Government Argues State Grants Were Not Capital Contributions

BROKERTEC HOLDINGS, INC.
F.K.A. ICAP US INVESTMENT PARTNERSHIP,
Petitioner-Appellee
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellant

IN THE UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT

ON APPEAL FROM THE DECISION OF
THE UNITED STATES TAX COURT

BRIEF FOR THE APPELLANT

RICHARD E. ZUCKERMAN
Principal Deputy Assistant Attorney General

TRAVIS A. GREAVES
Deputy Assistant Attorney General

GILBERT S. ROTHENBERG
(202) 514-3361
TERESA E. MCLAUGHLIN
(202) 514-4342
JUDITH A. HAGLEY
(202) 514-8126
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044

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TABLE OF CONTENTS

Table of contents

Table of authorities

Glossary

Statement of subject matter and appellate jurisdiction

Statement of the issue

Statement of related cases and proceedings

Statement of the case

Summary of argument

Argument

Conclusion

Certificate of bar membership

Certificate of compliance

Certificate of service

TABLE OF AUTHORITIES

Cases:

AT&T, Inc. v. United States, 629 F.3d 505 (5th Cir. 2011)

Baboquivari Cattle Co. v. Commissioner, 135 F.2d 114 (9th Cir. 1943)

Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950)

Commissioner v. Jacobson, 336 U.S. 28 (1949)

Commissioner v. McKay Products Corp., 178 F.2d 639 (3d Cir. 1949)

Commissioner v. Schleier, 515 U.S. 323 (1995)

Consolidated Edison Co. of New York, Inc. v. United States, 10 F.3d 68 (2d Cir. 1993)

Continental Tie & Lumber Co. v. United States, 286 U.S. 290 (1932)

Deason v. Commissioner, 590 F.2d 1377 (5th Cir. 1979)

Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1943)

Edwards v. Cuba R.R. Co., 268 U.S. 628 (1925)

Federated Dep't Stores, Inc. v. Commissioner, 426 F.2d 417 (6th Cir. 1970)

Federated Dep't Stores, Inc. v. Commissioner, 51 T.C. 500 (1968), aff'd, 426 F.2d 417 (6th Cir. 1970)

G.A. Stafford & Co. v. Pedrick, 171 F.2d 42 (2d Cir. 1948)

G.M. Trading Corp. v. Commissioner, 121 F.3d 977 (5th Cir. 1997)

Ginsburg v. United States, 922 F.3d 1320 (Fed. Cir. 2019)

Helvering v. Claiborne-Annapolis Ferry Co., 93 F.2d 875 (4th Cir. 1938)

HMW Indus., Inc. v. Wheatley, 504 F.2d 146 (3d Cir. 1974)

John B. White, Inc. v. Commissioner, 458 F.2d 989 (3d Cir. 1972)

John B. White, Inc. v. Commissioner, 55 T.C. 729 (1971), aff'd, 458 F.2d 989 (3d Cir. 1972)

Lykes Bros. S.S. Co. v. Commissioner, 126 F.2d 725 (5th Cir. 1942)

Maines v. Commissioner, 144 T.C. 123 (2015)

Southern Family Ins. Co. v. United States, 2010 WL 4974612 (M.D. Fla. 2010), aff'd, 476 F. App'x 228 (11th Cir. 2012)

Springfield St. Ry. Co. v. United States, 577 F.2d 700 (Ct. Cl. 1978)

Sprint Nextel Corp. & Subsidiaries v. United States, 779 F. Supp. 2d 1184 (D. Kan. 2011)

State Farm Road Corp. v. Commissioner, 65 T.C. 217 (1975)

Teleservice Co. of Wyoming Valley v. Commissioner, 254 F.2d 105 (3d Cir. 1958)

Texas & Pacific Railway Co. v. United States, 286 U.S. 285 (1932)

United States v. Chicago, Burlington & Quincy R.R. Co., 412 U.S. 401 (1973)

United States v. Coastal Utils., Inc., 514 F.3d 1184 (11th Cir. 2008), aff'g 483 F. Supp. 2d 1232 (S.D. Ga. 2007)

Statutes:

Internal Revenue Code (26 U.S.C.):

N.J.S.A. 34:1B-120 et seq. (1996)

N.J.S.A. 34:1B-126 (2001)

Tax Cuts & Jobs Act, Pub. L. No. 115-97, § 13312, 131 Stat. 2054

Rules and Regulations:

Fed. R. App. 13(a)(1)

N.J. Admin. Code 19-31-10.4 (2001)

T.D. 6220 (1956), 1957-1 C.B. 34

Treasury Regulations (26 C.F.R.):

Miscellaneous:

21 Fed. Reg. 10484 (1956)

Bittker & Lokken, Fed. Tax'n of Income, Estates & Gifts (2019), 1997 WL 439568

Maule, Gross Income: Overview & Conceptual Aspects, Tax Mgmt. Portfolio 501-4th (2018)

N.J. Assembly Committee Statement, A.B. 1415 (Jan. 29, 1996)

S. Rep. No. 83-1622 (1954)

GLOSSARY

BEIP	Business Employment Incentive Program
Doc.	Tax Court docket entries
JA	Joint Appendix
NJEDA	New Jersey Economic Development Authority
Op/JA	Tax Court opinion as paginated in Joint Appendix

STATEMENT OF SUBJECT MATTER AND APPELLATE JURISDICTION

On December 14, 2016, the Commissioner of Internal Revenue sent a notice of deficiency to BrokerTec Holdings, Inc. (BrokerTec) concerning its taxable years ending March 31, 2010, 2011, 2012, and 2013. (Doc. 1 (Petition).) On February 13, 2017, within 90 days after the mailing of the notice of deficiency, BrokerTec timely filed a petition with the Tax Court, seeking redetermination of the deficiencies. (Id.) See 26 U.S.C. (I.R.C.) § 6213(a). The Tax Court had jurisdiction over the petition under I.R.C. §§ 6213(a), 6214, and 7442.

On April 12, 2019, the Tax Court entered its decision. (JA3 (Decision).) That decision disposed of all claims of the parties. The Commissioner's notice of appeal was timely filed on July 8, 2019, within the 90 days allowed by I.R.C. § 7483. (JA1 (Notice of Appeal).) See Fed. R. App. 13(a)(1). This Court has jurisdiction over the Commissioner's appeal under I.R.C. § 7482(a)(1).

STATEMENT OF THE ISSUE

Whether the Tax Court erred in concluding that unrestricted cash grants provided by the State of New Jersey to taxpayer's affiliates are excludable from gross income under I.R.C. § 118 as nonshareholder contributions to capital.

This issue was raised by the Commissioner during the Tax Court proceedings (Docs. 38, 43 (Post-Trial Briefs)) and ruled upon by the Tax Court (Op/JA38-44).

STATEMENT OF RELATED CASES AND PROCEEDINGS

This case has not been before this Court previously. There is a case pending in the Tax Court that raises an issue similar to the issue on appeal, CF Headquarters Corp. v. Commissioner, No. 22321-12, which would be appealable to the Second Circuit.

STATEMENT OF THE CASE

A. Procedural overview

This tax case involves $56 million in cash grants paid by the State of New Jersey to affiliates of BrokerTec during the years at issue. BrokerTec excluded those grants from income on its consolidated federal income tax returns, claiming that they were contributions to capital within the meaning of § 118 of the Internal Revenue Code. The Commissioner determined that the grants did not qualify for exclusion under § 118. BrokerTec petitioned the Tax Court for review of that determination. After a trial, the court held that the grants were nontaxable contributions to capital under § 118. The Commissioner appeals.

B. Background: Section 118's exclusion for contributions to capital

As a general rule, corporations must recognize income whenever they receive cash or property. I.R.C. § 61; 26 C.F.R. (Treas. Reg.) §1.61-1(a) (providing that “[g]ross income means all income from whatever source derived, unless excluded by law”). In certain limited circumstances, however, such receipts may be excluded from income and thereby are not subject to taxation. One such exclusion is provided in § 118, which excludes from income “contribution[s] to the capital” of corporate taxpayers.¹ To qualify for this limited exclusion, the taxpayer must demonstrate (among other things) that the transferor (i) intended the contribution to become a “permanent part” of the taxpayer's “working capital structure,” and (ii) did not receive any “compensation” for the contribution. United States v. Chicago, Burlington & Quincy c. Co., 412 U.S. 401, 413 (1973) (“CB&Q”). For example, if the government transfers property, such as a building, to a corporation with the intent that the corporation relocate to a certain area and utilize the building as part of its permanent working capital, then the value of the building may be excluded from income as a nonshareholder contribution to capital. Treas. Reg. § 1.118-1. In contrast, cash “grants from a government available for the payment of dividends, interest, operating expenses, or other expenditures usually charged to profits are not contributions to capital because they are not restricted to the acquisition of assets.” Maule, Gross Income: Overview & Conceptual Aspects, Tax Mgmt. Portfolio 501-4th at A-116(1) (2018) (collecting cases).

