be made that properly designed incentives do not classify property for taxation. An examination of two guiding principles, taken from case law and the statutes, suggests a positive focus on how to build a cash incentive in such a way to make it difficult to characterize it as an illegal classification of property—even when the incentive is tied to tax revenues generated.

1.  Ensure incentives serve diverse public purposes. The seminal incentives case, Maready v. City of Winston-Salem, 342 N.C. 708 (1996), explains that incentives serve a public purpose when offered for the purpose of “enlarging the tax base.” This lessens the concern about tying an incentive to tax revenues generated by the business. After all, to ensure the tax base increases, it is necessary to measure incentives against tax revenues—perhaps even tying the two together directly. But the Maready court did not sanction the single-minded pursuit of tax revenues; rather, it said that public purposes are served by seeking diverse benefits such as “providing displaced workers with continuing employment opportunities, attracting better paying and more highly skilled jobs, enlarging the tax base, and diversifying the economy.” To put it simply, a cash incentive should be offered to obtain more than mere capital investment—it should be contingent on job creation, wage standards, or other factors unconnected to property tax revenue. Once an incentive is meaningfully contingent on factors other than taxable property—even if it is capped or even calculated as a percentage of tax revenue generated—it becomes difficult to characterize the incentive as a property tax classification or exemption.

2. Ensure incentives are governed by an agreement which comports with statutory requirements. G.S. 158-7.1(h) requires incentive agreements to contain provisions to recapture “sums appropriated or expended” in the event that the business (1) creates “fewer jobs than specified in the agreement,” (2) makes “a lower capital investment than specified,” and (3) fails to “maintain operations at a specified level for a period of time specified in the agreement.” I’ll save for later a discussion of how that requirement is applied in the context of cash incentives paid over a course of years, but for now it suffices to say that these provisions serve as excellent guidelines for local governments to follow in all incentive agreements. Employment- and wage-based contingencies are unrelated to property classifications. Likewise, requiring a business to maintain operations at a certain level captures much more public benefit—e.g., local supply purchases, business presence and activity, employee and management leadership in the community, employee spending—than is represented by the taxable value of the business’ property. To the extent that incentive payments are conditioned on these other factors—even if the incentive is capped or calculated as a percentage of taxes paid—one must strain to argue that the incentive is an unconstitutional classification of real or personal property.

Let’s conclude with an example and a question. Say that an incentive is designed such that a business will receive 10% of its property taxes paid in a given year for every employee hired at a certain wage, up to a maximum of ten employees (at which point the incentive will be equal to 100% of taxes paid). Is this an illegal property tax classification or is it a valid employment incentive? Because it is conditioned on hiring a certain number of employees at a certain wage standard, I would argue that this incentive isn’t an unconstitutional classification of real or personal property. Sure, it explicitly measures the incentive as a percentage of taxes paid, but it is based on much more than the value of taxable  property owned by the business; it also measures the number of employees making a certain wage (and by extension, the business’ continued operation at a certain level). Do you think a court would agree?

Tyler Mulligan (46 Posts)

Tyler Mulligan is a School of Government faculty member focusing on community development, economic development, public-private partnerships for revitalization, and development finance.

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2 Responses to Valid cash incentive or illegal tax rebate?

  1. Martha B. Bailey says:

    As a business owner and real estate broker, located in Marion, North Carolina, my response is based on information formulated from my day to day view of the struggle we face in recouping the lost of so many manufacturing jobs over the past five+ years in our small town.

    With the closing of so many of our base core manufacturing plants, we are seeing a dorment work force, struggling to make ends meet.

    The promise of any sort of new job growth is welcome news to these folks. Our local government works at securing any sort of new business to local in our area, however, it seems they fall through. Of course, large companies in today’s economy have come to expect a “package” deal from the local government. Any package offered to companies locating with the promise of creating a work force should have a well formulated plan. ny package encumbered with unknowns, would in my opinion, discourage business professionals.

    Rather, it would seem much more advisable to offer a “break”, for lack of a better word, in areas that would offer the first five years of production to achieve success. These “breaks” are more feasible in the terms of property tax relief, water and sever relief, ulitity relief, thereby reducing the production cost for the initial start period of five years.

    By no means am I suggesting a free ride, but rather, a deferred start up incentive program for operations. And futhermore, I do not feel these companies should be allowed to gleam their profits while the local folks foot the bill for the incentive package. Should there be a base line for profitiblity; number of jobs projected, sales tax revenue, competitive wages,etc. and the company exceed this base line during the first five years of operations, a percentage of profit should be deferred, from the company, back to payment for service rendered by the town for their start up incentive.

    Too often we see a company take the incentive program, make false promises, and within a short period of time, close leaving the local government and tax payers footing the bill. There could be in place a system by which the company and the local government choose a plan(from a choice of several plans and incentives per plan) based on the companies projected revenues during the first five years. The plan is reviewed yearly with an accounting of their base line revenues. Should they run their company efficiently and exceed the projected revenues, jobs created, sales tax revenues, they would be required to payback a percentage of incentive given per year.

    Would any well run business, which our local government should be, not have well established guidelines for incentives received? If our state government set forth these guidelines, there would be less abuse of any incentive “package” by large companies. It would also create a level playing field for all local governments throughout North Carolina. It would no longer be who can come up with the largest incentive programs. In the past, such practices have left smaller budget counties out in the cold.

    The best word I can think of for my thoughts is: ACCOUNTIBILITY!

  2. Thank you, Martha, for that thought-provoking response. I think everything you mention here is legally possible.

    Your idea about having a company pay back incentives if it is profitable sounds more like a loan (or perhaps an equity investment). Loans or equity investments could probably be offered under existing law, but the trick would be convincing a company to accept such terms. Right now, most companies are accustomed to receiving outright grants, so it would require some tough negotiating.

    It would also be possible to offer cash reimbursements for utility costs. Under North Carolina utilities law, local governments are not permitted to charge different utility rates or fees for similarly-situated customers, but a reimbursement program could be offered. Under such a program, all utility charges would first be paid in full by the company, and then the local government would provide a separate reimbursement for the amount paid. It is a legal technicality that must be observed.

    The suggestion that state government should establish incentive guidelines for local governments is intriguing. Some would suggest that state law already does that to some degree, as seen with the requirement that incentive agreements contain recapture provisions as discussed in the post above. Others have urged the General Assembly to pass legislation prohibiting local governments from offering incentives altogether. In either case, I believe the General Assembly has the authority to enact such restrictions, should lawmakers desire to do so.

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