In the April 18, 2005 Issue:

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Publisher's Note: After a week where most of the country spent time slaving over their tax returns last week (or slaving over requests for an extension), it seems only fitting that this week's Digest focuses for the most part on taxes.  With the exception of breaking news from Montana and this week's useful stat, the articles in this issue take a look at a variety of tax issues that affect the TBED community. We report on approaches that two states will be taking as a result of new legislation, a proposal to extend the federal R&D tax credit, and recent research on tax credits. Next week's issue will resume its normal format.

Montana Legislature Passes $60 Million VC Act
Venture capital investments in Montana may have become a little more attractive last Friday as the Montana House of Representatives passed the Montana Equity Capital Investment Act, moving the legislation to Gov. Brian Schweitzer for his consideration and expected signature.

To maximize the rate of return for investors, Senate Bill 133 calls for the creation of a $60 million Montana Equity Fund, which will be used as a provisional financial safety net for investors and distributed as tax credits should investments go badly. Adopting what is commonly referred to as the Oklahoma model, the act also establishes the Montana Capital Investment Board to oversee the fund's activities.

The goal of S.B. 133 is to attract local and out-of-state venture investment funds by providing a guaranteed monetary return to investors through tax incentives. The program is expected to mobilize capital in the state, creating a permanent source of funds that will be available for academic, technological and innovative start-up companies as well as expanding businesses.

More information on the Montana Equity Capital Investment Act is available at: http://data.opi.state.mt.us/bills/2005/billhtml/SB0133.htm

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New Mexico Adds Tax Credit, Loan Program to TBED Portfolio
Tech firms in New Mexico received happy tax news on April 4 as Gov. BIll Richardson signed several bills to encourage economic growth across New Mexico. House Bill 410 authorizes the Small Business Technology Tax Credit, created to attract R&D investment into the state by providing small companies with a three-year “tax holiday.” The tax credit is available to businesses with total revenue of $5 million or less, no more than 25 employees, and qualified research expenditures of at least 20 percent.

Gov. Richardson also signed H.B. 518, the SMART Money Initiative, which creates a $10 million fund to be used as loans for companies looking to build or expand in New Mexico, particularly in rural areas. The initiative will be administered by the New Mexico Finance Authority and is estimated to grow to $30 million over 10 years with loan paybacks. The governor anticipates the state's one-time $10 million investment will net approximately 3,000 jobs over the decade.

Both bills were priorities for Gov. Richardson during this session of the state legislature (see the Jan. 24 issue of the Digest). For more information on the individual bills, visit the New Mexico Legislative website at http://legis.state.nm.us/.

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New York Budget Calls for New Oversight of Empire Zones
New York's Empire Zones Program dodged a veto from Gov. George Pataki as an agreement was met with the legislature to restructure the program. The state budget, signed into law last week, extends the program and allows for an additional 12 zones to be created throughout the state.

Under the agreement with the legislature, Gov. Pataki will give up some control of the administration of the program to a new board, which will oversee creation of the new zones and rule on boundary issues for all existing zones, according to an article in the New York Times. The new board will consist of a panel of representatives appointed by the legislature and the governor.

Currently administered solely by the Empire State Development Corporation (ESD), the program provides tax benefits to companies operating inside a specific area that create jobs. Benefits are not provided to companies based on job projection, according to ESD, rather on jobs created or qualified business activity.

The program has over the past few years come under scrutiny from critics saying it is ineffective and blaming the program for contributing to sprawl through increased zones in suburban areas. Growing concerns that the program has strayed from its mission of revitalizing the most blighted areas also have risen from state lawmakers. State Comptroller Alan Hevesi conducted audits on 11 of the zones last year, reporting they were poorly administered, kept inadequate records, and did not hold firms that received tax breaks accountable for actually producing jobs.

Other findings revealed that 47 percent of businesses within the zones created fewer jobs than promised and 23 percent actually lost jobs, according to Hevesi's press office. A recent article in the New York Times reported that the governor's office disputes the claim that tax breaks were given to companies that lost jobs. The governor's office has maintained that the program is a success, stating that during the challenging years of 2000-2002, certified businesses within the zones added more than 56,000 new jobs, outpacing the national average.

Both Gov. Pataki and the legislature do agree that reforms are needed to maximize the effectiveness of the program and prevent abuse. Gov. Pataki recently updated his proposals for reform submitted last year to the legislature, including:

To ensure that benefits given to companies are more proportional to job creation and investment and to reduce the potential for abuse, ESD advocates revising tax law formulas, according to a press statement by chairman Charles Gargano. The newly created board, however, will decide all future changes to the program.

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Federal R&D Tax Credit to Become Permanent?
Legislation that would extend and expand the federal research tax credit was introduced in the U.S. Senate last month. Senate Bill 627 seeks to make permanent the research credit that was first enacted in 1981 and is set to expire Dec. 31, 2005. The bill, sponsored by Orrin Hatch (R-Utah), also would provide an alternative simplified credit for qualified research expenses and increase the rates of the alternative incremental credit.

The simplified credit addresses changes in business models and economic circumstances that currently prevents some businesses from using the credit. Under S.B. 627, companies could receive a credit of 12 percent for qualified research expenses that exceed 50 percent of the average of those expenses for the three previous years. The credit would be 6 percent for companies having qualified research expenses in just one year.

Qualified research expenses include in-house expenses for wages paid and supplies used in the conduct of qualified research, and up to 75 percent of contract expenses for qualified research, according to the Internal Revenue Service. The credit presently is equal to the sum of 20 percent of the excess of qualified research expenditures for the taxable year over a base amount, and 20 percent of basic research payments.

