Manufacturing and capital investment strategies: Tax considerations
Location strategy and building analysis are critical to achieving ROI
INSIGHT ARTICLE |
The Tax Cut and Jobs Act is expected to generate additional funds for manufacturing companies that can be invested in their businesses. Manufacturing companies making major investments in their businesses are often basing their decisions on a primary goal such as expanding the business, improving facilities or, in the case of parts manufacturers, being closer to their manufacturing clients. Focusing solely on these immediate priorities, however, often delays consideration of tax opportunities that could have a significant impact on the company’s cash flow.
Manufacturers developing plans to expand into new markets or improve existing facilities should take a multidisciplinary approach that includes analysis of tax opportunities early in the process. Without the analysis of a jurisdiction’s tax regime helping to drive decisions, management could be leaving money and tax credits on the table.
Opportunities for credits and incentives
Strategic business decisions are often driven by real estate, operational efficiency or labor considerations. How can the business grow? Where can operational costs be cut? Where are customers located? Are distribution options available and efficient? These questions may lead to decisions to consolidate operations or expand the business into a new location.
If tax planning is incorporated early on the process, it can reduce the time that companies will recover their investments. Many U.S. manufacturers are hoping to grow their businesses by focusing primarily on domestic markets, according to the 2017 RSM Manufacturing Monitor. An analysis of various state and local tax environments may yield a number of opportunities for tax credits and incentives that could help determine the right location. Negotiating with the appropriate state and local governing bodies, these may include opportunities such as:
- Discretionary grant awards: States, cities and other taxing jurisdictions don’t just collect revenue, they compete for business. Local governing bodies often award funds on the basis of a competitive process, offering a wide variety of credit and incentive programs to attract businesses. From property and sales tax relief to training grants and other programs, there is a good chance manufacturers could qualify for some form of tax relief as they consider where to establish operations.
- Infrastructure development support: Local jurisdictions can help manufacturers fast-track warehouse facility expansions or water and sewer infrastructure planning by expediting the permitting process or agreeing to fund and expedite infrastructure build-out to meet a company’s specific needs. Regional utilities can also smooth the planning and implementation process as an incentive for bringing business into their area.
- Statutory incentives: Performance-driven incentives, often through negotiated thresholds of job creation or local investments. These incentives may be in the form of tax credits (such as the Work Opportunity Tax Credit and capital investment credit), tax abatements for properties, or wage reimbursements or subsidies for employee training, among other options.
- Research and development incentives: Although the acquisition of depreciable property is excluded from the treatment as a research expense for Federal purposes under section 174, regulations issued in 2014 enhanced the ability to treat the cost of developing and constructing prototypes of plant equipment as deductible research expenses and potentially as qualified costs eligible for the research tax credit. In addition, many engineering and design costs that go into a building construction project can be treated as deductible research expenses. To take advantage of these research expense provisions it is important for the company to consistently use the proper accounting methods for research expenses. These benefits will only be available for a few more years. The Tax Cuts and Jobs Act will require capitalization and amortization of research and experimental expenditures over 5 years (15 years for research conducted outside the United States). These amortization requirements go into effect in 2022. Most states also have incentives for research and development, including income and franchise tax credits, property tax exemptions and sales tax exemptions.
Taking the time to compare offers by local and state jurisdictions to other incentives programs within the state—or to those in other states—can provide a valuable list of available options. Moreover, companies should be careful to evaluate the entire tax regime of a given state when considering credits and incentives packages. Although a package may look very lucrative when considered on a stand-alone basis, there could be other factors―such as tax rates and types of taxes the company would be subjected to―that could erode the overall benefit. A holistic approach to understanding the tax cost of doing business in a jurisdiction should be part of any location credits and incentives analysis.
A manufacturer of specialty pharmaceutical parts that was looking to expand its operations, for example, compared offers in North Carolina and Texas—two states where it had operations—to obtain the overall best value. The study of each state’s mix of incentives, statutory credits, property tax abatements and cash grants—not to mention the annual utility savings—allowed the manufacturer to make an informed (and money-saving) decision.
In another example, a privately held rubber manufacturer was able to negotiate a tax incentive package that varied greatly from the one originally proposed by the state. It gained nearly $700,000 in additional incentives for its expansion project in Indiana. In this case, understanding how much the company intended to invest in the expansion project—and when that investment would take place—made a profound difference in which state incentive program worked best for the company.
Opportunities for maximizing cash flow
Effective management means always keeping an eye towards maximizing cash flow. But tax issues are not always taken into consideration in capital investment strategies.
Many manufacturers are taking advantage of cost-segregation studies for their building properties. Cost-segregation studies have long provided benefits to taxpayers by segregating shorter-lived personal property from longer-lived real property. In addition to generally providing results favorable to taxpayers by accelerating depreciation deductions on the segregated property, these studies can help to break out the cost of components of building property.
For example, when a manufacturer acquires or constructs a building, the property often includes dedicated electrical and plumbing services for the processing equipment, as well as specialized process mechanical systems. Typically, there are also finish items such as carpeting and vinyl tile flooring. These are big-ticket items in manufacturing—and the items will likely need to be replaced sooner than the building itself.
Cost segregation can accelerate the depreciation deductions for these items, lowering the taxable income for the company and thereby generating savings. With 100% bonus depreciation and expanded application to certain used property, the benefit can increase greatly.
A cost segregation analysis was recently completed for a consumer and industrial products company of its expansion of an existing campus facility. The $115 million project included an office building, cafeteria with full kitchen, parking garage and significant land improvements. The analysis segregated assets into their appropriate classifications for federal tax depreciation, resulting in shorter depreciable lives to certain eligible assets and accelerating deductions into earlier years. This yielded a cash flow savings of $6.9 million in the first year.
When making capital expenditures to existing plants, cost segregation studies can also help identify partial dispositions related to renovations. If infrastructure is still being depreciated, companies can write off elements that have been removed in the current year. For example, when a company replaces the roof on a 20-year old building, the expenditures can either be expensed if considered a repair or the taxpayer can take a deduction for the remaining basis in the old roof if the expenditure must be capitalized.
Other opportunities include:
- Equipment and tools: Manufacturers may not be aware that, according to the Internal Revenue Service, manufacturing has certain asset classes for specific equipment and tools that may have a shorter life cycle than others. While the default life cycle is usually seven years, some asset classes may be eligible for life cycles of three to five years, depending on the type of manufacturing. A review of what may qualify could result in increased cash flow.
- Luxury car cap: Businesses considering the purchase of a fleet of company cars may want to consider the tax implications of the type of vehicles they are buying. Once they cross this pricing threshold, certain vehicles are subject to a depreciation cap, limiting the amount a company can deduct per year.
- Qualified improvement property: As a result of the Protecting Americans from Tax Hikes Act, certain interior, non-structural improvements made to a building are eligible for bonus depreciation for building owners. These include electrical improvements serving the general part of the building (rather than serving equipment), walls and even ceramic tile. Companies that lease buildings may be eligible for a shorter tax recovery period and bonus depreciation on qualified expenditures such as interior walls, partitions, lighting, plumbing and other non-structural property elements. The new tax rules starting in 2018 would not provide bonus depreciation nor a 15 year recovery for qualified improvement property placed in service after January 1, 2018. However now 100% bonus applies to used property to offset some of the loss. Also, qualified improvement property is eligible for section 179 expensing.
Raise the red flag
While juggling all of the considerations involved in strategic investment decisions, it can be easy to overlook some important issues:
- Timing is everything: State and local tax and other incentives are used as inducements to convince employers to locate jobs and make investments in a given market. Once a company has announced its intentions to move to a specific location, it has lost its leverage. Even in cases where the incentives are statutory and available to everyone, timing is often vital. Some programs are funded on an annual basis―with a finite pool of dollars―and paid on a first-come, first-served basis.
- Documenting details: Manufacturers need to make sure the deal they document is the deal they negotiated. For example, a company planning to build a new manufacturing facility negotiates a package of credits and incentives that is based on the total investment in the plant and on the number of jobs created. While the deal is with the company itself, a separate real estate entity is actually procuring the property and building the plant, which is then leased back to the company. The company is also staffing the plant through contract employment relationships with another party. When the company files to collect the benefit, it does not qualify because it neither made the investment in the plant nor actually employs the personnel working there. Those investments were made by separate legal entities that are not parties to the incentive contract.
- The volume of credits and incentives available: Due to the wide range and scope of available credits and incentives, companies without specialized expertise may need assistance in identifying and securing all the benefits available.
- Take a holistic tax approach: When considering moving to another jurisdiction, management needs to make sure the overall tax regime in the state is taken into consideration. In some cases, the company’s effective tax rate in a state could eat up all the incentives in the long term that the company might get up front. Management should look beyond the immediate credits and incentives and study their company’s total tax bill, including hiring and training, research and development, locations and equipment.
Bottom line: Incorporate tax into strategic planning
When manufacturers are developing a location strategy, tax should to be a component of—not a supplement to—the decision-making process. Working with experienced credit and incentives professionals can help company management negotiate a better deal and will also help ensure that the deal the company thought it had is the deal it actually receives.
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