During the challenging economic times currently facing many taxpayers, virtually no stone is being left unturned in the search to minimize out-of-pocket expenses and increase cash flows. However, for many companies, this search often overlooks one major opportunity: the purchase of state income and franchise tax credits. While not all credits are transferrable, many credits can be exchanged at an agreed-upon price. Such an exchange is a rare win-win-win scenario:
- Sellers — Cash is king! Taxpayers in loss positions are able to monetize credits that may have otherwise gone unused. Further, taxpayers can secure credits for the sole purpose of selling them.
- Buyers — Taxpayers purchasing credits are able to pay less than 100 percent of their tax liability from their own pockets, while still remitting 100 percent of their legal liability to the state.
- States — States appear to be on board as well, as the added incentive of being able to transfer the credits further induces taxpayers to engage in targeted activities in states.
Mechanics: How Does It Work?
Most transferable credits tend to be “project-based,” in that the activities giving rise to the credit have a distinct beginning and end. This allows a taxpayer to submit details of the activities (e.g., qualified expenditures) to the state for approval. Upon review, the state in turn will issue a certificate for the amount of credit approved (which the state reserves the right to audit at a later date). The greatest concentration of transferrable credits is in the areas of motion picture and film production, brownfield and historical redevelopment, and energy-related expenditures. However, only the entity earning and selling the credit needs to be in these industries. The purchasing or utilizing company can generally be in any industry. For example, a retail company may be allowed to purchase a film production credit.
Once a taxpayer receives the certificate from the state, the taxpayer is generally free to sell the certificate on the open market. In certain states, the issuing department will help facilitate the credit transaction. For example, the Oregon Department of Energy provides a “matchmaking” service for no fee to either party. Once the buyer and seller negotiate an agreed-upon price, they should execute a legal purchase agreement documenting the understanding of the parties.
After an agreement is entered into, the next step is to notify the state of the agreement if the state was not already involved in the negotiations. The method for transferring the credit is usually established in the relevant credit’s statute or regulation. Transfer forms generally need to be filed by both the selling and purchasing taxpayer. Once the forms are filed and approved by the state, the credit will be reissued in the purchasing taxpayer’s name. The taxpayer is then free to use the credit to offset its tax liability in the same manner that the original company would have used the credit.
Several states allow the transfer of certain credits, including, but not limited to, Arizona, Connecticut, Florida, Georgia, Illinois, Louisiana, Massachusetts, Michigan, Missouri, New Jersey, Oklahoma, Oregon, Pennsylvania, Rhode Island and West Virginia.
Of course, things are never as easy as they seem. There are several pitfalls to be wary of when purchasing or selling credits.
Know What You’re Buying
Taxpayers should do proper due diligence to understand the specific project the purchased credits relate to. For example, if a taxpayer is purchasing a motion picture production credit from a movie studio, it would be prudent to make sure the movie to which the credit relates is consistent with the company’s image and public profile. Another example is if a taxpayer is purchasing a historical redevelopment credit; the taxpayer may want to know how the project was perceived by the local community and how it might reflect on the purchaser.
Run the Numbers: How Much Credit Can Be Used?
Taxpayers should verify that the credit has not expired or been used by the selling company in earlier years. Also, taxpayers should check income projections to make sure there will be sufficient liability that needs to be offset by purchased credits. Furthermore, taxpayers need to be cognizant of the inherent limitations of certain credits. For example, the Pennsylvania film production credit can only be used to offset 50 percent of the overall liability. Such limitations need to be taken into account when determining the usefulness of the credit.
Know the Law
It is imperative that a taxpayer understand all the legal nuances of the credit being purchased. Several “traps” embedded in the law may not be readily apparent:
- A purchasing taxpayer that has a complex legal structure needs to be certain the credit is purchased in the proper filing entity’s name. For example, Georgia’s motion picture production credit may only be transferred one time, so if the “wrong” entity is listed as the purchaser, some or all of the credit may go to waste.
- Which tax or taxes can the credit be used against? Some credits are able to offset both income and franchise tax liabilities. However, some can only offset income tax liabilities.
- A taxpayer must be aware of when the credit can be used and structure the transaction accordingly. Some credits may be available for use immediately on the purchase date, while others may not be used until the certificate is reissued by the state (a potentially time-consuming process).
- A taxpayer must make sure all forms and notifications are submitted to the state on a timely basis. Missing a deadline can nullify the entire deal.
It may be useful to include an indemnity clause in the purchase agreement in the event the credit is eventually audited and a portion is disallowed.
Alvarez & Marsal Taxand Says:
The purchase and sale of state income and franchise tax credits is a rare situation where everyone involved wins. Sellers are able to monetize their credits, buyers are able to reduce their out-of-pocket tax expense, and states are able to support their larger initiatives. While taxpayers need to do their homework and avoid certain pitfalls, the reward is often well worth the time.
Managing Director, Miami
Kevin Polli, Director, and Edward Eschleman, Senior Associate, contributed to this article
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