C. BrokerTec

Taxpayer BrokerTec, formerly known as ICAP U.S. Investment Partnership, is a financial services company. (Op/JA6; JA481 (Stipulation).) During the years at issue (the taxable years ending March 31, 2010, 2011, 2012, and 2013), BrokerTec was the parent of a group of companies that filed a consolidated return. (Id.) Two of BrokerTec's subsidiaries received the grants at issue in this appeal: ICAP, North America Inc., formerly known as Garban Intercapital North America, Inc. (Garban) and First Brokers Holdings, Inc., formerly known as First Brokers Securities, Inc. (First Brokers) (collectively BrokerTec affiliates). (Id.)

Garban and First Brokers were interdealer-brokers and, as such, arranged transactions in the financial services industry, typically between banks and investment banks. (Op/JA7.) During 2001, they operated in downtown Manhattan and lost their office space in and around the World Trade Center due to the terrorist attack of September 11, 2001. (Op/JA7-8.) After the attack, they began to search for new permanent office space. (Op/JA8-9.) They learned that the State of New Jersey had a program, the Business Employment Incentive Program (BEIP) (described below), which offered financial incentives to attract businesses to move to the State and relocate in certain urban areas. (Op/JA9-11.)

D. New Jersey's BEIP grant program

Over the years, New Jersey has offered various types of financial assistance programs to companies operating within the State. (Op/JA9; JA341 (Transcript).) Some programs require the company to make capital investments in the State. (JA341 (Transcript).) Other programs provide unrestricted cash grants or tax credits based on a company's agreement to create jobs in the State. (JA329-343 (Transcript).) This case concerns the latter.

In 1996, New Jersey enacted the Business Employment Incentive Program Act, which created an unrestricted-grant program (BEIP) to encourage certain business development in the state. (Op/JA9-10; JA482 (Stipulation).) The program was administered through New Jersey's Economic Development Authority (NJEDA) and the New Jersey Division of Taxation. (Id.; JA281-284 (Transcript).) To obtain a BEIP grant, a company had to submit an application to, and obtain approval from, the NJEDA. (Op/JA11; JA177-178 (Transcript).)

Applications were evaluated on the basis of certain statutory and administrative criteria. (JA288-297 (Transcript).) The statute enacting the program, N.J.S.A. 34:1B-126 (2001), provided three conditions to the grant: (i) that the project proposed by the business “create” a “net increase in employment” by the business in New Jersey during the term of the grant, (ii) that the project be “economically sound” and “benefit the people of New Jersey by increasing opportunities for employment and by strengthening New Jersey's economy,” and (iii) that the receipt of the grant be a “material factor in the business' decision to go forward with the project.” Id. The official administrative guidelines for BEIP focused on these three statutory criteria. (JA722, 797 (BEIP Applications); JA865 (NJEDA Resolution).) These guidelines did not restrict the business's use of the grant money or require the business to make any capital investments. (Id.) During the trial, witnesses from the NJEDA confirmed that the grant funds could be used for any purpose, including the payment of operating expenses or dividends. (JA341-343, 431-434 (Transcript).)

To obtain a grant, applicants were required to relocate to, or expand a project in, New Jersey and maintain a minimum employment level at the project site for a period of at least 150% of the term of the grant. (Op/JA11-12; JA205 (Transcript).) As grants generally were paid over a 10-year period, the grant recipient was obligated to remain at the project site for 15 years. (Id.) The agreements that the NJEDA entered into with grant recipients did not require them to make any capital expenditures in order to receive a grant. (JA260-264, 341-343, 355-362, 365-366, 389 (Transcript); JA753-789, 815-852 (BEIP Agreements).)

The amount of the grant awarded by the NJEDA was 30% to 80% of the state income tax withholdings of the grant recipient's employees. (Op/JA12; JA736 (Scoring Guidelines).) The scoring criteria utilized by the NJEDA to compute the recipient's grant percentage focused on the number, location, and wage-amount of jobs that were expected to result from the applicant's relocation. (Op/JA14-16; JA736 (Scoring Guidelines).) The NJEDA provided larger grants for applicants that projected more and higher-paying jobs and for applicants in targeted industries (including financial service companies) willing to relocate to targeted urban areas in need of aid (urban-aid municipalities), such as Jersey City. (Op/JA10-11, 15-16; JA736 (Scoring Guidelines); JA298-300 (Transcript).)

The amount that the grant applicant planned to invest in capital assets or property improvements had no bearing on the amount of the grant that it would receive. (Op/JA14-16; JA268, 365-366 (Transcript).) Although the applicants described in their applications their anticipated costs for the project (including capital investments), and their source of funding for those costs (Op/JA13-14, 21; JA720, 727 (Application)), the scoring criteria did not take such investments into account, and the applicant would receive the same score if its projected investments were $44 million or just $50 (Op/JA14-16; JA736 (Scoring Guidelines); JA263-265, 359-362, 365-366 (Transcript)). The NJEDA did not try to verify the investment projections, but only the jobs created by the grant applicant. (JA313, 355-356, 361-362 (Transcript).)

In reviewing grant applications, New Jersey looked for applicants that were financially viable and did not need capital contributions from the State in order to operate their business. (JA258-259, 333-336, 359-360, 417-419 (Transcript).) BEIP applicants received a higher score if they had sufficient capital to fund all projected investments and did not require public funds as working capital. (JA736 (Scoring Guidelines); JA265, 346, 352-355 (Transcript).)

As a “tax-incentive program” that was “performance based,” the BEIP grant program was designed to provide New Jersey a direct benefit from the recipient's relocation. (JA484 (Stipulation); JA265, 299, 367-369 (Transcript).) The amount of the grant paid in any given year was calculated as a percentage of the actual income tax withheld from the wages of the recipients' employees and remitted directly to New Jersey. (Op/JA12; JA484 (Stipulation); JA234 (Transcript).) The grant recipient would not receive the grant proceeds until after New Jersey received the tax revenue generated by the jobs the recipient promised to relocate to and maintain in the State. (Op/JA12; JA484 (Stipulation).) Before a grant payment could be issued, the New Jersey Division of Taxation had to certify that the “amount of New Jersey gross income tax withholdings received” for the tax year at issue from the grantee “is equal to or exceeds the amount of the proposed grant.” (JA859-862 (Certifications).) Because the grants were only a percentage of the wage withholding that New Jersey received directly from the grant recipient, and therefore were less than the increased revenue the grant recipient provided to the State, the grants were revenue neutral and did not expose the State to any investment risk. (JA484 (Stipulation); JA194-195, 367-369 (Transcript).) Grants were subject to, and paid from, the State's general appropriations. (Op/JA12.)

In 2013, New Jersey stopped awarding new grants. (JA483 (Stipulation).) It maintained prior grants, but changed the form of the benefit, allowing companies to elect to receive tax credits in lieu of a cash grant. (JA371-373 (Transcript).) Companies that made this election could use the credits to reduce their state taxes instead of receiving cash grants that could be used to pay any operating expense (including state tax expense). (JA259-260, 373 (Transcript).) Although the form of the benefit changed after 2013, the purpose of the BEIP program remained the same. (Id.)

E. Garban's and First Brokers's unrestricted BEIP grants

During September-October 2001, Garban and First Brokers submitted BEIP applications to the NJEDA. (Op/JA12-23; JA484, 488 (Stipulation).) Both applications indicated that the company intended to relocate in one of NJEDA's targeted areas (Garban in Jersey City and First Brokers in Hoboken)² and operate in one of NJEDA's targeted industries (financial services). (JA724, 799 (Applications).) Garban represented that it would employ 250 new full-time workers for 15 years (later increased to 640 workers) and First Brokers represented that it would employ 80 such workers. (JA726, 783, 801 (Applications and Agreement); Op/JA16, 18, 22.)

The NJEDA approved Garban's and First Brokers's applications for 10-year BEIP grants and entered into agreements with each in 2002. (JA484-489 (Stipulation); JA753-789, 815-852 (Agreements).) It concluded that they were “economically” and “financially viable” and that the BEIP grants would be a “material factor” in their decision to relocate to New Jersey. (JA739, 808 (NJEDA Project Summaries).) Their grant payments were to be “calculated based on the total number of new employees in eligible positions during the grant term” and were contingent on the “State Treasurer's certification of income withholdings by the business for [those] employees.” (JA741 (NJEDA letter).) Garban's grant was based on 80% of the amount of its eligible employees' state income tax withholdings (Op/JA16; JA870 (NJEDA memorandum), and First Brokers's grant was based on 70% of its eligible employees' state income tax withholdings (Op/JA22; JA808 (NJEDA Project Summary)). First Brokers's percentage was less than Garban's percentage because First Brokers committed to creating fewer jobs. (JA237 (Transcript).)

