For decades, the US state of Michigan has competed with the Canadian province of Ontario for auto manufacturing investment. However, economic development officials in Michigan are being given an insight into just how tight that competition might become if a case pending before the US Supreme Court finds that state and local tax incentives are unconstitutional.

One attorney familiar with the situation says that some foreign investors are holding off on site selection decisions precisely because of the uncertainty stemming from this case, Cuno v. DaimlerChrysler (see fDi, June/July 2005). Joseph D Gustavus, a partner at Michigan law firm Miller, Canfield, Paddock and Stone, says these investors are looking at Ontario as a serious alternative.

Briefly, the case – which is expected to be decided in autumn – may decide that the tax incentives that state and local governments give to companies to locate or expand operations in their areas are unconstitutional. This would have a major impact on the US and foreign companies that use these incentives to offset the significant costs associated with building a new manufacturing or research facility. Mr Gustavus adds: “Foreign investors, especially European firms, tend to be more cautious as a group than US investors and they are definitely paying attention to this case.”

Worst fears

The companies are not the only ones watching closely. State economic development officials who rely on the role these incentives play in building industrial and manufacturing bases view Cuno v. DaimlerChrysler as the embodiment of their worst fears. But some opponents of the current incentive schemes believe things could go further.

Several factors – including some lower level court cases in the US and one pending at the World Trade Organisation (WTO), a growing resentment by other businesses of the incentives their competitors receive and local protests in many communities about lost revenues – suggest that states’ and local entities’ power to provide tax incentives and subsidies is being eroded by both pressure at the top and grass-roots action at the bottom. “This is a live issue, not only on the local level in the US but also internationally,” says Peter Enrich, a Northeastern University School of Law professor and lead counsel for Cuno for the past five years. For instance, he says: “There are growing discussions of the extent to which state tax incentives have an impact on international trade treaties.”

European disputes

Foreign governments and trade bodies such as the European Commission and the WTO are disputing the legality of these incentives, Mr Enrich says, citing a WTO hearing in which the US is challenging the Europeans over Airbus subsidies and the EU is challenging incentives and indirect aid bestowed on Boeing. Part of the EU case focuses on the $3.2bn in incentives provided by the state of Washington over the past 20 years as well as an additional $4.2bn in subsidies for Boeing-specific infrastructure.

At the same time, Mr Enrich says, businesses are becoming bolder in challenging incentives that they perceive to be unfair. In general, the corporate community has “done a good job of sticking together on this issue”, he says. But there are some examples of larger companies beginning to break ranks.

For instance, in 2002 Northwest Airlines filed a lawsuit in Dane County Circuit Court in Wisconsin, challenging the constitutionality of a new exemption from property taxes that the state had put in place the previous year. Called the Hub Facilities Tax Exemption, it was aimed at air carrier companies operating hub facilities in Wisconsin – a group that did not include Northwest.

The airline filed suit and the circuit court ruled that the property tax exemption was unconstitutional; the state attorney general is appealing this decision. As in Cuno, Northwest’s position was that the exemption violated the Commerce Clause of the Constitution, which forbids states to use their tax systems to treat two businesses differently.

It is not only large companies that are complaining about incentives, says Mr Enrich: “Smaller retailers are becoming increasingly resentful when larger retailers such as Wal-Mart come in and the states grant them all sorts of tax breaks.”

Local politicians, meanwhile, are eyeing the lost revenues from these tax breaks as a way to plug widening holes in city and state budgets.

In Memphis, for example, a local tax break programme called payment in lieu of taxes (PILOT) is under attack from some local council members who are concerned about a shortfall in school funding. They believe that the deferred revenue could be used to shore up the school system’s faltering budget.

The school funding issue is far too complicated to be addressed with such a simplistic solution, says Jim Mercer, executive vice president of industrial services at the Memphis office of property services company CB Richard Ellis. More to the point, he says, the programme pays for itself twice over, pointing to a study sponsored by proponents in 2000 that found that PILOT created $2.47 for every $1 the city and county did not collect. “The industrial area around Memphis has more than doubled in 10 years in large part because of this programme,” says Mr Mercer.

However, companies wanting to take advantage of it sometimes find themselves subject to unexpected demands from local councillors. Mr Mercer explains that the programme provides for specific tiers of tax deferral depending on the level of investment the company makes in the region: “Sometimes when companies come in front of the industrial committee for approval, there have been some council people making demands of companies at these meetings that are not part of the current guidelines.”

But do these incidents point to a wider trend of tax incentives being reined in? Hardly, say proponents of the current system. Mr Mercer does not believe PILOT will be rescinded – although it might be subjected to minor changes. And many believe that even if the outcome of Cuno (arguably the most immediate threat to state and local tax incentives) does overturn the status quo, legal solutions can be found to allow states to continue to offer tax incentives to investors.

Mr Gustavus proposes a solution that takes into account a narrow interpretation of the Cuno case. He believes a company can adhere to the Sixth Circuit Court’s findings by creating a new corporation in the state that is offering the incentive, even if that company already has an existing plant there. Ironically, it is a solution that would have allowed DaimlerChrysler to invest in Ohio unchallenged, he says.

Subsidy option

Another option (and Mr Gustavus stresses this is only for blue-chip investors) is for the state to agree to pay the investor a contingent subsidy payment if its tax incentives are overturned by Cuno. However, he says that a state “really has to be in love with a company” to agree to this.

Proponents of the status quo are also hopeful that the Supreme Court will either kick the case back to the state court system or, better yet, use it to define what is legal and illegal. Their ideal scenario is the Supreme Court holding that the Ohio tax incentive programme does not violate the Commerce Clause.

One line of reasoning it could take, according to Mr Gustavus, is that because the credit applies to income wholly derived within the state (based on the tax’s apportionment formula) and investments made wholly within the state of Ohio, its grant of an investment tax credit does not impermissibly regulate interstate commerce.

“The effect could be considered as neutral by the US Supreme Court on out-of-state income and investment activity,” he says.