Category: Corporations
Subject: Taxability of Government Subsidies
Title: Grant From City to Make Capital Improvements
IRC Sections: 118(a)
Filename: 1081.html
Date Produced: 7/97

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Facts
Taxpayer is an S corporation which has real estate holdings. Taxpayer received a substantial grant from the local city government. Under the terms of the grant, the taxpayer was required to use the grant money to make capital improvements to a particular property owned by the taxpayer and located in the city making the grant.

Issue
Is the grant taxable?

Answer
The grant is not taxable.

Discussion of Authorities
Section 1.61-1(a) of the Income Tax Regulations provides, in part, that gross income means all income from whatever source derived, unless specifically excluded by law. Section 118(a) of the Code provides that in the case of a corporation, gross income does not include any contribution to the capital of the taxpayer. Section 1.118-1 of the regulations provides, in part, that section 118 also applies to contributions to capital made by person 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.

The legislative history of section 118 of the Code provides, in part, as follows:

This (section 118) in effect places in the Code the Court decisions on the subject. It deals with cases where a contribution is made to a corporation by a governmental unit, chamber of commerce, or other association of individuals having no proprietary interest in the corporation. In many such cases because the contributor expects to derive indirect benefits, the contribution cannot be called a gift: yet the anticipated future benefits may also be so intangible as to not warrant treating the contribution as a payment for future services. S. Rep. No. 1622, 83rd Cong., 2nd Sess. 18-19 (1954).

In Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1943), 1943 C.B. 1019, the Supreme Court held that payments by prospective customers to an electric utility company to cover the cost of extending the utility's facilities to their homes, were part of the price of service rather than contributions to capital. The case concerned customers' payments to a utility company for the estimated cost of constructing service facilities (primary power lines) that the utility company otherwise was not obligated to provide. The Court found that the customers intended no contribution to the company's capital.

In Brown Shoe Company v. Commissioner, 339 U.S. 583 (1950), 1950-1 C.B. 38, the Supreme Court held that payments to a corporation by community groups to induce the location of a factory in their community represented a contribution to capital. The court concluded that the contributions made by the citizens were made without anticipation of any direct service or recompense, but rather with the expectation that the contribution would prove advantageous to the community at large. The contract entered into by the community groups and the corporation provided that in exchange for a contribution of land and cash, the corporation agreed to construct a factory, operate it for at least 10 years and meet a minimum payroll.

In United States v. Chicago, Burlington & Quincy Railroad Co., 412 U.S. 401 (1973), 1973-2 C.B. 428, the Supreme Court, in determining whether the Taxpayer was entitled to depreciate the cost of certain facilities that had been funded by the federal government, held that the governmental subsidies did not constitute contributions to the Taxpayer's capital. The Court recognized that the holding in Detroit Edison had been qualified by its decision in Brown Shoe. The distinguishing characteristic between these two cases was found to be the differing purposes motivating the respective transfers. In Brown Shoe the only expectation of the contributors was that such contributions might prove advantageous to the community at large. Thus, since the transfers were made with the purpose, not of receiving direct service or recompense, but only of obtaining a benefit for the general community, the result was a contribution to capital.

The Court in that opinion also stated that there were other characteristics of a non-shareholder contribution to capital implicit in Detroit Edison and Brown Shoe. From these two cases the Court distilled what it thought were some of the characteristics of a non-shareholder contribution to capital under both the 1939 and 1954 Codes:

1. It 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 must foreseeably result in benefit to the transferee in an amount commensurate with its value; and

