Are Hawaii's Tech Tax Credit Worth the Cost?

Comment

Comment by Bruce M. Bird on March 25, 2009 at 4:05pm

Hi Bill. I appreciate your input.

Let's assume that, in Year 1, a taxpayer invested, say, $1,000,000, into a newly-created company and, in exchange, received 100% of its common stock.

If the money "just sat there" in the company, I agree with you that the investor would not be entitled to claim Hawaii's investment tax credit on the $1,000,000 amount. First, the company wouldn't be a QHTB. And, I agree with your observation that this transaction would put the investor at risk of tax fraud.

So, we are definitely on the same page on the first part of your response.

Let's further assume that, in Year 1, a taxpayer invested $1,000,000 into his newly-created 100%-owned company. The company then spent $200,000 of the $1,000,000 amount in Year 1 on qualified activities in order to qualify as a QHTB. The investor would be "at risk" with regard to his entire $1,000,000 investment under federal tax law (IRC Section 465). He would also appear to have $1,000,000 "at-risk" in his investment under Hawaii state law.

So, it would appear that the Hawaii investment tax credit would be based upon the $1,000,000 (rather than $200,000) amount.

And, again, I do want to stress the word "hypothetical".

On a completely unrelated note: Several months ago I accessed the website for Tissue Genesis at: http://www.tissuegenesis.com. I really enjoyed it. It's an excellent website. I know that you recently mentioned Tissue Genesis on your HVCA website. Just a thought, but maybe you might want to consider providing a link to it.

Comment by Bill Spencer on March 25, 2009 at 11:43am

Bottom line and codified in the law itself is that the investment earning credits must be at risk. Your hypothetical assummes the money would just sit there and not be at risk. Such a transaction would put such an investor at risk of tax fraud and I don't know many who would do that, especially giving the myriad of other ways a high net worth individual has to shelter income from taxes.

Comment by Bruce M. Bird on March 24, 2009 at 9:34am

Hi Bill. I appreciate your input.

Let me give you my hypothetical example again:

"Under current law, a taxpayer can set up a solely-owned QHTB, invest money in it, and claim a 100% non-refundable investment tax credit based upon the amount invested --up to $2 million-- over a 5-year period. The QHTB is not required to hire a single employee. Nor is the QHTB required to spend all of the money invested in it."

Your point about your never having run into this situation is well-taken.

Your comment,"More likely would be the scenario where an entrepreneur who cannot get investors to invest might set up a QHTB, put their own money into, get the credits, but maybe fail to launch or get traction." is closer to the direction in which I was heading. In my hypothetical example, the investor owns 100% of the QHTB. By this, I mean that he is not seeking other investors. He would have no need for you to "vet" --or even know about-- his proposal. Nor would he be required to get a comfort ruling from the Department of Taxation or be involved in a Reg D offering.

You then ask, "Would that be such a bad thing?". And my answer is ,"Quite possibly".

The taxpayer would be able to reduce his state income tax liability over the next 5 years by the amount he invested in the QHTB regardless of whether all of the money he invested in the QHTB is spent by the QHTB.

In closing, I do want to stress the word "hypothetical".

Comment by Bill Spencer on March 24, 2009 at 7:45am

Hi Bruce, Thank you for your kind words about me. I have been on the board of Hawaii Angels since 2002 and President of HVCA since 1999. I certainly have seen a lot of deals pass by. Upwards of 2000 with Angels alone. I have never seen nor heard of an investment similar to your hypothetical scenario. I suppose you could argue that if it can be done, someone has probably done it. But I have never seen nor heard of this happening personally and none of my fellow Angels and friends doing investment have ever mention such a structure to me. One of the tests of a qualified investment is that the money has to be "at risk". It can't be a loan that get's paid back. Even bridge note deals must convert to stock within a year. Do you know of anyone who has actually done this? Is this common practice in your experience? I doubt it. More likely would be the scenario where an entrepreneur who cannot get investors to invest might set up a QHTB, put their own money into, get the credits, but maybe fail to launch or get traction. Would that be such a bad thing?
Thank you for your thoughtful comments.

Comment by Bruce M. Bird on March 24, 2009 at 6:53am

Hi Daniel. I forgot to mention one other point in my response to your earlier post. You stated: "Finally, I don't know that we need to specialize in a particular niche. Of the four or five most interesting Hawaii tech start-ups that come to mind, none are in the same area (Pipeline, Sopogy, Avatar Reality, etc.)."

I couldn't agree with you more.