In their agreements with the NJEDA, BrokerTec's affiliates committed to relocating eligible positions from New York City, employing a certain number of full-time workers at their Jersey City location and paying them a certain average wage. (Op/JA19; JA783, 845 (Agreements).) Neither affiliate committed to making any capital investments. (JA427 (Transcript); JA753-789, 815-852 (Agreements).) Both represented that the relocation would involve no “Construction.” (JA783, 845 (Agreements); JA260 (Transcript).) Consistent with those contractual commitments, they faced no penalty for failing to make any capital investments, but were to be “subject to penalties” if they failed to meet the “employment goal” set out in their BEIP agreements. (Op/JA18; JA389 (Transcript).) Any capital investment that they might elect to make during the term of the grant was wholly “immaterial” to New Jersey, according to the NJEDA Senior Vice President who testified during the trial. (JA382 (Transcript).)

The grants were unrestricted and could have been used to pay dividends or operating expenses. (Op/JA20; JA343, 431-432 (Transcript).) Garban and First Brokers chose to use the grant proceeds to purchase stock in a wholly owned subsidiary (Holdings). (Op/JA20-21; JA501 (Stipulation).) The NJEDA did not require them to use the unrestricted grants for that purpose. (JA501 (Stipulation).)

Garban began receiving BEIP grant payments in 2004 and received approximately $147 million over the subsequent decade. (Op/JA20; JA486-487 (Stipulation).) First Brokers began receiving grant payments in 2005 and received approximately $22 million during that same time period. (Op/JA23-24; JA490-491 (Stipulation).) After New Jersey offered tax credits in lieu of cash payments in 2013, Garban and First Brokers both opted to convert their cash grants into tax credits. (JA373 (Transcript).)

F. BrokerTec's tax treatment of the BEIP grants

During the trial, witnesses from the NJEDA testified that the grants were not intended to be capital contributions for the recipients, and they also confirmed that the grants were not conditioned on a company's investments and could be used for any purpose. (JA335, 341-343, 355-356, 365-366, 374, 427-434 (Transcript).) Consistent with that testimony, BrokerTec did not exclude the grants from income for book and financial-reporting purposes. (JA512-538 (Tax Returns).) For tax purposes, however, BrokerTec treated the grants as contributions to capital under § 118 and accordingly excluded them from income on its federal income tax returns. (JA508 (Stipulation).) For the years at issue in this case (2010-2013), BrokerTec excluded approximately $56 million from income. (Id.)

The Commissioner determined that the grants did not qualify for income exclusion under § 118. (JA509 (Stipulation).) He included the amount of the grants in BrokerTec's gross income and issued a notice of deficiency for the years in suit. (Id.)

G. The Tax Court proceedings

BrokerTec contested the Commissioner's determination in the Tax Court. (Doc. 1 (Petition).) BrokerTec argued that the grants qualified as nonshareholder contributions to capital because they were provided to induce Garban and First Brokers to relocate to New Jersey. (Doc. 39 at 93-98 (Post-Trial Brief).) BrokerTec relied on Treasury Regulation § 1.118-1, Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950), and Commissioner v. McKay Products Corp., 178 F.2d 639 (3d Cir. 1949), which all held that land or other assets transferred to taxpayers as a location inducement qualified for exclusion under § 118. (Id.) BrokerTec conceded that the BEIP cash grants were unrestricted and that the NJEDA did not require them to be used for capital investments in New Jersey or to purchase Holdings stock. (Doc. 42 at 66, 75-77 (Post-Trial Answering Brief).)

The Commissioner argued that the grants did not qualify for exclusion under § 118 because New Jersey did not intend the grants to become a permanent part of the working capital of BrokerTec's affiliates. (Doc. 38 at 46-48 (Post-Trial Brief) (citing CB&Q).) As the Commissioner explained, the structure of the BEIP program — how companies applied for the grants, how the grants were calculated, and the lack of restrictions on their use — evinced New Jersey's intent to create new jobs, but no intent that the grant payments would become a permanent part of the recipient's working capital. (Id. at 48-56).) As a result, the Commissioner contended, the grants amounted to no more than income subsidies. (Id.) The Commissioner further noted that payments in exchange for direct benefits do not qualify as capital contributions, and he pointed out that New Jersey received a direct benefit (increased tax revenue) through the BEIP grant program. (Id. at 67-68 (citing CB&Q).) Finally, the Commissioner countered BrokerTec's reliance on authorities treating certain location inducements as capital contributions, arguing that the authorities did not involve unrestricted cash grants and that not all location inducements qualify as capital contributions. (Id. at 68-75.)

After a trial, the Tax Court concluded that the unrestricted BEIP grants were excludable from BrokerTec's gross income as nonshareholder contributions to capital within the meaning of § 118. (Op/JA44.) The court stated that “the key to determining whether payments from a nonshareholder” are taxable to the recipient or nontaxable as a contribution to capital “is the intent or motive of the nonshareholder donor.” (Op/JA38.) The court determined that New Jersey's “intent and motivation for the BEIP grant was to provide a nontaxable contribution to capital.” (Id.) The court based that determination on the undisputed fact that New Jersey made the payments to BrokerTec's affiliates in order to “bring new jobs to the State” in certain “targeted area[s].” (Op/JA38-39.)

The Tax Court further determined that “[t]he facts in this case fall squarely within the four corners of [Treasury Regulation §] 1.118-1” and “are strikingly similar to those of Brown Shoe Co. and McKay Prods. Corp., wherein the donor entities sought to induce the businesses in question to move to facilities within the donors' localities.” (Op/JA39.) The court concluded that “[t]he circumstances surrounding the payments are substantially similar to those in Brown Shoe Co. and McKay Prods. Corp. and manifest the definite purpose of enlarging the working capital of petitioner's affiliates.” (Op/JA44.) To support that conclusion, the court observed that BrokerTec's “affiliates made the cash grants a part of their stake in the game by using the funds to acquire all of the stock” of their wholly owned subsidiary. (Op/JA42-43.) The court did not address the undisputed fact that New Jersey did not intend the funds to be so used. (JA501 (Stipulation); JA428 (Transcript).)

Finally, the Tax Court rejected the Commissioner's argument that the BEIP grants paid to BrokerTec's affiliates did not qualify as nonshareholder contributions to capital because New Jersey received a direct benefit in exchange for the grants. (Op/JA43.) The court concluded that New Jersey received only an “indirect benefit” from the affiliates' job creation. (Id.)

SUMMARY OF ARGUMENT

During the years at issue, the State of New Jersey provided BrokerTec's affiliates $56 million in cash grants in exchange for the affiliates' agreement to locate their businesses in Jersey City and to pay a certain number of employees a certain wage. The amount of the cash grants was computed as a percentage of the state income tax withheld from those wages and remitted to New Jersey. There were no restrictions on the use of the cash grants and no requirement that the affiliates make any capital investments or otherwise add the grants to their permanent working capital. The Tax Court nevertheless concluded that New Jersey intended to contribute to the affiliates' capital and that the grants qualified for income exclusion under § 118 as nontaxable contributions to capital. That conclusion is wrong as a matter of law.

ARGUMENT

The Tax Court erred in concluding that unrestricted cash grants provided by the State of New Jersey to BrokerTec's affiliates are excludable from gross income under I.R.C. § 118 as nonshareholder contributions to capital

Standard of review

Whether certain payments qualify as “contributions to capital” so as to be excludable from gross income for federal income tax purposes is a “legal” question reviewed de novo. Teleservice Co. of Wyoming Valley v. Commissioner, 254 F.2d 105, 105-106 (3d Cir. 1958).

A. Introduction: Nonshareholder contributions to capital

Gross income includes “all income from whatever source derived.” I.R.C. § 61(a). It is fundamental that “[t]he income taxed is described in sweeping terms and should be broadly construed in accordance with an obvious purpose to tax income comprehensively.” Commissioner v. Jacobson, 336 U.S. 28, 49 (1949). The “corollary” to that bedrock principle is the “'default rule of statutory interpretation that exclusions from income must be narrowly construed.'” Commissioner v. Schleier, 515 U.S. 323, 328 (1995) (citation omitted). One such exclusion is contained in § 118(a), which states that “[i]n the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.”

The pertinent Treasury regulation distinguishes between shareholder and nonshareholder contributions to capital. With respect to the latter, the regulation provides as follows:

Section 118 also applies to contributions to capital made by persons other than shareholders. For example, the exclusion applies to the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities. However, the exclusion does not apply to any money or property transferred to the corporation in consideration for goods or services rendered, or to subsidies paid for the purpose of inducing the taxpayer to limit production.

