Rate Reduction for D.C. QHTC Capital Gains to Begin… in 2019

By , and on January 23, 2015

Investors keeping a close eye on pending legislation (the Promoting Economic Growth and Job Creation Through Technology Act of 2014, Bill 20-0945) promoting investments in D.C. Qualified High Technology Companies (QHTC) will be happy to know it passed—but not without a serious caveat. While the bill was originally set to allow investors to cash in their investments after being held continuously for a 24-month period, the enrolled Act (D.C. Act 20-514) was amended to make the rate reduction applicable January 1, 2019 (at the earliest).

Background

In September 2014, the D.C. Council began reviewing a proposal from Mayor Gray that would lower the tax rate to 3 percent for capital gains from the sale or exchange of eligible investments in QHTCs, as previously discussed by the authors here. As introduced, the bill was set to be applicable immediately; however, all that changed when an amendment was made on December 2 that restricts applicability of the Act to the latter of:

  • January 1, 2019 to the extent it reduces revenues below the financial plan; or
  • Upon implementation of the provisions in § 47-181(c)(17).

As noted in the engrossed amendment, this was done to “ensure that the tax cuts . . . codified by the 2015 Budget Support Act (BSA) take precedence.” These cuts, previously discussed by the authors here and here, include the implementation of a single sales factor, a reduction in the business franchise tax rate for both incorporated and unincorporated businesses, and switch from cost of performance sourcing to market-based sourcing for sale of intangibles and services.

The Act was quickly passed on December 22 with the amendment language included and a heavy dose of uncertainty regarding when the reduced rate will apply (if at all), since it is tied to the financial plan and BSA. Practically, this leaves potential investors with the green light to begin purchasing interests in QHTCs, since the Act is effective now, yet leaves these same investors with uncertainty about the applicability of the reduced rate.

Practical Questions Unresolved 

The enrolled Act retains the same questionable provisions that were originally present upon its introduction, raised by the authors here. Specifically the language provides that the Act applies “notwithstanding any other provision” of the income tax statute and only to “investments in common or preferred stock.” The common or preferred stock provisions appear to arbitrarily exclude investments in pass-through entities, despite the fact that they are classified as QHTCs, disallowing investors that otherwise would be able to take advantage of the rate reduction. In addition, the Act lacks clarity regarding the practical application of basic tax calculations, such as allocation and apportionment. The Act seems to stand for the proposition that the investments should be set apart from the rest of the income of an investor, but to what extent? Absent regulations or guidance from the Office of Tax and Revenue (OTR), taxpayers taking advantage of the rate reduction in 2019 may fall into a Wild West-like situation and are encouraged to take advantage of the most favorable positions regarding categorization, allocation and apportionment, and losses.

Constitutional Limitation or Opportunity?

Because the favorable tax rate in this Act is imposed on investments in in-state companies only (since by definition a QHTC must be located in the District), serious constitutional questions are raised. The dormant Commerce Clause prohibits state taxation or regulation that discriminates against or unduly burdens interstate commerce and thereby ‘imped[es] free private trade in the national marketplace.’ ” Gen. Motors Corp. v. Tracy, 519 U.S. 278, 287 (1997). “No State, consistent with the Commerce Clause, may ‘impose a tax which discriminates against interstate commerce … by providing a direct commercial advantage to local business.” Boston Stock Exch. v. State Tax Comm’n, 429 U.S. 318, 329 (1977) (invalidating New York statute that reduced the transfer tax on securities sales if the sale of securities took place on an exchange within the state because the tax scheme “foreclos[ed] tax neutral decisions” and “creat[ed] both an advantage for the exchanges in New York and a discriminatory burden on commerce to its sister States.” Along the same lines, the Supreme Court found in Fulton Corp. v. Faulkner, 516 U.S. 325, 333 (1996), held that a North Carolina intangibles tax was impermissibly discriminatory because it “taxe[d] stock only to the degree that its issuing corporation participates in interstate commerce [and] favors domestic corporations over their foreign competitors in raising capital among North Carolina residents . . . discourag[ing] domestic corporations from plying their trades in interstate commerce.”

