Types of Incentives
State and local governments, as well as the federal government, provide various types of incentives to encourage business growth, project development, and job creation. Incentives come in many forms and while they fall into several different categories, it is helpful to sort them based upon their relative impact on the project:
- Up-Front Incentives: These are direct offsets to the company’s capital investment and may include grants, free or discounted land, construction period sales tax exemptions, and other incentives that reduce the initial capital outlay for the project. Permitting and impact fee waivers may also fall into this category. These up-front incentives often carry the most weight for a project since they directly reduce the company’s budgeted capital expenditures.
- Ongoing Incentives: These are direct offsets to the operating costs of the project and may include ad valorem tax abatements, withholding tax rebates, jobs or investment-based tax credits, training grants and reimbursements, and similar incentives. These also carry significant value but should be discounted to present value since these incentives may not be realized until several years after the start of the project.
- Public Infrastructure: These incentives make the project site more suitable for the company and can benefit the project by providing utility lines, road access, and similar infrastructure requirements. Since these are typically off-site improvements, they may still benefit the project but typically are not a direct offset to the company’s capital budget. As such, the value of these incentives may be discounted accordingly. Further, these infrastructure improvements often require public bidding and, depending upon the source of funding, may include additional environmental reviews, low-to-moderate income hiring requirements, and other constraints, which can further reduce their effective value to the project.
- Soft Incentives: These include expedited permitting, in-kind training services, appointment of a community liaison, and other offers that may streamline the development process or help the company integrate in the community. Soft incentives can have a material impact on the project’s success, so while the value of these may be difficult to quantify, they shouldn’t be overlooked. These incentives often become part of the company’s subjective review of the project’s “fit” for a particular community.
- Utility Incentives: These include negotiated utility rates and other grants or utility bill credits that may be realized because of the site selection process. These may operate as direct offsets to capital or ongoing incentives. It is important to negotiate utility agreements concurrently with state and local incentive negotiations.
The first step to negotiating a beneficial incentive package is to run an effective Request for Proposal process. As noted in “An Effective RFP Process for Your Next U.S. Capital Investment”, the RFP process lays the groundwork for incentive negotiations by creating a competitive environment, building credibility and rapport with communities, and exposing gaps or weaknesses in a location’s fit for the project.
Analyzing Incentive Offers
Once an incentive offer is submitted through the RFP process, the first step is to determine the real value of the incentives for your project. Some incentives may look valuable in an incentive offer, but the actual value to the project is minimal. For example, it may be difficult for a company to realize the full value of a nonrefundable state income tax credit if the company does not expect to have taxable income for several years.
The first step to negotiating a beneficial incentive package is to run an effective Request for Proposal process. Likewise, a company may not realize the value of a new wastewater treatment facility that is offered as an “incentive” if minor upgrades to the existing treatment facility would satisfy the needs of the project. Communities sometimes use new projects as an opportunity to build infrastructure for their future growth plans, beyond the needs of your project. While this may be a wise move for the community, you should adjust the value of the incentives according to the actual benefit derived from those improvements.
The best method for determining incentive value is to focus on the cost of doing business at a particular site, net of incentives, rather than focusing on a stated value for a particular incentive. A company should work with their consultant to prepare a multi-site analysis of their up-front capital costs and ongoing operating costs. This analysis should include labor, logistics, tax, utilities, site preparation, and construction costs. A good analytical model will enable the company to evaluate the actual, comparative cost of the project rather than focusing on the “discount” that may be offered from an incentive package.
Since many incentives are realized over time, the comparative analysis should discount future cash flows to present value based on a predetermined discount rate. It is important to determine your internal discount rate up front. This is typically the company’s weighted average cost of capital, though companies have used various formulas for determining this percentage on different projects. Discount rates typically range between 4 percent and 12 percent, with 8 percent being a typical rate for comparing future cash flows, net of incentives, for manufacturing projects.
As noted in the RFP article, the project team should avoid location bias of individual members of the project team. One area in which location bias might impact a project decision is on the establishment of the discount rate. If the discount rate is not established at the outset, the project team may adjust the rate to favor one community over another. For example, if “Community A” offers most of its incentives on an up-front basis and “Community B” offers most of its incentives on an ongoing basis, then Community A would benefit from a high discount rate and, vice versa, Community B would benefit from a low discount rate. By establishing the discount rate up front and comparing incentives over time with a net present value formula, Communities A and B would be properly compared without location bias.
To effectively negotiate incentives, it is critical that the company understand the community’s perspective. This is a business deal for them as well as for the company. By understanding how a community will benefit from your project, you will be better equipped to negotiate a favorable incentive package.