Treas. Reg. § 1.118-1.³

“Contribution to capital” is not defined in the Internal Revenue Code or Treasury regulations. The legislative history of § 118(a) explains, however, that the provision “restates the existing law as developed through administration and court decisions.” S. Rep. No. 83-1622, at 190 (1954). At the time that § 118(a) was enacted (i.e., 1954), the Supreme Court had considered on several occasions whether a nonshareholder payment to a corporation was a capital contribution. Compare Brown Shoe, 339 U.S. 583 (holding that property and cash contributed to a manufacturer to induce it to locate and construct factories in the contributing communities were capital contributions); Edwards v. Cuba R.R. Co., 268 U.S. 628 (1925) (holding that cash payments from the Cuban government to construct a railroad were capital contributions) with Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1943) (holding that cash payments from prospective customers to electric company to expand infrastructure were not capital contributions); Tex. & Pac. Ry. Co. v. United States, 286 U.S. 285 (1932) (holding that cash payments from the federal government to guarantee railroads' minimum operating income were not capital contributions); Continental Tie & Lumber Co. v. United States, 286 U.S. 290 (1932) (same).

In 1973, the Supreme Court reconciled its numerous decisions and refined its analysis in CB&Q. CB&Q had received more than $2 million worth of railroad facilities pursuant to a federal program to reimburse the costs of railroad improvements. 412 U.S. at 402-403. The Court had to decide whether CB&Q could depreciate the subsidized assets as capital contributions. Id. at 403-404. To provide guidance regarding the meaning of “contribution to capital,” the Court held that “the intent or motive of the transferor” is determinative of “the tax character of the transaction.” Id. at 411-412. Reviewing its prior cases, the Court “distill[ed] . . . some of the characteristics of a nonshareholder contribution to capital,” describing them as follows:

[1] It certainly must become a permanent part of the transferee's working capital structure. [2] It may not be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee. [3] It must be bargained for. [4] The asset transferred foreseeably must result in benefit to the transferee in an amount commensurate with its value. [5] And the asset ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect.

Id. at 413. The Court explained that these “factors” are “indicia of the transferor's intent or motive.” Id. at 411. In CB&Q's case, the Court determined that “[a]lthough the assets were not payments for specific, quantifiable services performed by CB&Q for the Government” (as was the case in Detroit Edison), other factors indicated that they were not capital contributions. Id. at 413-414. In particular, the Court observed that “the need of the railroad for capital funds was not considered.” Id.

A transferred asset need not be a capital asset, like land or buildings, to qualify as a nonshareholder contribution to capital. See Treas. Reg. § 1.118-1. Cash transfers can qualify so long as the transferor intends that the cash become a “permanent part of the transferee's working capital structure.” CB&Q, 412 U.S. at 413. Accordingly, a transfer of cash conditioned on a requirement that the transferee (i) invest in capital assets or (ii) restrict the transferred cash to a capital account may be deemed a contribution to capital. E.g., Brown Shoe, 339 U.S. at 586-587; Cuba R.R., 268 U.S. at 632-633; Southern Family Ins. Co. v. United States, 2010 WL 4974612 (M.D. Fla. 2010), aff'd, 476 F. App'x 228 (11th Cir. 2012). In contrast, a transfer of cash that is not so conditioned, and is available for any use by the transferee, cannot qualify as a contribution to capital. E.g., Tex. & Pac. Ry., 286 U.S. at 289-290; AT&T, Inc. v. United States, 629 F.3d 505, 517, 520 (5th Cir. 2011); Springfield St. Ry. Co. v. United States, 577 F.2d 700, 701-702 (Ct. Cl. 1978).

The mere fact that a payment is made to induce the taxpayer to relocate does not mean that it qualifies as a contribution to capital under § 118. This Court has addressed location-inducement payments on three occasions. In one case, the Court held that the payment qualified as a contribution to capital, while in two others, it held that the payment did not. Compare McKay Products, 178 F.2d at 643 (holding that a “physical plant” contributed to a taxpayer by a community group in order to induce it to locate its business in their community qualified as a contribution to capital) with John B. White, Inc. v. Commissioner, 458 F.2d 989, 990 (3d Cir. 1972) (holding that cash payments to a taxpayer in order to induce it to move locations did not qualify as a contribution to capital) and HMW Indus., Inc. v. Wheatley, 504 F.2d 146, 155 (3d Cir. 1974) (same). If the transferor does not intend the location-inducement payment to become a “permanent part” of the transferee's “working capital structure,” then it cannot qualify as a nontaxable contribution to capital. CB&Q, 412 U.S. at 411-413.

Nor is it true that “a government payment is a contribution to capital every time a public purpose is in some way implicated.” United States v. Coastal Utils., Inc., 483 F. Supp. 2d 1232, 1245 (S.D. Ga. 2007), aff'd, 514 F.3d 1184 (11th Cir. 2008). In affirming, the Eleventh Circuit adopted the district court's decision in full.⁴ As the Eleventh Circuit has explained, “this is one of the key insights of CB&Q, where the Supreme Court held that even though the payments were not compensation for services, and were for a more general public benefit, they should be considered as income because of other factors.” Id.

As demonstrated below, the Tax Court erred as a matter of law in concluding that New Jersey's unrestricted cash grants to BrokerTec's affiliates qualified for exclusion under § 118. There is no evidence whatsoever that New Jersey intended to make contributions to the affiliates' permanent working capital structure, because (i) the affiliates could use the funds for any purpose, including the payment of dividends or operating expenses, and (ii) the amount of the grants was calculated based on an operating expense (wages withheld to pay state income tax) rather than on a capital expenditure. See, below, § B. In addition, New Jersey made the BEIP payments in exchange for a direct benefit, a disqualifying factor for contribution-to-capital treatment under § 118. See, below, § C. The authorities cited by the Tax Court, including the Supreme Court's decision in Brown Shoe and this Court's decision in McKay Products, are distinguishable and do not support the court's ruling. See, below, § D.

B. New Jersey did not intend the funds transferred to BrokerTec's affiliates to become a permanent part of the affiliates' working capital structure

In CB&Q, the Supreme Court made it clear that to qualify for exclusion as a contribution to capital under § 118, the payment at issue “certainly must become a permanent part of the transferee's working capital structure.” 412 U.S. at 413 (factor one). As demonstrated below, BrokerTec cannot satisfy this essential element of a nonshareholder contribution to capital. The undisputed facts establish that (i) New Jersey did not restrict the affiliates' use of the funds, either explicitly or implicitly, and (ii) New Jersey did not calculate the amount of the funds on the basis of capital expenditures. On such facts, other courts of appeals have readily concluded that a government payment did not qualify as a nonshareholder contribution to capital. See, below, §B.1-2. The Tax Court's rationale for concluding otherwise cannot withstand scrutiny. See, below, § B.3-4.

1. The BEIP funds were unrestricted and were not transferred for the purpose of becoming a permanent part of the working capital structure of BrokerTec's affiliates

To discern whether a transferor intends to contribute cash payments to the recipient's permanent working capital structure, courts examine whether there are restrictions (explicit or implicit) on the use of the payments. Where the recipient of a cash payment is free to use the funds for any purpose, even for dividends or operating expenses, courts have held that the contributor did not intend the funds to become a permanent part of the recipient's working capital structure. Two Supreme Court cases illustrate this principle. In Cuba Railroad, the Supreme Court concluded that government payments that were “necessary [for the taxpayer] to construct the railroad” qualified as a nontaxable contribution to capital, emphasizing that “[n]either the laws nor the contracts indicate that the money subsidies were to be used for the payment of dividends, interest or anything else properly chargeable to or payable out of earnings or income.” 268 U.S. at 632-633. In sharp contrast, the Supreme Court reached the opposite conclusion in Texas & Pacific Railway, where the government payments “might be used for the payment of dividends, of operating expenses, of capital charges, or for any other purpose within the corporate authority, just as any other operating revenue might be applied.” 286 U.S. at 289-290. The absence of any restrictions there evidenced that the contributor did not intend to make capital contributions. Id.

The restrictions need not be explicit for a payment to qualify as a contribution to capital. In certain situations, they may be implicit. For example, in Brown Shoe, certain nonshareholder cash payments qualified as contributions to capital even though there was no explicit restriction on the use of the funds. In that case, the restriction on the use of the funds was implicit. In this regard, the funds (i) were transferred to the taxpayer pursuant to a contract that “required” the taxpayer to “construct” or “enlarge” particular capital assets (factories) and operate them for specified periods and (ii) were “less than the amount expended by it” to construct the contemplated “local factory building and equipment.” Brown Shoe, 339 U.S. at 586-587. In exchange for the cash transfers, therefore, the taxpayer promised to make capital investments of greater value. Id. at 587. Given those facts, the taxpayer was effectively required to invest the funds (or a like amount) in its permanent working capital structure.

