Tax Court: Gross Receipts Must Include Interest & Investment Income for Research Tax Credit Calculation

This fairly nuanced Tax Court opinion defines the scope of gross receipts for calculating research tax credits under Sec. 41. The case demonstrates that a thoughtful examination of return calculations, and what is included and excluded from those calculations, can yield significant tax savings. However, since the issue raised in this case was addressed by regulations defining gross receipts for Section 41 published after the tax years involved in the case, the direct application of this holding in current years is limited.

A vast over-simplification of the issue at controversy is as follows: Hewlett Packard sought to exclude dividends, interest, investment and other “non-sales” income from the definition of gross receipts that it used to calculate qualifying tax credits. HP wanted to reduce the total gross receipts in the calculation because the rate at which qualifying expenses became eligible for the credit increased in direct relation to the percentage of gross receipts represented by those expenses. Said differently, HP accumulated credits at a higher percentage once the qualifying expenses passed 1%, then 1.5% and finally, 2% of the gross receipts. Qualifying expenses in excess of 2% of HP’s gross receipts generated credits at the rate of 3.75% as opposed to 2.65% if the expenses were less than 1.5% of gross receipts. Thus, a lower gross receipts base meant that HP reached percentage of expenses threshold, and the higher credit percentage, more quickly.

The government argued to the contrary – a position consistent with the later promulgated regulations mentioned above. The Tax Court agreed with the government. It ruled that HP’s dividends, interest, rent, and other income must be included in total gross receipts for purposes of the calculation. You can add it all up yourself if you care to read the opinion below.

Read the opinion here:
Hewlett Packard v. Commissioner, 139 T.C. No. 8 (2012)

3rd Circuit: Historic Rehab Tax Credits Denied for Lack of a Bona Fide Partnership

The Third Circuit Court of Appeals has reversed the Tax Court on the transfer of historic rehabilitation tax credits from the New Jersey Sports and Exposition Authority (“NJSEA”) to Pitney Bowes through the purchase of a partnership interest that held the credits.

NJSEA formed a partnership, Historic Boardwalk Hall (“HBH”), in order to sell federal historic rehabilitation tax credits (section 47) earned when it redeveloped an Atlantic City property known as East Hall. A number of investors purchased interests in the partnership. The partnership interest allowed the investors to claim ownership of the rehab tax credits for the purposes of offsetting other federal taxable income. Pitney Bowes purchased a partnership interest and used the credits to offset its taxable income.

The IRS challenged the validity of the partnerships and the two sides found themselves in the U.S. Tax Court. The Tax Court found in favor of the taxpayers in Historic Boardwalk Hall v. Commissioner, 136 T.C. No. 1 (2011). The IRS appealed.

The appellate court focused on the government’s argument that Pitney Bowes “should not be treated as a bona fide partner in HBH because [it] did not have a meaningful stake in the success or failure of the partnership.” The Third Circuit viewed the transactions through the lens of the Second Circuit’s opinion in TIFD III-E v. United States, 459 F.3d 220 (2d Cir. 2006) (better known as “Castle Harbour“) and the Fourth Circuit’s holding in Virginia Historic Tax Credit Fund LLC 2001 v. Commissioner, 639 F.3d 129 (4th Cir. 2011). Applying that perspective, the Third Circuit determined that Pitney Bowes was not a bona fide partner in the HBH partnership. It follows that Pitney Bowes therefore was not entitled to use the historical rehabilitation tax credits held in the partnership.

The taxpayer argued in favor of the substance of the partnership, but was rebuked by the Court of Appeals with this strong language, “[r]ecruiting teams of lawyers, accountants, and tax consultants does not mean that a partnership, with all its tax credit gold, can be conjured from a zero-risk investment of the sort [Pitney Bowes] made here.” As suggested by the amici in this case, this opinion may have a chilling effect on future historic redevelopment projects by limiting the transfer of the valuable historic rehabilitation tax credits generated by those projects.

Read the opinion here.
Historic Boardwalk Hall v. Commissioner, No. 11-1832 (3d Cir. August 27, 2012)

California Supreme Court: Employer Must Prove Qualified Employees to Receive Tax Credit

In a long-awaited decision affecting many large California employers and hundreds of millions of dollars of tax credits, the California Supreme Court reversed the Court of Appeal decision in Dicon Fiberoptics v. Franchise Tax Board, holding that the Franchise Tax Board (FTB) may require a taxpayer to establish that certain employees in specified enterprise zones are “qualified employees”, above and beyond the state’s certification process, in order to receive hiring incentive tax credits.

The Court of Appeal had held that the state-issued vouchers received by Dicon (and every other employer who participated in the enterprise zone tax credit program) were “prima facie” proof of a qualified employee and that the FTB had to establish that the employee was not eligible under the program before denying the employer the benefit of the associated tax credit. As a practical matter, the Court of Appeals case treated the state-issued certifications as conclusory evidence of the employee’s qualification. The Supreme Court reversed this crucial element of the Court of Appeal decision, thereby allowing the FTB to deny the credit where the only evidence of the employee’s qualification was the voucher and shifting the burden to the taxpayer to establish that the employee was otherwise qualified for the incentive tax credit.

Read the entire opinion here:
Dicon Fiberoptics v. Franchise Tax Board, No. S173860 (Ca. Sup. April 26, 2012)

Tax Court: HP’s Tax Credit Generator Denied on Debt/Equity Grounds

The Tax Court, in a memorandum opinion by Judge Goeke, characterized Hewlett-Packard’s investment in a foreign corporation as a loan rather than equity for federal income tax purposes, thereby denying HP the benefit of foreign tax credits generated by the foreign entity. Though the court found for the government, it declined to consider the government’s arguments that the economic substance doctrine or the step-transaction doctrine applied and rested its decision solely on a debt/equity analysis.

The court adopted the Ninth Circuit’s 11 factor debt/equity analysis to determine the merits of the debt according to the Golsen rule, which requires the Tax Court to follow the law of the federal circuit where an appeal would lie. The Ninth Circuit analysis is notable because Hewlett-Packard has a pending suit in a U.S. District Court in the Ninth Circuit seeking a refund of foreign tax credits generated in other tax years attributable to the same transaction in question in the Tax Court case.

To the best of our knowledge, this is the first court decision to address a Tax Credit Generator transaction.

Read the entire opinion here:
Hewlett-Packard Company v. Commissioner, T.C. Memo 2012-135

Fed. Circuit: Taxpayer Failed to Certify WOTC and WtW Credits

The Court of Appeals for the Federal Circuit affirms the Court of Federal Claims grant of summary judgment in favor of the United States ruling that the taxpayer failed to meet the necessary certification requirements to be eligible for the Work Opportunity Tax Credit (WOTC) and Welfare to Work (WtW) tax credit.

Read the Opinion:
Manor Care v. U.S., No. 2010-5038 (Jan. 21, 2011)

U.S. District Court: Interco Transactions Excluded from Gross Receipts for Research Tax Credit

On a motion for partial summary judgment, the U.S. District Court for the Southern District of Ohio rules that intercompany transactions may be excluded from gross receipts when calculating the federal research tax credit under Section 41.

Proctor & Gamble v. United States, Docket 1:08-cv-00608 (S.D. Ohio June 25, 2010)

California Court of Appeals: Vouchers are Prima Facie Evidence for Tax Credits

The California Court of Appeals has held that state-issued vouchers certifying certain employees as “qualified” under a hiring incentive tax credit is “prima facie” evidence that the employee was qualified and the Franchise Tax Board must prove otherwise before disallowing an employer’s claim for the credit.

Read the opinion here:
Dicon Fiberoptics v. Franchise Tax Board