The alternative incremental credit tax credit is available for companies having dramatically increasing sales figures or otherwise stagnant research expenditures. Under S.B. 627, rates for this three-tiered credit would increase from 2.65 percent to 3 percent, 3.2 percent to 4 percent, and 3.75 percent to 5 percent.

In introducing the bill, Hatch said the regular research credit would serve as a staple to the thousands of research-based companies in his state, Utah, where high tech jobs paid nearly 10 percent of wages in 2004 -- this, despite comprising only 5 percent of the state's workforce. The legislation cites the impact of R&D performed in the U.S. to produce "quality jobs, better and safer products, increased ownership of technology-based intellectual property, and higher productivity in the United States."

The federal R&D tax credit has been extended a dozen times since it was first offered in 1981. At least 34 states have their own versions of the R&D credit, but several states have recently considered eliminating their R&D tax credit - most notably California.

S.B. 627, the Investment in America Act of 2005, has been referred to the Committee on Finance; it is available through Thomas Locator at http://thomas.loc.gov/. For more information on the federal research tax credit, visit: http://www.irs.gov/businesses/small/industries/article/0,,id=97643,00.html#aic

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Recent Research
Tax Credits Are Good for Companies, But Do They Make Good Policy?
Do tax credits pave the way for more investment in R&D and equity investments in new enterprises? Or, do they reward companies and venture capitalists for investments they would have made anyway?

Discussions on these questions can become quite heated and fueled by data supportive of both sides, as two new academic analyses demonstrate.

The recent studies examine two Canadian business tax credits, but come to opposite conclusions. One study reviews the impact of Canadian R&D tax credits, a permanent feature of the Canadian tax code. A second study focuses on a Quebecquoise investor credit established a decade ago to encourage local venture capital to the region.

In Evaluating the Impact of R&D Tax Credits on Innovation: A Microeconometric Study on Canadian Firms, Dirk Czarnitzski, Petr Hanel and Julio Miguel Rosa use national survey data to compare firms who claimed the credit with similar firms who did not. Canada offers companies an R&D tax credit of 35 percent for the first $2 million and another 20 percent on any excess amount (see article above for U.S. comparison). Individual provinces provide additional credits so that some companies can write off up to as much as 50 percent of their R&D expenditures. Roughly a third of all companies take advantage of the Canadian R&D tax credit.

Based on econometric modeling, the authors found that R&D tax credits had the following positive impact:

According to the analysis, one-third of the firms taking the credit might not have conducted R&D without the credit. Czarnitzski, Hanel, and Rosa found tax credit recipients were twice as likely to introduce a world-first invention (17 percent versus 8 percent) and were a third more likely to have a unique Canadian product (40 percent versus 24 percent) than the non-credit-taking firms. However, the authors found no significant difference on general performance indicators between the credit recipients and the control group based on analysis of company responses to subjective questions on the national survey.

In the second paper, Cecile Carpentier and Jean-Marc Suret of Laval University analyze the ownership and operating performance of the tax-sheltered investor groups established under a Quebec tax law. In their paper, On the Usefulness of Tax Incentives for Business Angels and SME Owners: an Empirical Analysis, the authors conclude tax incentives for venture capital were not effective in Quebec.

The tax benefits for small business capitalization have failed to deliver its desired results ­ and may only provide tax credits for informal investors related to the venture in some way. The Quebec program appears to benefit “companies with low profitability, most of which disappear after a few years.” Based on their analysis, Carpentier and Suret note that the tax incentives appear to add to market inefficiencies ­ investors can write off such a high level of their investment they are not motivated to actively monitor their investment nor negotiate some element of control.

Carpentier and Suret suggest that tax credits focus on external investors, who might take on the high risk of a new venture that is untried and demand greater controls and accountability from the new enterprise. The authors note the Quebec program actually prohibits any shared risk via convertible shares ­ a contractual arrangement favored by investors in the U.S. In fact, Quebec issued a moratorium on their investor tax credit in 2003 pending a review by the Ministry of Finance.

Editor's Note: An Organisation for Economic Co-operation and Development (OECD) study compared R&D tax relief programs for its member countries, ranking nations in terms of tax relief and style. Canada ranked in the top five for both large and small company relief, while the U.S. came in 10th for large and 13th for small companies. The study notes that the U.S. favors direct funding while Canada uses primarily tax incentives to promote R&D funding. See R&D Tax Incentives: Trends and Issues at http://www.oecd.org/dataoecd/12/27/2498389.pdf

Evaluating the Impact of R&D Tax Credits on Innovation: A Microeconometric Study on Canadian Firms is available at:
www.cirst.uqam.ca/PDF/note_rech/2005_02.pdf.

On the Usefulness of Tax Incentives for Business Angels and SME Owners: an Empirical Analysis is available at: http://d.repec.org/n?u=RePEc:cir:cirwor:2005s-13&r=all.

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Useful Stats
State Rankings of GSP Per Capita: 1999-2003
Gross State Product (GSP) is considered, at least in theory, to be an effective measure of the "value added" by a state's economy. That is, the figure represents the sum of all net industrial activity within the state, where net activity is defined as total outputs (sales or receipts and other operating income, commodity taxes, and inventory change) minus total inputs (consumption of goods and services purchased from other industries or imported).

Comparing states' GSPs is difficult without some form of standardization, such as population or "per capita." Examining standardized trends over several years for an individual state or for comparison among two or more states may serve as a macro indicator of the state's economic health or direction.

To test this, SSTI has prepared a table presenting:

National Gross Domestic Product rose 18.58 percent from 1999 to 2003 but only 13.79 percent on a per capita basis. At 33.42 percent, Wyoming experienced the greatest change in GSP per capita. The state's ranking also improved over the five years, rising from 16th in 1999 to seventh in 2003.

SSTI's table, with a downloadable Excel version of the file is available at:http://www.ssti.org/Digest/Tables/041805t.htm

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