Historically, incentive grants and property contributions were tax-free for the company since they were excluded from gross income and treated as a non-shareholder contribution to capital for federal tax purposes. However, the Tax Cuts and Jobs Act of 2017 amended Internal Revenue Code Section 118 so that those incentives are now included in the gross income of the company. A community should perform a cost benefit analysis that builds its business case for incentivizing your company to locate. You can support this effort by conducting your own analysis to estimate the direct and indirect benefit of the project to the community. This often gives a company the ability to negotiate for specific incentives, since it has already calculated the marginal increase in revenue that the project will provide to the state and community. For example, if you plan to develop a manufacturing facility on a greenfield site and the community is hesitant to provide a certain level of grant funding, you could calculate the projected incremental property tax revenue for the community, net of abatements, and use this number to support the grant request.
It is important for an incentive package to align with the needs of the project. To facilitate this alignment, you should identify gaps or shortfalls in the site as they relate to the project. Identifying these gaps further supports your request for specific incentives that will enable the community to make up for any site-related shortfalls. This is particularly true with respect to site and infrastructure issues but may also apply to workforce issues and other shortcomings that are not related to the site itself. Rather than asking for an increase in incentives without any basis for the request, it is more meaningful to have specific reasons for the request, particularly when those reasons stem from a location-related shortfall.
Applying for Incentives
The approval process for many incentives requires the submission of applications as well as public meetings to vote on these incentives. The process may include several long lead-time items, which can jeopardize the project’s overall timeline if not considered in advance. Always request a summary of the timeline for approval of each incentive offered by the state or community.
The incentive approval process may also jeopardize the confidentiality of the project. The further that your company progresses in the incentive process, the more difficult it becomes to maintain confidentiality. This is because many incentive programs require a public approval process, which may require disclosure of the company name. While you should usually have the community execute a non-disclosure agreement, if there is not an option to maintain confidentiality, you need to be aware of this up front and make plans to address any publicity that may arise during the incentive approval process.
Drafting Project Agreements
You should memorialize all state and local commitments in writing. While it’s important to develop trust between the company and community, each party’s respective commitments should be spelled out in a project agreement. Memories fade and personnel change over time. What remains is the written agreement between the parties. Though it’s important to maintain the goodwill of the community and have a strong working relationship with them, ultimately you must have a written agreement to support your project.
When negotiating project agreements, you should also consider the relative importance of your project agreement wish list. Some issues are worth pushing and others may require you to make minor concessions. Making some concessions in the process is important to maintain goodwill with the community; you may need it in the future. When problems arise, you will need to keep community relations intact to facilitate the community’s assistance with these issues.
The company should pay attention to clawbacks, recapture provisions, and performance-based requirements. It should expect the community to include these types of provisions, but they should be closely scrutinized to avoid unintended consequences, such as incentive recaptures that are disproportional to a shortfall in the company’s commitments.
This tax treatment may also cause a company to negotiate more heavily for abatements and other tax credits over cash or property contributions since those abatements and credits typically do not count as gross income to the recipient. It’s important to include any ancillary or “soft” incentives in the drafting process as well. It may be easy to focus on the big-ticket items such as cash grants and property tax abatements, but the training incentives, utility contracts, and similar incentives should not be overlooked.
Maintaining leverage during the incentive negotiation and project agreement drafting process is critical. Leverage comes from having competing options for the project. The competing option may be an alternate site in another state or country, or it could be the option to not move forward with the project at all if certain financial metrics are not achieved. These competing options should be maintained as long as reasonably possible, but a company should not drag along a competing community merely for leverage. It is, however, important to have legitimate location alternatives in the event of a major, unforeseen issue at the preferred site, which might cause the company to select an alternate location.
Evaluating Tax Implications of Incentives
Historically, incentive grants and property contributions were tax-free for the company since they were excluded from gross income and treated as a non-shareholder contribution to capital for federal tax purposes. However, the Tax Cuts and Jobs Act of 2017 amended Internal Revenue Code Section 118 so that those incentives are now included in the gross income of the company. The revised Section 118 now provides that “any contribution by any governmental entity or civic group” is no longer considered a “contribution to the capital of the taxpayer.” Instead, contributions of cash or property from state and local governments will be considered taxable income to the company.
This tax change will impact the value assigned to various incentives and will require an analysis of the effects of federal income tax on the overall project costs. This tax treatment may also cause a company to negotiate more heavily for abatements and other tax credits over cash or property contributions since those abatements and credits typically do not count as gross income to the recipient. Companies may need to consider other transaction structures to minimize this impact. While cash grants and property contributions have traditionally been the most valuable type of incentive, the new tax laws will require an adjustment to the realized value of those incentives based upon the tax implications to the company.
Once the project agreements and other incentive documents are signed and project development begins, the company, along with its external team, must begin tracking incentives and any triggering events for submission of forms, compliance certificates, requests for reimbursement, hiring requirements, and other project information. It is a good practice to create a project checklist or use project management software to track each of these items so that deadlines aren’t missed.
In addition to preparing incentive checklists, you should obtain a project agreement transcript and compliance binder to maintain the documents in an easily-accessible form in the event a question arises about any deal points.
Ultimately, a good incentive package is one that meets the needs of the project. This begins with the RFP process, continues with teamwork from the company’s internal project team and its external advisors, and culminates in the successful implementation of a project through partnership with the community.