David Stewart:   0:01
Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: incentives truce. For years, states have enticed businesses to relocate or expand operations by offering tax breaks and other financial incentives. But following a recent high-profile bidding war, some have called for a cease-fire. Here to talk about recent efforts to limit incentives competition through an interstate compact is Tax Notes reporter Aaron Davis.  

David Stewart:   0:30
Aaron, welcome back.  

Aaron Davis:   0:32
Hi, thanks for having me.  

David Stewart:   0:33
Why don't we start off with can you explain these interstate compacts? And what is the idea behind them?

Aaron Davis:   0:38
So these interstate compacts, they're mostly an attempt by states to set some rules on the battlefield of tax incentives and collectively agree not to use particular economic development tools against each other as they compete for businesses. Many of the proponents behind this, they point to the famous game theory paradox called the prisoner's dilemma as a good example. In that situation, you have two prisoners in solitary confinement. Prosecutors offer them a plea bargain to betray their confederate, and they can both betray each other and lose. One can betray the other and win. Or they can both remain silent and be better off than when they betray each other. And here the prosecutors of the companies and site selection firms and the states are the prisoners who feel compelled to offer larger and larger tax breaks and grants to win the political award of bringing a business to your state. But the compact itself starts off with a small buy-in, almost similar to, you know, a prisoner exchange. I mean, in this case, states would need to agree to end company-specific subsidies to poach businesses from another compact state. And once two states agree then the interstate compact is created, and a board of directors is appointed. And over time, additional economic development strategies and policies can be agreed upon so that less tax dollars are lost from what appears to be a zero-sum competition.

David Stewart:   1:48
Now what brought about this recent push for compacts?

Aaron Davis:   1:52
So it really seems, you know, from all the people I've talked to, it seems like the public spectacle of the Amazon HQ2 search embarrassed, you know, many of the politicians and their constituents. Or angered them as well, after seeing immense sums and services offered to what, at the time, was the largest company in the world. That display certainly soured many people and that in turn informed many politicians who agreed to work on legislation for this compact. It was also a big motivating factor for Dan Johnson, the Chicago-based lobbyist who helped connect politicians to initially collaborate on this. And I've also heard about resurging popularity of compacts. More as a reflection of citizens', I guess, dwindling faith in the effectiveness of the federal government. They're sort of going about doing it themselves. In looking around, I saw compacts to commit to the national popular vote -- this one's been going on for a while -- rather than the Electoral College. There were also many compacts to address the interstate licensing issues and some to create Second Amendment sanctuaries and others.

David Stewart:   2:45
Let's take a step back and how about let's talk a bit about the history of tax incentives and how they first became used to entice businesses.

Aaron Davis:   2:53
So the history actually goes back a long ways. There was early example of a tax incentive war from the 16th century, when Italian port cities' competition with one another essentially eliminated duties and excise taxes. But are instances a little bit more recent? Many of our states have particular rules written into their constitutions to prevent gifts and/or subsidies to private enterprise. This started back in 1825, around that area, when the Erie Canal had opened, and it was funded through a revenue bond scheme. And repaid after 20 years through tolls on canal users. Around that time, it was a wild success, and a lot of states started funding railroads, canals, and these public projects. And after a little bit of a dip in the economy, a lot of them couldn't be paid back and state was on the hook. So around that time, many states put into their constitutions prohibitions on funding private enterprise, I guess. For a while that held, but over the years it was sort of eroded through court decisions until around in the 1920s. There was one mayor in Columbia, Missouri, Hugh Lawson White, who sort of kicked off the modern flavor of tax subsidies with this program called Balance Agriculture with Industry program. And it's described sort of as ... he got a lot of the town together to basically commit to building infrastructure for this one dress shirt and pajama making company called the Reliance Manufacturing Company. And that actually brought this company down to Columbia, Missouri. And it was a wild success at the time, you know, because they also had job training programs as well. And it did help bring that town, you know, some economic success. But later he eventually became governor of Missouri, and he implemented this statewide, and this was no longer private money funding the relocation of industry. It became public money, and that actually passed through the courts. And so that was considered legal and did not violate those gift clauses. After that, the rest is sort of history. It continued on from there through economic development agencies and programs, and all the way up until sort of a modern supercharging of it too. Actually, no pun intended here, when, in 2014 Jeff Bezos, the head of Amazon, learned a little bit about incentives granted to the Tesla Motors company in Nevada, about $1.3 billion, this is according to reporting from Bloomberg. And he was a little bit envious of that large of the award and told his people to go out and find a bigger one. And there we have HQ2.

David Stewart:   5:19
Now, how big of an issue are tax incentives today? Like how much money are we talking about?

Aaron Davis:   5:24
So there's some disagreement on how to count it. But research from Tim Bartik at the Upjohn Institute places that it about $45 billion annually. But a recent paper, published by Cailin Slattery of Columbia Business School and Owen Zidar of Princeton, pegged the low end at around $30 billion. So you know, in comparison, NASA's budget is $22.6 billion. 

David Stewart:   5:43
So what states are proposing to curb tax incentives?