The courts of appeals have engaged in similar analyses in evaluating whether cash payments qualified as nonshareholder contributions to capital. Compare G.M. Trading Corp. v. Commissioner, 121 F.3d 977, 979 (5th Cir. 1997) (holding that government payments that were “restricted to the construction of a sheep skin processing plant” in Mexico qualified as a contribution to capital) with AT&T, 629 F.3d at 517 (holding that government payments that “can be used for the payment of a wide variety of expenses” were not contributions to capital); Springfield, 577 F.2d at 701 (holding that government payments made to encourage “public” transportation were not contributions to capital because “no law or regulation . . . prevented the recipient of a grant from using it for wages and salaries . . . or other noncapital expenditure[s],” even though the taxpayer “elected to use the grants it received to acquire capital assets”); Baboquivari Cattle Co. v. Commissioner, 135 F.2d 114, 116 (9th Cir. 1943) (holding that government payments made to a taxpayer for improving its land were not contributions to capital because there was not “any restriction on their use,” and the taxpayer was “free to use the money for any purpose it might see fit, as to defray operating expenses or to pay dividends”); Lykes Bros. S.S. Co. v. Commissioner, 126 F.2d 725, 727 (5th Cir. 1942) (holding that government payments that could be used for any “purpose,” and were not “required” by contract to be used for capital assets, did not qualify as contributions to capital); Helvering v. Claiborne-Annapolis Ferry Co., 93 F.2d 875, 876 (4th Cir. 1938) (holding that government payments for operating a ferry “in the public interest” were not “intended” as a “contribution to capital” because they could be used for “operating expenses”).

As the Fifth Circuit has explained, if payments “were available for a multitude of purposes,” and were not provided “exclusively for the specific purpose of making capital improvements, such as building an airport or locating and constructing a plant,” then they were not intended to be “a permanent part of [the taxpayer's] working capital structure, as is demanded by the first CB&Q requirement.” AT&T, 629 F.3d at 520; see also Sprint Nextel Corp. & Subsidiaries v. United States, 779 F. Supp. 2d 1184, 1196 (D. Kan. 2011) (holding that the “permanent part of the transferee's working capital structure” CB&Q factor was not satisfied where the government “did not condition [payments] on capital expenditures,” but instead permitted the payments to be used for “general operating expenses”).

Here, it is undisputed that New Jersey placed “no restrictions” whatsoever on the “use” of the approximately $170 million transferred to BrokerTec's affiliates, as the Tax Court found (Op/JA20) and the record supports (JA341-343, 458 (Transcript)). Nothing in the BEIP's enabling act or the implementing regulations limits the use of the BEIP grants or evidences any intent that the grants become a permanent part of the recipient's working capital structure. See N.J.S.A. 34:1B-120 et seq. (1996); N.J. Assembly Committee Statement, A.B. 1415 (Jan. 29, 1996); N.J. Admin. Code 19-31-10.4 (2001). Significantly, New Jersey administered other benefit programs that did condition grants on investments by the recipient, but the BEIP grants were not so conditioned. (JA341 (Transcript).)

Consistent with this enabling law, the agreements that the BrokerTec affiliates entered into with the NJEDA did not require the affiliates to make any capital investments or to otherwise make the grant funds a permanent part of their working capital structure. (JA753-789, 815-852 (Agreements); JA374, 427-428 (Transcript).) They simply required the affiliate to “create new employment opportunities” in New Jersey and to “pay wages” to eligible employees that were subject to state income tax withholding. (JA753, 815 (Agreements).) Wages, however, are not a capital expenditure. Instead, they are an operating expense, the cost of which is immediately deductible by the business. See I.R.C. § 162.

The undisputed trial testimony further establishes that New Jersey did not intend the grant funds to become a permanent part of the recipient's working capital structure. (JA260, 341-343, 427-428, 433 (Transcript).) Witnesses from the NJEDA confirmed that what the recipient does with the grant money is of “absolutely no concern to the BEIPs program” (JA458 (Transcript)), and that New Jersey did not “care” how the money was used (JA342 (Transcript)). In this regard, they further confirmed, BEIP grants could be used to pay dividends, to invest in foreign countries, or for any other purpose, because the recipient has “unfettered use of these funds.” (JA341-343, 431-434 (Transcript).)

As both witnesses from the NJEDA acknowledged, it was neither New Jersey's purpose nor its intent to contribute capital to the grant recipients. (JA335, 427-428, 433-436 (Transcript).) In evaluating applications for the grant program, the only thing that New Jersey ultimately cared about was how many revenue-raising jobs would be relocated to New Jersey. (JA424-427 (Transcript).) The government's intent was to increase jobs — particularly higher-paying jobs that would increase tax revenue — in specific locations within the state. (JA381-382 (Transcript); JA540 (NJEDA Annual Report).) To achieve that goal, New Jersey supplemented the grantees' operating income by providing them a “percentage” of the new tax revenues that New Jersey would receive. (JA175, 367, 381 (Transcript).) But it was ultimately left to the grantees to determine how to spend the money, and there was no requirement that it become a permanent part of the company's working capital structure. (JA260, 341-343, 382, 427, 433 (Transcript).) Indeed, when the state grants were converted to state tax credits in 2013 (including the grants authorized for BrokerTec's affiliates), the conversion did not change the purpose of the program. And when tax credits are used to reduce an operating expense (tax expense), they cannot — by definition — become part of a taxpayer's permanent working capital structure. (JA259-260, 371-373 (Transcript).)

The fact that BrokerTec's affiliates had to locate their business in Jersey City as a condition for receiving the grant funds cannot change the undisputed fact that there were no restrictions whatsoever on their use of the grant funds. (JA235 (Transcript).) In each of the cases discussed above in which the court concluded that a cash transfer was taxable income rather than a nontaxable capital contribution, the transferee had agreed to do something to earn the funds. See, above, pp. 30-34. But if the transferee was not required to make capital investments, or to otherwise make the funds a permanent part of its working capital, then the cash transfer was intended to be an income subsidy, rather than a capital contribution. Here, it is undisputed that BrokerTec's affiliates did not have to invest “a penny” in leasehold improvements or any other capital expenditure, so long as they were able to provide jobs in the designated locations. (JA366, 374 (Transcript).) On such facts, the Tax Court should have followed the Texas and Pacific Railway line of precedent and concluded that the BEIP grants did not qualify for exclusion under § 118.

2. The BEIP funds were calculated on the basis of an operating expense, not a capital expenditure

To discern whether a transferor intends to contribute cash payments to the recipient's permanent working capital structure, courts also examine the method of calculating the amount of the payments. As the courts have recognized, “the method of calculating the payments at issue informs whether the payments are contributions to capital.” Sprint, 779 F. Supp. 2d at 1195 (holding that payments calculated on the basis of the payee's “expenses” were not contributions to capital). Where the amount of the cash payment is based on the amount of the capital investment, and is thereby designed to fund, or reimburse, that investment, the calculation method evidences that the transferor intended to make a contribution to capital. E.g., Cuba R.R., 268 U.S. at 632 (holding that subsidy payments that were “proportionate” to railway-track “mileage completed” indicated a “purpose to reimburse [the railroad] for capital expenditures”). But where (as here) the amount of a cash payment is not based on the amount of a capital investment, but is instead based on an operating expense (or revenue), the calculation method evidences that the transferor intended to subsidize the recipient's income, rather than contribute to its permanent working capital structure. E.g., Tex. & Pac. Ry., 286 U.S. at 289 (holding that payments measured by “operating income” are not contributions to capital); AT&T, 629 F.3d at 515 (holding that payments tied to “companies' rates charged to customers” are not contributions to capital); Springfield, 577 F.2d at 704 n.12 (holding that payments “measured by [excise] taxes” are not contributions to capital but are “in substance, a recovery of an expense of operations”).

Indeed, courts have determined that cash payments do not qualify as contributions to capital even where the taxpayer's capital investments are a component of the computation of the grant amount. For example, in Coastal Utilities, the Eleventh Circuit determined that certain government payments were not contributions to capital based on the method by which the payments were calculated. 483 F. Supp. 2d at 1243. There, the payments were calculated based on the taxpayer's “investments” as well as its “operating expenses.” Id. at 1242. The court nevertheless concluded that this “mechanism for calculation demonstrates that the [governmental] payments are not intended as a contribution to capital” because “the amount of payments takes into consideration a wide range of operational expenses” and thus the “payments are not solely for capital purposes.” Id. at 1243 (emphasis added); accord Sprint, 779 F. Supp. 2d at 1195.

As these cases make clear, New Jersey's formula for determining the amount of the grant payments is a relevant — and strong — indicator of the government's intent in making the payments. Here, New Jersey's grant formula indicates that it did not intend to contribute to the recipient's permanent working capital structure.

New Jersey described its calculation method as follows: the grant “can equal [up] to 80% of the total amount of state income taxes generated by the grantees' newly created jobs.” (JA540 (NJEDA Annual Report).) As the Tax Court found, the grants “were based on remitted New Jersey State income tax withheld from the recipients' employees' wages,” not on capital expenditures. (Op/JA12.) Indeed, “the need of the [recipient] for capital funds was not considered” when computing the amount of the grant, as was also true in CB&Q. 412 U.S. at 414. To the contrary, the NJEDA's scoring formula (which determined what percentage of income tax withholding the recipient would receive) favored those applicants who had no capital needs and were — like BrokerTec's affiliates — “100%” capitalized. (JA740, 809 (BEIP Formula Evaluations); JA261-265 (Transcript).)

