D.C. Bill Ostensibly Lowers Tax on Capital Gains from Qualified High Technology Company (QHTC) Investments… But How?
On September 23, District of Columbia Council Chairman Mendelson introduced the Promoting Economic Growth and Job Creation Through Technology Act of 2014 (Bill 20-0945 , hereinafter the “Act”) at the request of Mayor Vincent Gray. This marks the second time that the Council has considered the introduced language; it was originally included as part of the Technology Sector Enhancement Act of 2012 (Bill 19-747), but was deleted prior to enactment. The Act would add a new provision to the D.C. Code (§ 47-1817.07a) to impose a lower tax rate on capital gains from the sale of an investment in a Qualified High Technology Company (QHTC) beginning in 2015. The rate would be 3 percent as compared with the current rate of 9.975 percent for business taxpayers. Notably the proposed provision is limited in scope and only applies when the following three elements are satisfied:
The investment was held by the investor for at least 24 continuous months;
The investment is in common or preferred stock or options of the QHTC Company; and
During the taxable year, the investor disposed or exchanged of some or all of his or her investment in the QHTC.
As introduced, the proposed tax is explicitly applied “notwithstanding” any provision of the income tax statutes.
Good Thought, Poor Drafting
The intent of this legislation is clear, but the practical application is not. As a threshold matter, the second element requires the investment to be “in common of preferred stock or options,” which by definition excludes partnerships and limited liability companies since only corporations can issue stock. On its face, the language of the bill appears to be limited to investments in a QHTC organized as a corporation, despite the fact that other entities are eligible for QHTC status under D.C. law. Therefore, limited partners and members investing in pass-through QHTC’s appear to fall outside the scope of the proposed legislation.
Second, by imposing a different rate on only a certain type of income and by taxing the gains notwithstanding any other provision of the income tax statute, the proposal fails to account for basic tax calculations necessary to arrive at taxable income in the District for a business taxpayer. For example, the allocation and apportionment provisions would seem to be negated both practically and legally. What part of a multistate taxpayer’s gain from a QHTC is subject to the 3 percent rate? Is it all of the gain; an apportioned part of the gain – and if so, based on whose apportionment percentage? What if the gain would have been categorized as non-business income and the taxpayer is a non-resident? The answer is certainly not obvious from the legislation. Similarly, how do a taxpayer’s losses, both in the current year and carried over, affect the amount of gain available to tax? Can all of the losses be used against other types of income first? Can the losses be used at all against the QHTC gain?
Third, how is a taxpayer notified that the gain qualifies for the special QHTC rate? Similarly, are companies at risk for shareholder lawsuits if they fail to elect QHTC status?
Finally, existing constitutional and categorization problems with the QHTC designation complicate the special tax rate application. Investors may find that what they thought was a QHTC is ultimately determined not to qualify or the whole designation is invalidated on constitutional grounds. Or, the QHTC designation may actually be available to far more companies based on Commerce Clause objections to D.C.’s current standard and thus available to far more investors than D.C. anticipates.
Practice Note: The Act would seem to apply only to direct investments in a QHTC organized as a corporation. Many investors finance such business endeavors through holding companies and other investment vehicles. Gains from sales of an interest in an entity owning a QHTC may not qualify for the special tax rate. Taxpayers holding investments in any technology company operating in the District of Columbia are encouraged to contact the authors and discuss the effect this legislation would have on the taxation of their investment, if enacted. The proposed legislation was referred to the Committee on Finance and Revenue immediately after introduction and is being closely monitored by the authors.
Eric Carstens contributed to this article.