In 1998, Daimler Chrysler negotiated some $280m worth of tax benefits with city and state officials to help finance the construction of a new manufacturing facility to be located near its existing plant in Toledo, Ohio. At the time, no doubt, representatives for the automobile conglomerate thought that the deal would eventually disappear from public scrutiny, joining the legions of other similar transactions that have been made over the decades between corporations and the states in which they have invested. As it turned out, they were wrong.

Companies, especially those that are bringing coveted manufacturing operations to an area, have always driven hard bargains, playing states off against one another to cut the best deal possible. In exchange for the investment, states offer breaks – in the form of tax credits, subsidies and other similar structures – on property, corporate, sales and inventory taxes.

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For the most part, local legislators and business leaders have acquiesced to such practices – not always happily, considering the lost tax revenue – because the long-term advantages of the investment were thought to outweigh the shorter-term losses. Daimler Chrysler’s project, as one example, was valued at $1.2bn, including the creation of several thousand jobs in a region that had been hit hard by the loss of manufacturing jobs over the decades.

End of an era?

However, a case that has been put to the US Supreme Court for consideration, Charlotte Cuno vs Daimler Chrysler, is threatening to upend this long-standing dance between corporates and local governments.

After Daimler Chrysler was granted its tax credits for the project, a group of Ohioans – small businesses, local homeowners – with the backing of a public interest group, filed a suit on the grounds that the tax incentives were a violation of the US Constitution, specifically its Commerce Clause, thus hindering interstate commerce.

Over the next few years the case worked its way through the court system. In its first venue, the district court found in favour of Ohio. However, upon appeal to the 6th Circuit Court, that decision was reversed, with an exception for property taxes carved out of the ruling. The reasoning for that, says Tom Stringer, a tax partner in the International Tax Practice of BDO Seidman, LLP, was that the Commerce Clause does not regulate municipalities. “It is not about inter-municipality commerce; it is about interstate commerce,” he explains.

Holding pattern

At the moment, Cuno is one of many cases that have been put to the Supreme Court for consideration. The court will decide which cases to hear sometime over the summer, with hearings to begin in the autumn.

Meanwhile, companies considering making investments in those states that fall under the 6th Circuit Court’s jurisdiction – Ohio, Michigan, Kentucky and Tennessee – are on standby.

But Cuno has broader implications than in just the so-called ‘Rust Belt’. For starters, there are cases pending in at least four states, including Louisiana, Nebraska, Oklahoma and North Carolina, that are also challenging the legality of state incentives. Much will depend on the individual state’s constitution and laws when the various courts make their ruling, but Cuno could have an impact even outside its own jurisdiction.

“Other courts may consider the ruling as persuasive,” says Mike Semes, a partner in the business tax practice group at Blank Rome LLP and a former attorney in Pennsylvania’s revenue department. “If it stands as it is, the ruling is limited to the 6th Circuit and those four states. My opinion is that the type of credit that was struck down in that case, although not plain-vanilla, will have universal applicability to the types of credits that many states grant.”

Pressure builds

Few observers would go so far as to say state incentives for business investment are under assault. “There has been decades of litigation surrounding this issue as to whether tax incentives are a violation of the commerce clause,” says Scot Butcher, a tax partner in the International Tax Practice of BDO Seidman, LLP

But, anecdotally at least, pressure against them has been building, manifesting itself not only in the state courts but also in state legislatures that are hamstrung by growing budget deficits. These local legislators wonder if the new jobs are equal in value to the lost tax revenues.

At the same time, Cuno has also revived the issue of the fairness of these tax incentives to businesses already in the state. It is a point that is easy to forget, as this issue tends to be painted as a ‘business interests versus anti-business interests’ fight. But one effect these investment incentives have for businesses already established in a state – some of which have been providing employment for decades – is that they are taxed at a higher rate than newcomers, who might even be competitors. Increasingly, this constituency is making itself heard.

Hopes and predictions

Of course, this debate over incentives becomes moot if the Supreme Court hears Cuno, and ultimately supports the ruling. The best case scenario, as far as the business community is concerned – at least that part of the community that uses incentives to help finance investment – is for the Supreme Court to hear the case and strike down the ruling.

“What markets like most is predictability,” says Jay Biggins, managing director, national incentives for Stadtmauer Baikin Biggins. “When the rules are up in the air the way they are now, and there is so much uncertainty, participants have a hard time reaching agreement on projects. In many cases, the incentives are of such material value to an overall project it can seize-up normal operations of the market.”

In the 6th Circuit Court, it is unclear when or if ‘normal operations’ will return.

Those companies that have already invested in the states in question did so counting upon receiving tax credits to offset some of the financial outlay; these firms have been impacted the most.

“What does a company that has been granted these types of credit do on their financial statements?” Mr Semes wonders. “They had expected to receive these credits that are valued in the millions of dollars for the next 10 years, or whatever term they had negotiated. They have prepared their financial statements assuming that the credit will be there – now, they will have to modify all that. And the reversal is likely to increase their effective tax rate substantially.”

Alternative options

Companies with pending investments are in the best position, although there is still an element of uncertainty. They can either opt to go elsewhere, or can negotiate separate agreements with the states to ensure they receive credits in one form or another.

Mr Stringer says his firm has helped clients insert a ‘Cuno clause’ in incentive agreements that spell out alternative funding sources that would be put in place by the state if the negotiated incentives are ever deemed unconstitutional or illegal. “It is particularly important for large projects,” Mr Butcher says.

It is a good rule to follow, even if the investment is not in the 6th Circuit, Mr Semes says. “You have to look at the state’s laws and constitution to see if it is possible, but I am recommending to clients to have a side agreement or additional agreements that spell out that if these credits are found to be unconstitutional and the company must give them back, then the state will indemnify the company and provide another source of funding.”

For instance, instead of a tax credit, a state could promise to provide a subsidy in the same amount, he says. While subsidies and tax credits are essentially two sides of the same coin to companies, the two options are viewed as separate transactions by courts.

Opposition continues

But even subsidies are being challenged in some areas. In Louisiana, for instance, the state supreme court is considering a case that is challenging a subsidy to support incoming investment, according to A. Kelton Longwell, a partner with a New Orleans-based firm, McGlinchey Stafford PLLC, which helps structure incentives for firms in Louisiana and Mississippi. The case involves a proposal to convert a landmark office building in downtown New Orleans – the city’s World Trade Center – into a hotel.

Opponents, which include local tourism and hotel associations, say the subsidy does not facilitate economic development in the city; rather it is something that would merely benefit the developers and investors in the project.

Ms Longwell says this and another case that is also challenging the use of state incentives in Louisiana has had a chilling effect on investment. “Most of the potential investment that I see now is either being put on hold or the companies are coming up with alternative financing plans,” she says. “But mostly firms are putting deals on hold because if they don’t have incentives the investment will not work. And people won’t wait two or three years for a court ruling to see if they can build a plant.”

Potential solution

One possible source of relief for businesses is Senate Bill 2881. Introduced by Ohio Senators George Voinovich and Mike DeWine, it has been designed to circumvent the Cuno ruling. It is difficult to say whether this – or any other bill for that matter – will be passed, however, given the partisan rancour in both legislative chambers.

Even if this bill does pass, though, some observers say it won’t be that helpful. “The question is, how broad will the legislation be,” Mr Semes says. “The draft I have seen is somewhat narrow and may not be read to encompass the panoply of credits that are out there.” The upshot, he says, is that a “son of Cunos lawsuit” could be filed, challenging other forms of investment incentives not explicitly covered by federal law.

That, plus the certainty it would afford, is why many are hoping the Supreme Court will hear Cuno. “No one disagrees about the importance of Cuno to the use of investment incentives,” Mr Stringer says. “If the Supreme Court doesn’t step in, it could have a serious economic impact.”

But even if the Supreme Court doesn’t hear Cuno, others believe it will hear – at some point – another, related case, now that the genie is out of the bottle. “What could happen is that another jurisdiction makes a ruling at odds with Cuno,” Mr Semes says. “Then you have a split among the circuits and that is something that increases the likelihood of the Supreme Court accepting the case.”

States prepare

Meanwhile, companies and states are only now coming to terms with the possibility that the Supreme Court could hear and then support Cuno. Such an eventuality would be a bitter pill for the three-quarters of US states that use some type of economic development incentive to encourage and attract investment, not to mention the companies that rely on the incentives to expand investment.

“What will happen is that the states that don’t have any exposure to this problem, by virtue of the nature of their incentives, will find their competitive position has dramatically improved,” Mr Biggins says. Such imbalance would take years to reverse.

The landscape for corporates, though, might not be as dismal if a Supreme Court decision that makes Cuno the law of the land eventually provides businesses with relief in other areas.

Consider Nevada, which levies no corporate or personal tax. To be sure, this has been a primary reason why businesses have invested in the state, Somer Hollingsworth, president and CEO of the Nevada Development Authority, says. But, he continues, it is his opinion that other factors play a role as well, especially in luring California companies to move to Nevada.

Business hot-buttons

“It’s true – if you are coming from state where you pay 8%-9% in corporate tax – receiving a credit could make a big difference on your bottom line. But there are hot-button business issues for firms that go beyond taxes.”

He says many companies that have migrated from California to Nevada in recent years did so because of onerous workers’ compensation regulations and other legislation that businesses feel have added to their operational costs. And, in general, Nevada has

a relatively cheaper operating environment. “These costs, such as the cost of power, can almost be as draining as high taxes, especially for a manufacturer or back-office operation that runs 24 hours a day,” Mr Hollingsworth says.

“As a result, we have been receiving interest from industries that traditionally would be in California, such as biotech or technology.”