Are Hawaii's Tech Tax Credit Worth the Cost?

Comment

Comment by Bill Spencer on April 4, 2009 at 1:00pm

Investor dollars must be at risk. Act 221 is not a loan program nor is it a savings account. Investors expect a high rate of return not a mere 15%. People seem to be very creative in figuring out ways to scam the system in theory, but to my knowledge and according to how many audits of QHTB's there have been, the evidence of scams such as those proposed by Lee and Bird simply do not exist. Even the audits that have been conducted have focused on R&D refunds, not 221 investment credits. As of 2008, of 15 suspect deals, three were audited. I don't know the outcome because this a private tax matter. But 3 audits out of 333 QHTB's would seem to indicate that people subject to the temptation of "moral hazard" afforded by Act 221 are few and far between. It would seem that such smart folks as you all might better spend your time dreaming up useful IP businesses than worrying about how unscrupoulous people could risk the consequences of tax fraud.

Comment by Laurence A. Lee on April 4, 2009 at 12:22pm

So basically, Act 221 would allow me to get a 2nd Mortgage on my home, invest all of that into my own startup, and have the State pay me back the principal balance over 5 years -- as long as I'm a QHTB that meets the profit/loss criteria for X years?

Sure, I think I can park all that cash and dip into it slowly - as long as that cash doesn't earn enough interest to mess up my qualified profits/losses, right?

Hmm... I think I'm going about this all wrong. if I set up a business and managed other peoples' cash properly, I could create some awesome High-Tech IP in Hawaii. Then after X years of avoiding any clawback, I can just transfer that IP to a new out-of-state business, dissolve the Hawaii business, and still have cash left over in my coffers to return to the original investors as "interest" -- the principal being covered by state tax credits.

5% APY? 10%APY? 15%? Name your price, investors! I can be frugal with your $$ millions for a few years! :-D

Comment by Bruce M. Bird on March 31, 2009 at 7:55am

Hi Bill. Thank you for your comments.

As you know, my hypothetical involved a business 100% owned by the taxpayer. The taxpayer invested $1,000,000 in the business. The business engaged in a qualifying activity, but spent only $200,000 of the $1,000,000 invested in it. The taxpayer claimed a nonrefundable credit of $1,000,000 over a 5-year period.

My question was; "Are you implying that the situation I described in my hypothetical example is one of an investor "just trying to scam the system"?

You wrote: "It is irrelevant how much is spent by the QHTB in regard to the credits allocated to the investor".

So, I take it you did not mean to imply that the scenario I described involved "just trying to scam the system". And, from what I can gather, we also both agree that the situation I described in my hypothetical can occur.

You wrote: "My issue about your hypothetical is that it is not a likely scenario except in the case of a drop down subsidiary where their is only one investor. There is nothing wrong with this so long as the drop down is a QHTB."

My hypothetical did not state whether it was a "likely" or "unlikely" scenario. But I appreciate your sharing your opinion on this.

We agree that this situation can --and does-- occur in the context of a drop down subsidiary where there is only one investor. And, as you know, over the years, several companies have "spun out" their IT functions into newly-created subsidiaries ( one of which, I might add, I am now a part-owner in my capacity as a U.S. taxpayer ).

But we definitely disagree with respect to the issue of "moral hazard". I think it can exist both in the situation described in my hypothetical example and in some situations involving the use of a drop-down subsidiary. My sense is that you do not share this view.

By the way, there's an article in today's Honolulu Advertiser on Act 221 and job creation at : http://www.honoluluadvertiser.com/article/20090331/BUSINESS/903310316/1071 .

Comment by Bill Spencer on March 30, 2009 at 6:19pm

It is irrelevant how much is spent by the QHTB in regard to the credits allocated to the investor. The investor can invest up to $2M per QHTB and will get 35% the first year, 25%, the second, 20% the third, 10% the fourth and 10% the fifth. The amount spent by the QHTB is not correlated to the credits claimed by the investor. The law specifies maximum investment and the formula for how many credits can be claimed. It is not conditional on how much the company spends.