Aaron Davis:   5:47
So right now we've got 14. Alabama, Arizona, Connecticut, Delaware, Florida, Hawaii, Illinois, Iowa, Maryland. New Hampshire has a bill, but it is more to study what would happen if they join this. Then New York, which has been leading the charge here particularly last year because they had filed in 2019 as well, as well as Rhode Island. Utah has a slightly different bill, and I'll come back to that in a second, and West Virginia. Utah's bill is different than the other states in that it A) has gone the farthest so far, it's gotten out of committee and was approved, not by the full legislature. But it also only comes into effect when all 50 states actually sign an interstate compact, and it has more of a different direction in both impact and intention. It's called an interstate compact to promote economic cooperation, something close to that.

David Stewart:   6:35
Alright.

Aaron Davis:   6:35
And it's more so a pro-business approach rather than a limiting of economic tools. It's more of a promotion of shared economic tools to draw on businesses. There is more to it than that, but I'm simplifying it.

David Stewart:   6:48
Now is there one state that's sort of leading this effort, or how is this happening?

Aaron Davis:   6:52
One state that did file in the previous wave that also refiled and has been proactive on social media as well as outreach efforts has been New York. Illinois has as well. They've hosted a lot of press conferences there as well as gotten a lot of the word out and promoted it. But New York had filed bills in the previous wave, then when there were only five states who were filing these interstate compact bills, and they filed in this round. And I believe Assembly member Ron Kim has been very active on this, both writing op-eds as well as promoting this legislation.

David Stewart:   7:21
So New York and Illinois involved, if I remember correctly, both New York and Illinois were deep into the competition to get HQ2.

Aaron Davis:   7:29
Absolutely. And I think that might have been the double-edged sword of that. Involving themselves so deeply in a pitch for their state to Amazon HQ2, I think, soured some of both the voters as well as some of the legislators there. That they thought those who look at the budgets every day and say we don't have money for this or money for that saw large packages put together for Amazon and felt like they needed to, I guess, lead the charge in ending that sort of thing. Particularly, when it resonated so much with voters of their state.

David Stewart:   7:59
Are there any states that actively don't want to join this? Maybe they see it as an opportunity to capitalize on being the only players left competing for these businesses?  

Aaron Davis:   8:07
So that's the thing is that with this compact they wouldn't be able to capitalize on any new business, since the compact would only end the tax incentive wars or particular devices between the states who signed the agreement. These states that have signed the compact, they're still free to use any of these economic development tools in pursuit of businesses in states that haven't signed the compact. If you have not signed the compact, you still are an open target, I guess would be a term to use. But like I said, with Utah, there are some states that want to take a different approach, but are still interested in it. I think most legislators would prefer to save a dime on certain company relocations, but there haven't been any states that have actively opposed it.

David Stewart:   8:48
Assuming that some of these compacts do come about, they do get agreed to, how would they be enforced?

Aaron Davis:   8:54
Part of the enforcement is a behavioral thing, much like with prisoner's dilemma. You don't want to sell out your compatriot, I guess, because if this thing keeps happening, they're going to be the one who sells you out next time. So part of it is behavioral. But another part is that it is a compact that each state has given taxpayers in other states standing in their courts to enforce the letter of the law in the compact. So and here this is still up in the air as to how this would exactly work. But, you know, say Illinois violated the compact, taxpayers in New York would be able to potentially sue in Illinois courts to have the attorney general enforce the laws in the compact. With compact law, it's still a little bit tenuous. The Supreme Court has not taken up several cases that would resolve some lingering questions. Another thing is that many people have, I guess, criticized it in a way to say that in the end, states are still free, legislators are still free to leave the compact when a good deal comes around. So that is one chink in the enforcement. But it still is enforced through both a shared willingness to lay down arms as well as granting standing in their states' courts.

David Stewart:   10:01
Now, you recently wrote an excellent piece about this. Did you talk to anyone who raised issues about these proposed compacts? 

Aaron Davis:   10:08
Certainly. There was several people who raised issues and, like all large collective action, you know, there are always going to be issues. I think a lot of people on the positive side did say one of the main benefits of this is that it shows people are willing to engage in this. But some of the main, I guess, criticisms people have had are that the compact could potentially run afoul of the commerce clause, particularly in regulating interstate commerce, because it gets a little convoluted from there. I can't give an exact example at the moment, but it would be potentially regulating grants and or businesses from even site selection firms, things like that, from being able to engage in business. But there were also other criticisms of that. Enforcement would not be as solid if Congress had actually enshrined this compact into law. If federal law was supporting this compact, then that would make it far more of a solid and enforceable set of rules. There were also worries about it, particularly that its initial buy-in to end company-specific subsidies doesn't get to some of the biggest, more egregious deals. Particularly, the largest deal was actually for Boeing, and that deal was written to be a narrowly targeted industry deal that targeted the aerospace industry. But there really is one. The biggest tree in the forest is Boeing. So it wasn't a company-specific deal, but it ended up being that way.

David Stewart:   11:28
Well, alright, Aaron, I thank you very much for coming here. This has been fascinating, and I'm sure we'll have you back to talk if these compacts go anywhere.