The QHTC rate reduction with “no doubt . . . facially discriminates against interstate commerce” like the Court found in Fulton and Boston Stock Exchange. Any investor in the District is impermissibly incentivized to keep their investments local (based on the favorable rates allowed on the basis of the company’s location) and not invest in the interstate market, where D.C. would tax their gains at an increased rate. This is a classic example of the economic protectionism the dormant Commerce Clause is aimed to prevent. While the violation is clear, the implications of this violation are not. There is a real possibility that far more companies will be able to take advantage of the rate reduction (e.g,. investments in otherwise QHTC-qualifying companies located outside the District). Because the QHTC qualifications are extremely broad, available here, there is a strong argument that OTR may be compelled to honor the lower rate for investments in companies outside the District.

The questionable constitutionality of in-state rate reductions is not specific to the QHTC or even the District. Taxing jurisdictions routinely adopt protectionist measures that run afoul of the commerce clause. For example, New York offers a reduced rate for “eligible qualified New York manufacturer” that similarly should be expanded beyond New York due to discrimination and economic protectionism. Oklahoma has a similar deduction that allows a taxpayer to adjust its Oklahoma taxable income for qualifying gains receiving capital treatment that result from the “sale of all or substantially all of the assets of an Oklahoma company,” which is defined as “an entity whose primary headquarters have been located in Oklahoma for at least three (3) uninterrupted years prior to the date of the transaction from which the net capital gains arise.” Just like the QHTC provision in the Act, these rate reductions based on an in-state interest are facially discriminatory and should be broadened—not struck down—so they fall outside the limitations of the dormant Commerce Clause. Taxing jurisdictions that adopt such constitutionally suspect measures put their taxpayers and fisc at risk. This is unfortunate, because it is not difficult to craft an effective incentive package that is also constitutional.

Practice Note: Any company that invests in a technology company should consider taking the stance that they are entitled to the reduced rates offered by the Act on capital gains. As noted, short-term investments do not qualify under the Act—they must be held for at least 24 months—and the applicability of the rate reduction will not begin until 2019 (or beyond).

The authors encourage any District taxpayer considering investing in or selling a businesses to contact the authors and explore the possibility of classifying the investment as a QHTC, regardless of whether the investment is in a D.C. company.

Eric CarstensEric Carstens
  Eric D. Carstens focuses his practice on state and local tax matters, assisting clients with state tax controversy, compliance and multistate planning across all states for a variety of tax types and unclaimed property. Eric engages in all forms of taxpayer advocacy, including litigation, legislative monitoring and audit defense. He works closely with several of the Firm's taxpayer coalitions focused on specific state tax policy issues such as the taxation of digital goods and services and unclaimed property. Read Eric D. Carstens' full bio.


Diann SmithDiann Smith
Diann Smith focuses her practice on state and local taxation and unclaimed property advocacy. Diann advises clients at any stage of an issue, including planning, compliance, controversy, financial statement issues and legislative activity. Her goal is to find the most effective method to achieve a client's objective regardless of when or how an issue arises. Diann emphasizes the importance of defining a client's objective - whether it is finality of a frequently audited issue, quick resolution of a stand-alone tax liability, or avoiding competitive disadvantages in the application of a tax. The defined objective then governs the choice of the path to a solution. Read Diann Smith's full bio.


Stephen P. KranzStephen P. Kranz
Stephen (Steve) P. Kranz is a tax lawyer who solves tax problems differently. Over the course of his extensive career, Steve has acquired specific skills and developed a unique approach that helps clients develop and implement holistic solutions to all varieties of tax problems. He combines strategic thinking with effective skills for the courtroom, the statehouse and the conference room. Read Stephen P. Kranz's full bio.

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