My issue about your hypothetical is that it is not a likely scenario except in the case of a drop down subsidiary where their is only one investor. There is nothing wrong with this so long as the drop down is a QHTB.

Comment by Bruce M. Bird on March 30, 2009 at 11:25am

Hi Bill.

You wrote: "...typically you rarely have a situation such as your hypothetical unless the investor is just trying to scam the system, or in the case of a wholly owned drop down subsidiary".

That is quite a statement. I realize that its primary purpose is to state your experience in these matters, but it also travels in many, many directions.

Are you implying that the situation I described in my hypothetical example is one of an investor "just trying to scam the system"? I think you are, but it's a bit hard to tell.

If so, would your opinion change if the taxpayer invested $1,000,000 in a newly-created 100%-owned QHTB where the QHTB spent $700,000 ? Please note that the nonrefundable Hawaii investment tax credit to the taxpayer would again be based upon $1,000,000 (as I have stated in my previous posts).

So, is it the fact that there is only one investor in the QHTB that concerns you? Or that the nonrefundable investment tax credit to the investor is based upon the $1,000,000 even though $200,000 is spent by the QHTB? Or that the credit to the investor is based upon the $1,000,000 even though $700,000 is spent by the QHTB?

Also, when you wrote: "unless the investor is just trying to scam the system, or in the case of a wholly owned drop down subsidiary", I know that you weren't implying that scams and wholly owned drop down subsidiaries are somehow associated with each other. But I would be interested in your thoughts on the types of situations in which you think that they might be.

Comment by Bill Spencer on March 26, 2009 at 10:50am

Regarding ownership, I'm just saying that typically you rarely have a situation such as your hypothetical unless the investor is just trying to scam the system, or in the case of a wholly owned drop down subsidiary. Most if not all of the 2,000 business plans I've looked at in the last 7 years involve founders seeking investors, where ownership is typically in the hands of more than one person. Hope this clarifies.

Comment by Bruce M. Bird on March 26, 2009 at 10:35am

Hi Bill.

Enclosed please find my responses in brackets [ ].

1) You wrote: "No one takes 100% of the risk as an investor."

[ My sense is that you are stating your opinion. For your statement to be fact, you would presumably have to have had access to confidential tax return data from the Hawaii Department of Taxation for 1) each of the 333 QHTBs mentioned on page 12 of the Department of Taxation's 25 page report; and 2) each of the investors in these QHTBs. Of course, that would be illegal, so, again, my sense is that you are stating your opinion.

In other contexts, I can give you many, many examples of a taxpayer taking 100% of the risk as an investor. For example, single member LLCs are quite common.

What I think we both can agree upon is: 1) I can't "prove" that the situation described in my hypothetical is occurring in Hawaii; and 2) you can't "prove" that the situation described in my hypothetical is not occurring in Hawaii. ]

2) You wrote: "What about founders, family, friends and former friends?"

[My hypothetical example consists of an individual taxpayer and his solely-owned QHTB. The investment tax credit is based upon the $1,000,000 invested by the taxpayer in the QHTB, even though the QHTB spends $200,000 on qualifying activities. My hypothetical example doesn't happen to involve a situation involving founders, family, friends and former friends. However, it could have been structured that way.]

3) You wrote: "...If you are talking about a drop down subsidiary, that is not a true commercial entity, then I would agree with you."

[In my hypothetical example, I wasn't referring to a situation involving a drop-down subsidiary. But, at another time, I would be happy to discuss the issue of "moral hazard" as it relates to the use of drop-down subsidiaries.]

4) "...Act 221 was designed to stimulate high net worth individuals and companies to invest in deals in Hawaii rather than put their money elsewhere. The market decides the rest. I'm for the least government interference with the process."