David Stewart:   11:34
Thank you very much. I appreciate it.

David Stewart:   11:35
Now for another edition of Willis Weighs In, where Tax Notes contributing editor Ben Willis discusses tax planning issues.

Ben Willis:   11:42
Thanks, Dave. Today we'll be discussing PLR 202009002 and answering the following question: What types of industries will not qualify for an active trade or business ruling with no income?  

Ben Willis:   11:56
My answer is simply none. This is based on section 355 itself, its underlying policies, and the facts and circumstances analysis that govern all active trade or business determinations.  

Ben Willis:   12:08
The recent PLR was released February 28, 2020, and I'd like to give a shout-out to Emily Foster, who's provided our readers with fantastic coverage on the ruling and issues related to it. The IRS ruled although no income was collected on the division of a likely pharmaceutical business, that this still qualified for section 355 treatment. Now when I say likely pharmaceutical business, this is due to the fact that the ruling actually mentions regulatory functions, which are often associated with requirements related to pharmaceutical companies and drug testing. And they also discussed testing phases before commercialization of the products being tested. So I believe it's a fair assessment for folks to view this as a pharmaceutical ruling.

Ben Willis:   12:55
But this has led people to question whether or not rulings can be obtained in other areas, other industries, like the technology industry. As I've said, I believe there should be no limitation on the type of industry or business that is capable of qualifying for an active trade or business but not have income.  

Ben Willis:   13:14
Why is there so much commotion about this ruling? Well, the 355-3 regulations provide that generally, in order to have a qualifying active trade or business, there must be the collection of income. Now I say generally because before that statement is made, the word ordinarily is used in the regulation. And folks have historically relied on that ordinarily provision to gain comfort in knowing that there may be some exceptions to that general rule. However, because of the length of drug testing, pharmaceutical companies, some of the new industries in technology, you can take SpaceX, for example, and launching people into space and other industries, which will take a long time in order to generate profits or income, and realize that this ruling could be applicable to a wide variety of taxpayers.

Ben Willis:   14:14
And so when I look at this issue and ask myself, "Ben, how are you getting comfort in the fact that industries outside of tech and pharma might be able to obtain this ruling?" I really look to Rev. Rule 2019-9, which is where the IRS suspended two revenue rulings from the fifties in which they believe those revenue rulings could be interpreted as requiring income in order to satisfy the active trade or business requirement. These revenue rulings are in the real estate and oil business, which is very important. So one can't look solely at the study or the notice itself and say, "Well, because pharma and tech were the only fields mentioned, these must be the only areas in which the IRS is looking to provide rulings."  

Ben Willis:   15:06
I would argue, in fact, the opposite is true. I think they're actually looking at these areas because they happen to be ripe for situations in which there are lengthy R&D periods, and before income can be accrued and profits be developed. If Congress thought special rules should exist for certain entities like S corporations, REITs, or foreign businesses, they easily could have included those rules. If Congress thought that certain trades or businesses should be limited from the active trade or business requirement inside of 355(b), they could have included those. They didn't. But what they did include is a large grant of regulatory authority to the IRS in order to provide these regulations. And the IRS is now studying its historic regulation that requires that ordinarily income must be collected. But they've given us these clues from these historic rev rules that have been pulled as well as this new revenue ruling and citing the pharmaceutical and technology fields as examples where exceptions could be made. I would like to encourage the IRS as well as taxpayers to be open minded in terms of the types of businesses that they seek rulings for and exceptions that can be made to this general rule.  

Ben Willis:   16:31
Before leaving, I would like to thank each of you for reaching out with your questions and comments. They are greatly appreciated. You can reach out to me at  @WillisWeighsIn on Twitter or through email at ben.willis@taxanalysts.org. I'd also like to announce Tax Notes will soon be launching a new podcast called Willis Weighs In, where I'll be discussing controversial topics and tax planning.

David Stewart:   16:53
And now, coming attractions. Each week, we preview commentary that'll be appearing in the Tax Notes magazines. I'm joined by Executive Editor for Commentary Jasper Smith. Jasper, what'll you have for us?

Jasper Smith:   17:05
Thanks, Dave. In Tax Notes Federal, Stephen Bates, Michael Lukacs, and David de Ruig consider how recently proposed regs treat cloud computing transactions. Christopher Wajda looks at information that the IRS could use to determine whether a taxpayer had a cryptocurrency taxable event. In Tax Notes State, David Bertoni, David Swetnam-Burland, and Jamie Szal discuss several serious consequences from Wayfair. Timothy Noonan and Ariele Doolittle discuss how New York’s personal income tax rules are applied to wage-based compensation for nonresidents. And in Tax Notes International, Gabriela Capristano considers the use of alternative forms of dispute resolution to resolve tax treaty disputes. Joseph Brothers discusses how the U.S. ECI rules can conflict with tax treaty profit attribution principles. Finally, in the Opinions page, Carrie Elliot looks at routine activity theory and tax compliance.

David Stewart:   17:56
You can read all that and a lot more in the March 16 editions of Tax Notes Federal, State, and International. That's it for this week. You can follow me online @TaxStew that's S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk.