Synopsis:  Until recently, the taxability of Smart Grid Investment Grants (SGIGs) was an undecided issue.  Effective March 10, 2010, the Internal Revenue Service (IRS) has announced that these grants will be treated as nonshareholder contributions to the capital of grant recipients and thus not included in their taxable gross income.  Corporations receiving these grants must take a zero basis in any property purchased with grant funds. Specifically, the new IRS guidance applies to SGIGs under 42 U.S.C. § 17386 made by the U.S. Department of Energy (DOE) to a corporation for qualifying investments under the Smart Grid Investment Matching Grant Program as authorized by Section 1306 of the Energy Independence and Security Act of 2007 (Pub. L. No. 110-140), as amended by Section 405, Division A of the American Recovery and Reinvestment Act of 2009 (Pub. L. No. 111-5).

Discussion:  The taxability of SGIGs was described as a major obstacle to contract execution between the DOE and grant recipients.  The potential for these grants to be taxed at corporate rates as high as 35% would adversely impact their value to smart grid projects.  While not all government grants are treated alike for income tax purposes, assuming certain criteria are met, some grants are considered to be contributions to the capital of recipient corporations and thus nontaxable income.  The IRS has decided to include SGIGs in this category of exclusions from gross income.

Section 118 of the Internal Revenue Code (the Code) excludes from a corporation's income any contribution of money or property to the capital of the corporation.  This exclusion applies to both shareholder and nonshareholder contributions, e.g., when a governmental unit or civic group makes a contribution to the capital of a corporation to induce the corporation to locate its business in a particular community, or to enable the corporation to expand its operating facilities.  However, the exclusion does not apply to money or property contributed to a corporation in consideration for goods or services rendered or to subsidies paid to induce the corporation to limit production.

While the IRS has often held that government grants were nontaxable contributions to capital, on several occasions the IRS has held a contribution to be a taxable event for the recipient.  For example:

1. Grant compensation for losses resulting from the September 11, 2001, attacks on the World Trade Center (payments were considered "more akin to insurance payments received for losses") and grant funds earmarked for payment of employee wages (considered ordinary business expenses); but note, grant funds used to acquire furniture and equipment were treated as nontaxable contributions to capital;
   
2. Virgin Islands tax subsidies designed to induce and encourage new business development (the subsidies were considered to constitute refunds but not contributions to capital because the credits reduced the amount of tax before the tax became due, which would reduce a corporation's operating expenses and therefore would not become a permanent part of the corporation's working capital); and
   
3. State credits to subsidize ordinary business expenses or operating expenses such as employee compensation.

Alternatively, on at least two occasions, the IRS has decided that payments from the government to a corporation 1) to assist in the construction of a plant, and 2) to expand its business by establishing a facility in a specified location were contributions to capital under Section 118 of the Code because all of the requirements listed below, which constitute the characteristics of a contribution to capital, were satisfied. 

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

As the foregoing illustrates, the IRS has considered some government grants to be nontaxable contributions to capital but others as taxable gross income.  The IRS is treating SGIGs as nontaxable contributions to capital, but the taxability of government grants in general still depends upon the specific facts relevant to each transfer.  If the list of characteristics of a contribution to capital is entirely satisfied, the grant will likely be treated as a nontaxable contribution to capital.  Otherwise, the grant may be deemed to be the taxable gross income of the recipient.

Additional Information:  This update is only intended to provide a general summary of the new IRS guidance with respect to the tax treatment of SGIGs as provided in Revenue Procedure 2010-20. View full text of the Revenue Procedure.