[You make a good point. The title of this blog is "Are Hawaii's Tech Tax Credits Worth the Cost?". So, while it's important to have useful information about the costs and benefits of the Act 221/215 credits, it's also quite understandable to be wary of too much government interference.]

P.S. -- Thank you for the link to the interview with Mr. Jones. I will view it in the next day or two.

Comment by Bill Spencer on March 25, 2009 at 8:22pm

Hi Bruce,

Nope, I'm not giving up. Your formula goes wrong in your ownership assumptions. No one takes 100% of the risk as an investor. What about founders, family, friends and former friends? Other investors. If you are talking about a drop down subsidiary, that is not a true commercial entity, then I would agree with you. Current legislation considers this situation. Act 221 was designed to stimulate high net worth individuals and companies to invest in deals in Hawaii rather than put their money elsewhere. The market decides the rest. I'm for the least government interference with the process. I building a tech sector good for Hawaii? Is more investment capital good for building a tech sector? Michael Jones of Goolge and creator of Google Earth said the following on KGMB 9 when interviewed at the State of the Web 2009 event:

“Especially and unique to Hawaii
is the special law that has been
passed (Act 221) to provide investment
advantages for local people to invest
in technology companies. I think that
was very farsighted. It really has
engendered a much larger technology
company population. That investment
is really precious. It is great that there
are local venture capitalists and laws
that reward them to invest locally. It
has created an amazingly good home
for technology and with the Internet
Hawaii is directly across the street
from everyone on the planet.”
Michael Jones, Chief Technology
Advocate, Creator Google Earth/Maps

You can see his interviews here: http://kgmb9.com/main/content/view/15410/245/

He gets it.

Comment by Bruce M. Bird on March 25, 2009 at 7:35pm

Hi Bill.

Thank you for taking the time to share with me your thoughts.

I think that we are pretty much on the same page regarding the tax treatment of the Hawaii investment tax credit in the hypothetical example being based upon the $1,000,000 --as opposed to the $200,000-- amount.

Here's why I think this is an example of moral hazard. Why invest $200,000 in a 100%-owned QHTB and have the QHTB spend $200,000 when you can invest $1,000,000 in a 100%-owned QHTB and have the QHTB spend $200,000 ? After all, in the 1st situation, the investor's investment tax credit --over 5 years-- would be $200,000. In the 2nd situation, the investor's investment tax credit --over 5 years-- would be $1,000,000. In the 2nd situation, the taxpayer's investment tax credit would be based upon the $1,000,000 amount he invests in the QHTB even though the QHTB would not be required to spend the $1,000,000 under current law.

My guess is that we will just have to "agree to disagree" on this one.

P.S. -- By the way, one thing I think we both can agree upon is that we disagree with the Department of Taxation's computation of the "cost to the state per job created" under Act 221/215. Talk about apples and oranges...

Comment by Bill Spencer on March 25, 2009 at 5:39pm

Thanks Bruce.

The law allows an investor to invest $2M per QHTB per year. The QHTB must have 50% of its activity in R&D in Hawaii or 75% of its business activity in Hawaii. The investor is entitled to receive a credit against Hawaii state tax liability of 35% in the first year of the investment, 25% in the second year, 20% in the third year and !0% in the remaining two years. If all of the credits are not applied during the first five years they can be carried over, so long as the QHTB continues to meet the qualifying criteria. Otherwise, there is a 10% recapture provision for credits claimed and no further credits can be claimed. As long as the QHTB has qualifying activity, then you are right it doesn't matter whether all of the investment is spent in year one or not. What I take issue with is the notion that an "investor" would set up a dummy QHTB and invest soley to get the credits. The key word here is "dummy". If the QHTB is a real company, doing qualified activity, then I don't understand where the "moral hazard" shows up. The credit is based upon how much is invested, not upon how much a company spends.

By the way, a comfort letter ruling is not required by the law. A company does not need a comfort letter ruling from the tax department. It is common practice however to obtain one and most investors expect the company to have one.

Thanks for your suggestion re: Tissue Genesis.

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