When it was considering whether to relocate to New Jersey, BrokerTec understood that New Jersey's BEIP grant was a financial incentive that was calculated as a percentage of the income taxes paid by its employees to New Jersey, not as a percentage of its capital expenditures. (JA855 (BrokerTec memorandum); JA129-130 (Transcript).) Indeed, BrokerTec described the BEIP grant as a “rebate” of those taxes (reflecting the fact that New Jersey would not pay the grant until its Division of Taxation confirmed the amount of taxes actually received from the employees of BrokerTec's affiliates). (JA855 (BrokerTec memorandum); JA954-955 (BrokerTec email); see JA144-145, 157-159, 244-246 (Transcript).)

The fact that the amount of the grant was defined by an operating expense incurred by BrokerTec's affiliates (wages paid to their employees and withheld for state income tax purposes), and not by any capital outlay, is further evidence that New Jersey did not intend to make contributions to their capital. As in AT&T, the grant program here “did not specifically state whether the payments were intended as income or capital contributions, but by designing the payment mechanisms” to be parallel to, and conditioned on, an operating expense (employee wages), New Jersey's program “narrowed the possibility that the payments could be viewed as anything but income.” 629 F.3d at 515. Indeed, here, the design of the BEIP program eliminated the possibility that the grants could become a permanent part of the recipient's working capital structure: to obtain $1 in grant money, the company would first have to spend far more in labor costs. Accordingly, the grant could minimize the recipient's costs, but could never add to its working capital.

3. The Tax Court erred in equating the State's intent to benefit the public with the intent to provide a nontaxable contribution to capital, as all governmental economic incentive programs, including taxable subsidies, are designed to benefit the public

The Tax Court determined that there was “clear evidence” that New Jersey intended the BEIP grant “to provide a nontaxable contribution to capital.” (Op/JA38.) But in so determining, the court conflated the State's intent to “develop New Jersey's economy” and “bring new jobs to the State” with an intent “to provide a nontaxable contribution to capital.” (Op/JA38-39.) The two are not the same. Many financial incentives provided by state and local government are designed to create jobs or to otherwise serve the “public interest” but are nevertheless taxable income. Claiborne-Annapolis, 93 F.2d at 876; see Ginsburg v. United States, 922 F.3d 1320, 1326 (Fed. Cir. 2019) (holding that refundable portion of state tax credit designed to encourage the development and cleanup of contaminated property was not excludable from income where “there were no restrictions on the [taxpayers'] use of” that payment); G.A. Stafford & Co. v. Pedrick, 171 F.2d 42, 43-44 (2d Cir. 1948) (holding that federal subsidy to encourage exports was taxable income); Baboquivari, 135 F.2d at 116 (holding that government payments did not qualify as nonshareholder contributions to capital even though they were intended for “the general good” of the community); Maines v. Commissioner, 144 T.C. 123, 124, 136-138 (2015) (holding that refundable portion of state tax credit provided “as an incentive” for “economic development” in “targeted locations” was “taxable income”).

What the Tax Court failed to appreciate is that “[a]t the highest level of generality, all government spending should, theoretically, and at least indirectly, be for the purpose of benefiting the community.” Coastal Utils., 483 F. Supp. 2d at 1245. Nevertheless, “[g]overnment subsidies are ordinarily included in gross income unless excluded by a particular statutory provision.” Bittker & Lokken, Fed. Tax'n of Income, Estates & Gifts, ¶16.4 (2019), 1997 WL 439568. A state's offer to subsidize income in return for a taxpayer's engaging in certain activity may be motivated by the state's desire to benefit the public, as New Jersey sought to do through its BEIP grant program. But where (as here) the offer does not meet the specific requirements for a nonshareholder capital contribution, that subsidy is taxable “income” — not nontaxable “capital.” Coastal Utils., 483 F. Supp. 2d at 1245-1246 (holding that the government “payments [at issue] were income even though the general purpose was to benefit the public”).

The fact that New Jersey intended the grants to induce job creation, without more, does not mean that the grants qualify for exclusion under § 118. The Tax Court incorrectly assumed so. (Op/JA38-39.) The relevant question is whether New Jersey intended to induce job creation by contributing to the grant recipient's permanent working capital structure (in which case the grant might qualify under § 118) or whether New Jersey intended to induce job creation by subsidizing the grant recipient's operating income (in which case the grant could not qualify under § 118). The BEIP grant program did not require any capital investment, but did require incurring labor costs. By effectively returning a percentage of those labor costs to the recipient, the BEIP program increased the recipient's operating income, not its permanent working capital.

4. The Tax Court further erred in relying on BrokerTec's unilateral decision to use the BEIP funds to purchase the stock of a wholly owned subsidiary

Ignoring its findings that New Jersey placed no restrictions on the use of the BEIP grants (Op/JA20), and computed the grants as a percentage of an operating expense incurred by BrokerTec's affiliates (rather than their capital needs) (Op/JA12), the Tax Court relied on the fact that the grants were used to purchase Holdings stock (Op/JA42-43). That fact, however, has no bearing on whether New Jersey intended the BEIP grants to be capital contributions. As the Supreme Court made clear, it is the “intent or motive of the transferor” that is controlling, not the “use to which the assets transferred were applied.” CB&Q, 412 U.S. at 411.

Indeed, once a court determines that the transferor permits the funds to be used for “any” purpose, there is no need to determine what the funds were actually used for. E.g., Tex. & Pac. Ry., 286 U.S. at 290. The mere fact that the transferor “did not condition [payments] on capital expenditures” precludes those payments from being considered a “permanent part of [the taxpayer's] working capital structure.” Sprint, 779 F. Supp. 2d at 1196. A taxpayer cannot “bootstrap itself into a favorable decision [under § 118] by self-serving characterizations or actions.” State Farm Road Corp. v. Commissioner, 65 T.C. 217, 228 (1975). As the court in Springfield explained, the fact that the taxpayer there spent the unrestricted government funds on capital assets (buses) “does no more than show that [the taxpayer] elected to use the grants it received to acquire capital assets” that furthered the government's purpose of encouraging “mass transportation,” but “does not sustain the burden of showing that the grants were contributions to capital” by the government. 577 F.2d at 701.

Nothing in the record supports the notion that New Jersey intended BrokerTec's affiliates to use the BEIP grants to purchase Holdings stock. To the contrary, it is undisputed that New Jersey intended the grants to be used for any purpose, and did not care if they were used to purchase stock. (JA427-428 (Transcript).) Indeed, the parties specifically stipulated that the agreements between New Jersey and BrokerTec's affiliates “did not require that Garban and First Brokers use the BEIP grant proceeds for this purpose [i.e., purchasing Holdings stock].” (JA501 (Stipulation).) And, as explained above (§ B.2), the amount of the grant was based on the withheld state income tax (and thus indirectly on the affiliates' labor costs), not the price of Holdings stock. Accordingly, the fact that BrokerTec's affiliates ultimately used the BEIP grants “to acquire all of the stock” of their wholly owned subsidiary (Holdings) (as the Tax Court emphasized (Op/JA42-43)) is irrelevant.

By focusing on BrokerTec's application of the funds, rather than on New Jersey's intent regarding the funds, the Tax Court erred as a matter of law. See CB&Q, 412 U.S. at 411; Springfield, 577 F.2d at 701. To deem the stock purchase relevant, as the Tax Court evidently did, would allow the self-serving, unilateral actions of a transferee to dictate the tax consequences of a grant, rather than the “intent” of the “transferor,” in contravention of binding precedent. CB&Q, 412 U.S. at 411. It would also yield unequal tax treatment among the recipients of the BEIP grants, depending on how they used the unrestricted BEIP funds. Such an approach is untenable.

C. New Jersey expected to receive a direct benefit from BrokerTec's affiliates and, in fact, conditioned the BEIP grants on the receipt of that direct benefit

The unrestricted BEIP cash grants also fail to qualify for income exclusion under § 118 because New Jersey expected to receive a direct benefit in exchange for those grants. As the Supreme Court made clear in CB&Q, a nonshareholder contribution to capital “may not be compensation.” 412 U.S. at 413 (second factor). If the transferor expects to receive a benefit that is “direct,” “specific,” or “certain,” then the transfer is compensation for that benefit and not a contribution to capital. Id. at 411.

