Debate continues over the role of infrastructure projects, including government incentives, in job creation. Before weighing in on the debate, it is important to look at some developments related to existing incentives for infrastructure spending. One notable example of discretionary government incentives has been the use of Tax Increment Financing (TIF) bonds.
TIFs have been around since the early 1950s when they were originally implemented in California. Almost every state, including the District of Columbia, has enacted legislation that allows local governments to use this type of incentive. Some states, such as New York, are currently looking at modifying their TIF statutes to enhance the ability of municipal governments and taxpayers to use TIFs. Although TIFs are widely used across the nation, the actual laws in each state vary greatly. Some flexibility is generally given to local jurisdictions on how to use TIFs and, as a result, the process of having a TIF approved is both cumbersome and political. Examples of large-scale use of TIFs can be found in Chicago, California, Denver and other locations.
What Is a TIF?
TIF is a financing tool used to pay for land, improvements, capital projects and infrastructure projects in specified geographic areas. Proceeds from the sale of TIF bonds through the municipal securities market are made available to fund large-scale capital projects. The TIF district formed to facilitate this type of program is a special taxing district set up to fund ongoing development or redevelopment costs. Any incremental tax revenue generated over the base year amount belongs to the TIF district and is used to service the bonds. The proceeds of the bonds are used to fund development costs and the accrued interest on the bonds until the tax revenues are available to service the bonds.
Project sponsors who receive payments or benefits from TIF bond proceeds to fund a portion of their development costs need to understand how to characterize the payments for income tax purposes. The possible characterizations include:
- Proceeds from a loan that must be repaid;
- Contribution to capital in aid of construction;
- Taxable grants; and
- Tax-exempt development cost reimbursements.
The federal income tax consequences of receiving TIF proceeds vary depending on many factors including, but not limited to, the manner in which the TIF repayment is funded, the tax characterization of the recipient (i.e., corporation versus partnership), the use of the proceeds by the recipient, the ultimate ownership of the resulting asset and whether there is a fixed obligation for repayment.
Proceeds from a Loan That Must Be Repaid
If there is a fixed obligation of the recipient to repay the amount received from the TIF, then it may be classified as debt for U.S. federal income tax purposes. For this purpose, a repayment using solely taxes that qualify as "generally applicable taxes" is not considered a fixed obligation to repay. Note that many incentives contain remote or contingent liabilities of repayment. Though these contingent liabilities result
in additional business risk, they may not rise to the level of debt for income tax purposes initially. The issuer and holder of a TIF must generally address a host of income tax issues including, but not limited to:
- The imputation of interest under original issue discount (OID) concepts may be an issue if the debt is not excepted from the below-market interest rate loan rules of IRC Section 7872.
- The taxability of the interest payments to the recipient/holder of the TIF bonds may be governed by the private activity bond rules under IRC Sections 141 and 103.
Contribution to Capital vs. Taxable Grant
If there is no fixed obligation for repayment, then the federal income tax consequences vary depending on the tax characterization of the recipient (i.e., corporation versus partnership), the use of the proceeds and the ultimate ownership of the asset towards which the proceeds are applied. As a general rule, TIF proceeds applied towards the permanent benefit of a private taxpayer will give rise to current or deferred income taxation.
Contribution to Capital in Aid of Construction
Deferred taxation generally results when there is a permanent private benefit and the recipient is classified as a corporation for federal income tax purposes. The provision of the TIF proceeds in these instances generally results in a contribution to capital under IRC Section 118. As such, the current receipt of the proceeds is not taxable to the recipient; however, the basis of the applicable property must be reduced by the amount of the proceeds under Reg. Section 1.118-1 and IRC Section 362(c). The result to the recipient is a significant tax benefit in the form of deferred income.
Current taxation generally results when there is a permanent private benefit and the recipient is classified as a partnership for federal income tax purposes. This results because there are no statutory provisions applicable to partnerships that produce similar results as IRC Sections 118 and 362(c) in the corporate context. This seems to make little sense from a policy perspective; however, the IRS position is that it will attack partnerships that attempt to use Section 118 concepts to deal with TIF proceeds. Taxpayers may attempt to rely on old case law (preceding the codification of Section 118 and Section 362(c)) to achieve contribution to capital treatment in a partnership context, but these taxpayers should remember the IRS position and the resulting risk of an audit. There have been efforts to change the tax laws to eliminate this trap for partnerships, but they have not been successful to date.
Tax-Exempt Development Cost Reimbursements
No current or deferred income taxation may result when there is no obligation to repay TIF proceeds that are expended to benefit the general public. In these cases, the TIF district generally owns the applicable property for the entire useful life or longer. As a result, the recipient may not generally be subject to current or deferred income tax related to this public use property.
The following chart summarizes the potential results for the recipient of TIF proceeds:
Recipient Tax Characterization
Fixed Obligation for Repayment
Contingent Obligation for Repayment
No Obligation for Repayment
Contribution to Capital Likely
Contribution to Capital
Taxable Grant Likely
Non-Taxable Reimbursement Likely
Alvarez & Marsal Taxand Says:
Although TIFs are favored by some jurisdictions because of the flexibility allowed for local authorities, the use of TIFs is not without critics. This criticism adds to the political complexity of getting some TIFs approved. TIFs are sometimes combined with other federal or state incentives to achieve viable overall financing. Political actions can adversely affect certain incentives with a perceived negative image, such as the recent flap about the tax credit for the reality TV show "Jersey Shore" that was blocked by Gov. Chris Christie of New Jersey. Careful planning for the use of TIF proceeds is required. One can no longer assume that incremental property taxes will automatically be there to service the bonds. No two TIFs are alike, and caution is advised. Partnerships or other non-corporate recipients of TIF proceeds have to be particularly diligent to avoid tax surprises. Efforts to make current law treatment for corporations also applicable to partnerships have not been successful to date. Government opposition may mean that any legislative relief for partnerships will be prospective only.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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