In addition, I can empathize with any investor who wants to start a high-tech business in Hawaii that doesn't fit within one of the favored "niche" activities specified under current law. Or an investor who wants to create a business in Hawaii with high-paying jobs that aren't necessarily "high-tech" in nature.

Also, it's a bit ironic that a QHTB, upon finding it difficult to operate within a given "niche" activity, may find it necessary to operate on a substantially reduced basis --in order to maintain its QHTB status over a 5-year period-- so that its investors can continue to receive their investment tax credits without recapture.

I wonder if you have any thoughts on how you would like state tax incentives (if any) to be structured.

Comment by Bruce M. Bird on March 23, 2009 at 4:53pm

Hi Bill. You make several good points.

However, I respectfully disagree with you on the moral hazard issue with respect to Hawaii's nonrefundable investment tax credit.

Under current law, a taxpayer can set up a solely-owned QHTB, invest money in it, and claim a 100% non-refundable investment tax credit based upon the amount invested --up to $2 million-- over a 5-year period. The QHTB is not required to hire a single employee. Nor is the QHTB required to spend all of the money invested in it.

Please note that I am not taking issue in the above example with Hawaii's refundable research tax credit. Nor am I taking issue with Act 88. In fact, the reason that I rather like these credits --when compared with Hawaii's investment tax credit-- is that each one is computed based upon a percentage of the money required to be spent in Hawaii. (By some measures, Act 88 is a "deal" in that it arguably operates at or near break-even on a "net" basis). Both the refundable research tax credit and the Act 88 credit require a company to have "skin in the game" prior to the credit being claimed.

But that is not necessarily true with regard to the QHTB investor who claims the nonrefundable investment tax credit in the above hypothetical example.

In any event, I know that you do good work and I applaud your efforts to create new businesses and high-tech jobs in Hawaii.

Comment by Bill Spencer on March 23, 2009 at 9:15am

Hi Bruce and Daniel -

A cap on investment is being discussed presently, but is only a short term solution to deal with budget crunch. Why would you wnat to tie the hands of the only stimulus program we have working in Hawaii at this time. Rather spend $3B on short term construction projects that will be financed for the next thirty years and employ people for a short time? Don't foget about the other money that comes into the state from non-tax advantaged investors, presenltyh 3:1 ratio. Also don't forget that no one has bothered to account for the tax revenues generated by companies, payroll taxes, GET, etc. If you look closely at Hu's article, he has done very little research to back his conclusions, mostly relying on Honolulu Advertiser stories and very few other direct or indirect sources. The moral hazard issue has been fueld by the Advertiser's bias and bad reporting. Better to stick to the facts.

Comment by Bruce M. Bird on March 23, 2009 at 4:26am

Hi Daniel. The article's main proposals include 1) reducing the investment tax credit rate; 2) limiting the amount of claimable investment tax credits; and 3) creating a state sponsored fund-of-funds program to further encourage venture capital formation in Hawaii.

The article's proposal to reduce the investment tax credit rate partially addresses the moral hazard issue. Its proposal to limit the amount of claimable investment tax credits appears to be a credit cap for the state.

Tax policy is an area that generates a lot of "heat". I like your approach of seeking consensus. Act 221/215 has a number of success stories (and success stories in the making). Act 221/215 also "costs" quite a bit more than the tax incentive programs offered by other states. (By "cost", I am only referring to the amount of "foregone revenue" by the State of Hawaii in the amount of the credit claimed).

Comment by Daniel Leuck on March 22, 2009 at 6:49pm

Hi Bruce, I was unaware of this article. Thank you for the link. Like you, I believe Hu brought up some excellent points, although I don't agree with all his conclusions. I'm not clear if he is proposing a credit cap for the state or per company. I also don't think we need more state sponsored "community networking events". We had about ninety events in the TechHui calendar last year. Finally, I don't know that we need to specialize in a particular niche. Of the four or five most interesting Hawaii tech start-ups that come to mind, none are in the same area (Pipeline, Sopogy, Avatar Reality, etc.)

Comment by Bruce M. Bird on March 22, 2009 at 2:43pm

Daniel:

Hi. First, I would like to applaud the manner in which you have broached this topic. It is one about which reasonable minds can disagree. Your blog contains many insightful comments.

There is an article by David H. Hu in the University of Hawai'i Law Review (Vol. 30, 2008) that examines Act 221/215. It can be found at: http://www.hawaii.edu/lawreview/HLRW/V30_N2/hu.pdf . This article touches upon the issue of moral hazard. While I don't agree with some of its conclusions, I do think it contains quite a bit of "food for thought".

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