This principle is illustrated by John B. White, Inc. v. Commissioner, 55 T.C. 729 (1971), aff'd, 458 F.2d 989 (3d Cir. 1972). In that case, the Tax Court held — and this Court affirmed — that a location-incentive payment provided by a car company (Ford Motor Company) to one of its dealerships did not qualify as a contribution to capital under § 118 because Ford expected “direct benefits” from the taxpayer's relocation. Id. at 736. As the court explained, because Ford “anticipated” that it would “derive valuable direct benefits” from the dealership-taxpayer's relocation, the “incentive payment” there was “consideration” for the direct benefits and not a contribution to capital. Id. If, on the other hand, any benefit that the transferor may receive is at most “speculative” and thereby “indirect,” then the payment is not disqualified from being a nonshareholder contribution to capital. Federated Dep't Stores, Inc. v. Commissioner, 426 F.2d 417, 421 (6th Cir. 1970).

The facts in this case are analogous to those in John B. White, and this Court's binding precedent should be followed here. New Jersey expected to receive a direct benefit from its BEIP grant program, and that benefit was certain and specific. As the New Jersey Assembly emphasized when it enacted the BEIP program, the amount of the grants provided by the program “may not exceed” the amount of the direct benefit that New Jersey would receive in “income tax revenues generated from the new jobs created by the grant recipients.” N.J. Assembly Committee Statement, A.B. 1415 (Jan. 29, 1996). In its annual reports, the NJEDA promoted this direct benefit, noting that, after paying the grant, “New Jersey retains the balance of new income tax revenue generated by the new jobs and is the beneficiary of growth from other ancillary revenues, such as Sales and Corporation Business Taxes, which spin off from economic development.” (JA540 (NJEDA Annual Report).) As BrokerTec's grant consultant acknowledged, a “large factor[ ]” in the BEIP program was increasing New Jersey's “revenue base,” and the tax-based grant computation would “make sure that they're [i.e., New Jersey] making money.” (JA194-195 (Transcript).)

New Jersey not only expected to receive direct benefits from the grant program, but it also insisted on receiving those benefits in advance of paying out the grants. The new tax revenue was the quid pro quo for the grant. Before New Jersey would pay any portion of the BEIP grant to BrokerTec's affiliates, it would first have to certify that it had received the tax revenues generated by the jobs created by the affiliates. (JA426-431 (Transcript); JA766, 828 (Agreements).) And the grant was only a percentage of that received tax revenue. In this way, the grant program was — to use BrokerTec's own term — “self-funded.” (JA159 (Transcript); JA955 (BrokerTec email).) Because the grant program was “self-funded,” and because New Jersey was assured of “making money” (JA159, 194-195 (Transcript)), New Jersey was not exposed to the risk of a capital investment.

To be sure, New Jersey also hoped that the grant payments would more broadly “develop [its] economy and revitalize its cities.” (Op/JA43.) The critical fact remains, however, that New Jersey knew that it would receive a specific, certain, and direct benefit before it paid anything to BrokerTec's affiliates (JA367-369 (Transcript)). And it is that “specific,” “certain,” and “direct” benefit that precludes the unrestricted cash payments from qualifying for exclusion under § 118, CB&Q, 412 U.S. at 411, not the additional, speculative indirect benefit that New Jersey hoped to receive from a developed economy and revitalized cities.

The Tax Court concluded otherwise, holding that the “increased tax revenue of the new business brought to the State under the BEIP” was only an “indirect benefit” of the program. (Op/JA43.) That is incorrect. The new tax revenues received by New Jersey were a “direct” and expected benefit upon which New Jersey conditioned its grant payments to the BEIP recipients, as the undisputed testimony from a NJEDA witness confirms. (JA367-369 (Transcript).) Indeed, that benefit is even more specific, certain, and direct than the benefits at issue in John B. White. In that case, the transferor (Ford) offered the “incentive payment in order to increase the sales of its products and enhance its image” by having the taxpayer's automobile dealership relocate. 55 T.C. at 733. The payment was not conditioned on any actual sales increase or image enhancement. Rather, the payment was made in “anticipat[ion]” that those benefits “could reasonably be expected to follow” the relocation. Id. at 736. Here, in contrast, New Jersey did not merely anticipate some unknown amount of increased tax revenue. Rather, it conditioned its payment on the actual receipt of a specific amount of increased tax revenue, and it calculated the payment as a percentage of that direct benefit. The Tax Court did not cite — and our research has not uncovered — any case in which a cash grant that was effectively funded by the transferee qualified as a contribution to capital.

The Tax Court misplaced its reliance on Brown Shoe and Federated Department Stores in rejecting the Commissioner's direct-benefit argument. (Op/JA43.) Those cases are inapposite. In Brown Shoe, the transferor did not anticipate any “recompense whatever.” 339 U.S. at 591. And in Federated Department Stores, the benefit to the transferor was “speculative” only, and as a result, the payment was in no sense compensation for a specific, certain, and direct benefit. 426 F.2d at 421. The transferor there faced the “risk” that it would not benefit from the taxpayer's services at all. Federated Dep't Stores, Inc. v. Commissioner, 51 T.C. 500, 519 (1968). Here, in sharp contrast, not only did New Jersey receive direct benefits (increased tax revenues), but it also faced no risk whatsoever because it received those benefits before — and as a condition to — the payments it made to BrokerTec's affiliates. Far from being speculative, the exact amount of the direct benefit that New Jersey receives from its location-inducement payment is actually known in advance of the payment being made. And because New Jersey insisted on receiving its “quid” before it provided a grantee its “quo,” the cash grants were referred to by the recipients as a “rebate” of the direct benefits that New Jersey received from the program. (JA855 (BrokerTec memorandum); JA954 (BrokerTec email); see JA144-145, 157-159, 244-246 (Transcript).)

The Tax Court's related suggestion that there is “no nexus between the services provided by [BrokerTec's] affiliates and the aid provided by the donor” (Op/JA43) ignores the fact that the “aid” was conditioned on the “services provided” by the affiliates. If the affiliates did not relocate eligible positions to New Jersey and employ a specified number of employees and pay them wages from which tax revenues would flow to New Jersey, then the affiliates would receive no “aid” whatsoever.

The disqualifying “direct benefit” provided to New Jersey need not be the specific service that BrokerTec's affiliates provide their general customers (financial services). Compensation can be deemed taxable income even when it is provided for direct benefits other than a taxpayer's usual business offerings. For example, in Consolidated Edison Co. of New York, Inc. v. United States, 10 F.3d 68, 70 (2d Cir. 1993), the local government provided the taxpayer (a utility company) a “discount” on its local taxes in exchange for the early payment of those taxes. The discount was deemed to be taxable income because it was paid by the government “as consideration for [the taxpayer's] agreement to prepay its tax liability.” Id. at 73-74. That direct financial benefit to the government was wholly unrelated to the taxpayer's utility business.

Similarly, in Deason v. Commissioner, 590 F.2d 1377 (5th Cir. 1979), the court held that payments made by the federal government to the taxpayer were income rather than contributions to capital even though the taxpayer was not providing services to the government. There, the taxpayer received the payments in exchange for its agreement to hire and train certain individuals. The court held that the payments were consideration for the taxpayer's job-training “services,” even though the government was not itself the recipient of those services. Id. at 1379. That holding is consistent with the plain language of the Treasury regulation, which excludes from § 118 “money or property transferred to the corporation in consideration for goods or services rendered” without requiring that the goods or services be rendered to the transferor. Treas. Reg. § 1.118-1.

D. The authorities cited by the Tax Court do not support its conclusion

1. Treasury Regulation § 1.118-1 does not displace the Supreme Court's CB&Q analysis or address unrestricted cash payments provided as a location inducement

Contrary to the Tax Court's opinion, the “facts in this case” by no means “fall squarely” within Treasury Regulation § 1.118-1. (Op/JA39.) The regulation sets out the general rule that “any contribution of money or property to the capital of the taxpayer” is excluded from gross income under § 118 and clarifies that the exclusion “applies to contributions to capital made by persons other than shareholders.” Treas. Reg. § 1.118-1. It does not provide a test for evaluating whether a specific transfer qualifies as a contribution to capital. Rather, it sets out “contrasting examples” of when the exclusion applies and when the exclusion does not apply that are “derived from a series of Supreme Court cases” discussed above in § A. Coastal Utils., 483 F. Supp. 2d at 1238 & n.8. The examples do not purport to define the limits of either category. Treas. Reg. § 1.118-1; Federated Dep't Stores, 426 F.2d at 422 (observing that “by express language,” the examples in Treasury Regulation §1.118-1 are “not intended to be exclusive of other possible applications”).