5. The assets ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect.

In determining whether a transfer of money qualifies as a non-shareholder contribution to capital under section 118 of the Code, the transfer must be examined from both sides of the transaction. First, the transferor's intent must be determined. If the transferor does not have the requisite motivation, the analysis ends and there is no contribution to capital. However, if the transferor has the requisite motivation, then the analysis shifts to the recipient corporation and the determination is made whether the transfer has the necessary economic effect on the corporation. If so, the transfer qualifies as a contribution to capital. In other words, in order for a transaction to qualify as a non-shareholder contribution to capital under section 118 of the Code, not only must the transferor have the requisite intent or motive, the transfer must have a certain economic effect on the recipient corporation. If either the requisite motivation or the necessary economic effect is lacking, the transfer does not qualify as a contribution to capital.
Those cases which have considered the question whether cash payments are income or contributions to capital have distinguished between cash payments restricted to use in purchasing assets and cash payments which are unrestricted and available for any use the corporation makes of them. The earliest of such cases is the premier authority on the issue, Edwards v. Cuba Railroad Co., 268 U.S. 628 (1925), IV-2 C.B. 122.

In Cuba Railroad Co., the Supreme Court had held that money subsidies (proportionate to mileage completed) paid by the Cuban government to promote construction of railroads in Cuba and used for capital expenditures were not taxable income, notwithstanding that the cost of construction carried on the books was not reduced by such payments. The Court said, supra at 632, 45 S. Ct. at 615:

The subsidy payments were proportionate to mileage completed; and this indicates a purpose to reimburse plaintiff for capital expenditures. . . Neither 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.

The Supreme Court distinguished Detroit Edison and Brown Shoe, by focusing on the intent or motive of the transferor. In Detroit Edison the Court concluded that the customers regarded the payments as the price of the service and had no intention of making a capital contribution to capital. The community groups had the necessary intent or motive.

In Texas & Pacific Ry. v. United States, 286 U.S. 285 (1932), XI-1 C.B. 263, and Continental Tie & Lumber Co. v. United States, 286 U.S. 290 (1932), XI-1 C.B. 260, the question was whether payments by the federal government to railroads under sections 209 and 204, respectively, of the Transportation Act of 1920 constituted taxable income. In holding that such payments were taxable income, the Supreme Court noted that the "underlying purpose of Congress" was the same in both cases, namely a partial redress for losses due to federal control and/or operation. The Court stated that:

The sum received under the act were not subsidies or gifts, --that is, contributions to the capital of the railroad, -- and this fact distinguishes cases such as Edwards v. Cuba Railroad Co., 268 U.S. 628, where the payments were conditioned upon construction work performed. Here they were to be measured by a deficiency in operating income, and might be used for the payments of dividends, of operating expenses, of capital charges, or for any other purposes . . . operating revenue might be applied. The Government's payments were not in their nature bounties, but an addition to a depleted operating revenue consequent upon a federal activity.

In Springfield Street Railway Co. v. United States, 577 F.2d 700 (Ct. Cl. 1978), the Court of Claims found that grants by the Commonwealth of Massachusetts to a taxpayer were not conditioned on the taxpayer's use of such funds for the acquisition of capital assets. As a result, such funds were not considered to be contributions to capital and were included in the taxpayer's gross income.

Conclusion
It seems fairly clear that the taxpayer in this case has received a non-shareholder capital contribution from the local government. Looking at the five characteristics set forth in United States v. Chicago, Burlington & Quincy Railroad Co, I believe the taxpayer's circumstances comply with all five requirements.

1. Given that the local government grant required the monies to be expended for capital improvements to the taxpayer's property, I think it would be fair to say that the grant in question is a permanent part of the taxpayer's working capital structure.

2. Based on the facts as I understand them, it does not appear that the grant is direct payment for any kind of services provided by the taxpayer.

3. I would assume that the grant was received only after some kind of application process and only as quid pro quo for making the capital improvements to the property. Accordingly, I believe the taxpayer's grant was bargained for.

4. I can only assume that the local government would not have made the grant absent a belief that the value to be derived therefrom was commensurate with the amount of the grant.

5. It seems to me that the capital contributions in question will be employed by the taxpayer to produce additional income from this property.

Based on the foregoing, I conclude that the local government grant is properly treated as a non-shareholder capital contribution and is thus excludable from gross income.