As relevant here, the regulation does not address an unrestricted cash grant provided by a nonshareholder to a company as an incentive for it to relocate its business to a certain location. Rather, the regulation explains, by way of a descriptive example, that “the exclusion applies to the value of land or other property contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the corporation to locate its business in a particular community, or for the purpose of enabling the corporation to expand its operating facilities.” Treas. Reg. § 1.118-1. This example, however, is specifically cast in terms of the transfer of capital assets, “land or other property,” not unrestricted money, such as the BEIP grants.⁵

In any event, the regulation says nothing about the situation where the transferor makes cash payments in exchange for a direct benefit and does not restrict the cash to acquiring capital assets or otherwise contributing to the permanent working capital of the corporation. As noted above, a cash payment cannot qualify as a nonshareholder “contribution to capital” if the transferor (i) does not intend the payment to “become a permanent part of the transferee's working capital structure” or (ii) receives a direct benefit. CB&Q, 412 U.S. at 413 (first two factors). Treasury Regulation § 1.118-1 is not to the contrary. Promulgated in 1956, the regulation could not overrule the 1973 CB&Q decision. See T.D. 6220 (1956), 1957-1 C.B. 34 (final regulations); 21 Fed. Reg. 10484 (1956) (proposed regulations). Here, New Jersey transferred cash without imposing any restrictions whatsoever after receiving a direct benefit from the transferee. Under the test set out in CB&Q, and similar to the facts in cases such as Texas & Pacific Railway, the cash grant here does not qualify for exclusion under § 118.

2. Brown Shoe and McKay Products are distinguishable because there (unlike here) the transferors contributed capital assets or payments that were intended to become a permanent part of the transferee's working capital

The Tax Court's reliance on Brown Shoe and McKay Products is misplaced. Although the court held that both decisions were “strikingly similar” to this case (Op/JA39), they are in fact materially distinguishable. Specifically, both cases are distinguishable in the critical respect that the first and second factors of the CB&Q test — that the payment (a) “certainly must become a permanent part of the transferee's working capital structure” and (b) cannot be “compensation” (412 U.S. at 413) — were satisfied in Brown Shoe and McKay Products but are not met here.

a. In McKay Products, a community group transferred to the taxpayer an asset so that it could become a permanent part of the corporation's working capital structure — “a plant for the conduct of its business.” 178 F.2d at 640; accord id. at 642 (describing the contributed plant as “working assets committed to the [taxpayer's] enterprise”). The Court ruled that the taxpayer was entitled to include the cost of the plant in its basis for depreciation because it represented “invested capital” that was “used by the taxpayer in the operation of its business.” Id. at 642-643. Unlike this case, McKay Products did not involve the payment of unrestricted cash grants. Rather, it involved a transfer of what clearly was a capital asset that added to the taxpayer's “committed” — and therefore permanent — “[w]orking capital.” Id. at 642.

Brown Shoe is similarly distinguishable from the case at bar. As in McKay Products, in Brown Shoe, community groups transferred capital assets (land and buildings) to a manufacturing company as an inducement to locate or expand factories in the communities, and the Court held that such capital assets were capital contributions and were depreciable by the company. 339 U.S. at 589. The community groups also transferred cash to the company, but did so pursuant to contracts that required the company to invest in capital assets as a condition for receiving payments. Id. at 586-587. As the Court emphasized, “[i]n every instance the cash received by [the company] was less than the amount expended by it for the acquisition or construction of the local factory building and equipment.” Id. at 587. Although the cash was deposited into the company's “general bank account,” and was not “earmarked” or segregated for any specific purchase, the transfers of the cash were expressly made in consideration for the company's promise to construct or expand particular factories and to operate them for specified periods. The arrangement implicitly restricted the use of the cash, ensuring that it became a permanent part of the company's working capital. Id. at 586-587.

On these facts, the Court in Brown Shoe found that the transfers were “additions to 'capital' as that term has commonly been understood in both business and accounting practice” and allowed the company to depreciate the buildings even if they were “acquired with cash” transferred by the community groups. 339 U.S. at 588-589 & n.11. In other words, in the parlance of CB&Q, 412 U.S. at 513, the assets transferred were intended to, and did, become “a permanent part of the transferee's working capital structure.” That is not true of the unrestricted cash grants at issue here, which were not paid in order to make a capital investment and which could — among other things — be paid out to shareholders as dividends. See, above, § B.1.

The Tax Court's suggestion (Op/JA41-42) that McKay Products defined when a cash payment is intended to become “working capital” is incorrect. As noted above, that case did not concern a cash payment, but instead concerned a capital asset (a building). And the Supreme Court in Brown Shoe did not “adopt[ ]” a “definition of working capital” from McKay Products, as the Tax Court further suggests (Op/JA42). Rather, to exemplify the common understanding of “capital” in the context of nonshareholder contributions to capital, the Supreme Court in Brown Shoe cited its earlier ruling in Texas & Pacific Railway and the appellate rulings in Lykes Brothers and Claiborne-Annapolis.⁶ 339 U.S. at 589 & n.11. By doing so, the Court reaffirmed its prior holding that completely unrestricted cash payments cannot be contributions to capital. Tex. & Pac. Ry., 286 U.S. at 290. Nothing in McKay Products — which, again, did not concern cash payments — is to the contrary. A cash payment that can (as here) be used to pay for anything, including operating expenses or dividends, is not cash that is intended to be invested “in the business” so as to constitute a “stake” in that business.⁷ (Op/JA42 (quoting McKay Products, 178 F.2d at 642).)

The Tax Court's passing reference to the accounting definition of “working capital” as “'current assets less current liabilities'” (Op/JA42 n.14) sheds no light on the issue here. All payments — including income subsidies — add to current assets and are, under this definition, working capital. That accounting concept is distinct from § 118's requirement that a transferor intend a payment to become a permanent part of a taxpayer's working capital structure. Moreover, the court's reliance on accounting concepts ignores the fact that BrokerTec did not treat the BEIP payments as capital for book and financial-reporting purposes. (JA512-538 (Tax Returns).)

Disregarding Texas & Pacific Railway and related analogous authority, the Tax Court latched onto the fact that this case, Brown Shoe, and McKay Products all involved assets that were transferred for the purpose of inducing a company to locate its business in a certain area. (Op/JA39.) But that common fact — standing alone — does not make those cases materially similar to the one at hand. As discussed above in § C, John B. White was also a location-inducement case, and there the Tax Court held — and this Court agreed — that the payment designed to induce the taxpayer's relocation did not qualify for income exclusion under § 118. See also HMW Indus., Inc. v. Wheatley, 504 F.2d 146, 155 (3d Cir. 1974) (holding that government payments made to induce businesses to locate in the U.S. Virgin Islands was not a “non-shareholder contribution to capital”).

There is no blanket exclusion from income for location inducements, as the Tax Court erroneously suggested. (Op/JA39-40.) Brown Shoe and McKay Products did not turn on the fact that the payments were location inducements. They were decided based on the fact that the transferors intended to add to the transferees' permanent working capital structure. Indeed, when the Supreme Court distilled the relevant factors from Brown Shoe in CB&Q, it did not list “location inducement” as a factor. 412 U.S. at 413.

b. Further distinguishing Brown Shoe and McKay Products is the fact that the transferors there did not receive direct benefits from the transferee's relocation, whereas the transferor here did. In particular, neither Brown Shoe nor McKay Products addressed a government cash transfer made in exchange for receipt of actual tax revenue generated by a relocation. As explained above (§ C), if a transferee receives a location inducement as “compensation” for benefits provided to the transferor, CB&Q, 412 U.S. at 413, then the inducement does not qualify as a contribution to capital, see John B. White, 55 T.C. at 736. In Brown Shoe and McKay Products the transferors received — at most — only speculative, indirect benefits, whereas here, New Jersey received actual, direct benefits in exchange for the BEIP grants.

In short, the Tax Court's decision to allow BrokerTec to avoid taxation on the $56 million subsidy that it received from New Jersey during the years at issue is wholly unsupported. Contrary to the Tax Court's flawed reasoning (Op/JA39-40), the fact that the case involves a location inducement does not mandate that the $56 million be treated as a contribution to capital. As the Supreme Court made clear in CB&Q, part of the required inquiry into the transferor's intent is to determine what the transferor intends the funds to be used for and whether the funds are intended as compensation rather than capital. If the transferor intends that a location inducement become a “permanent part” of the transferee's “working capital structure,” and receives no direct benefit in exchange, then it may be excludable as a contribution to capital. CB&Q, 412 U.S. at 413 (first two factors). But if — as here — the transferor merely intends to subsidize the transferee's relocated business, permits the transferee to use the funds for either capital or noncapital purposes, and receives a direct benefit from the transferee's relocation, then the contribution cannot qualify for exclusion under § 118.⁸

CONCLUSION

OCTOBER 2019

The decision of the Tax Court should be reversed.

Respectfully submitted,

RICHARD E. ZUCKERMAN
Principal Deputy Assistant Attorney General

TRAVIS A. GREAVES
Deputy Assistant Attorney General

GILBERT S. ROTHENBERG
(202) 514-3361
TERESA E. MCLAUGHLIN
(202) 514-4342
JUDITH A. HAGLEY
(202) 514-8126
N.Y. State Bar No. 2427797
Attorneys
Tax Division
Department of Justice
Post Office Box 502
Washington, D.C. 20044