State seeks stricter rules for high-tech tax-credits

By John Duchemin
Advertiser Staff Writer

The state's high-technology tax credit has brought millions of dollars in investment to Hawai'i, but accusations of abuse and demands for reform are propelling efforts to change the law.

Critics argue the law is too liberally worded and open to exploitation as a tax shelter, noting that the largest single investment yet under the legislation has been for production of the movie "Blue Crush." Filmed in Hawai'i earlier this year, the Universal Studios-backed company that produced it received a $16 million tax credit from the state.

But proponents of the legislation, passed last year as Act 221 and allowing for a half-dozen types of state tax relief for high-tech companies, say the law has done its job by attracting investors to Hawai'i and helping many startup companies get money they otherwise might not have.

"If the perception is too strong that there are excesses, that could kill (Act 221)," said David Klinger, president of Get2Hawaii, a Honolulu-based travel software firm. "That's very unfortunate, because Act 221 is a clear draw for businesses."

Technology industry backers are concerned that political momentum will shift against the law, leading to major changes that could scare away would-be investors. Republican gubernatorial candidate Linda Lingle stoked fears late last month, saying she wants to overhaul the tax credit and investigate rumors of abuses. Democratic candidate Mazie Hirono did not return calls requesting comment on the issue.

The legislation, passed in 2001 after several years of intense lobbying by local technology backers, was widely hailed as a solid step toward stimulating the state's fledgling high-tech industry.

With provisions for tax credits of up to 100 percent of an investment in a Hawai'i technology company, the legislation is still one of the most generous technology incentives in existence.

"A 100 percent return will get through the white noise anywhere," said Michael Fitzgerald, chief executive officer of private economic development organization Enterprise Honolulu. "Act 221 is clearly a net positive, because it's got Hawai'i on radar screens that it wouldn't be on otherwise."

Since its passage, the legislation has contributed to several local startup technology companies securing investments ranging from a few thousand to several million dollars. Beneficiaries include 'Aiea-based Hawaii Biotech, which is developing a vaccine for dengue fever; college recruiting technology company HotU; fuel cell technology firm Hoku Scientific; and Kailua-based AssistGuide, which offers online services to healthcare providers.

"I could have set up my business anywhere, but I came to Hawai'i because of Act 221," said Henk Rogers, founder of Blue Lava Wireless, a startup company developing Tetris and other games for wireless phones.

"I'm about to go to Japan, and will certainly tell everyone there about the act and the advantages of doing business in Hawai'i," he said.

Most critics of the act agree that it has been valuable in helping many small technology businesses in the Islands. But they say modifications are needed quickly because the law's liberal sweep and language make it vulnerable to abuses.

Taken at its most liberal, the language in Act 221 could apply to practically any company, Jim Plummer, founder of California-based consulting firm QED Research, said at a recent Hawaii Venture Capital Association meeting.

"I could take pictures of my granddaughter with a digital camera, set up an Internet site and sell the pictures to relatives, and I would have a 'qualified high-technology business,' " Plummer said.

As the law cycled through the Legislature, lawmakers broadened it from three types of companies — software, biotechnology and research — to seven categories. Sensor and optic technologies, ocean sciences, astronomy and nonfossil fuel technology were added. The performing arts industry was a late eighth addition.

Under the performing arts category, investors in Beach Orchid Film Productions, the "Blue Crush" producer, were granted tax credits as a "qualified high-technology business."

But some industry observers — including the former state tax director — say the tax department erred in approving those credits. The law is supposed to help businesses stay in Hawai'i for the long run, but Beach Orchid left the state shortly after filming ended this spring. Critics say taxpayers ended up subsidizing a one-shot movie deal that did little to help the economy.

"If it's just a one-off deal, people aren't supposed to qualify (for the tax credit)," said Ray Kamikawa, the former state tax director and lawyer who helped industry lobbyists design Act 221. "It was a mistake for the tax department to issue that ruling."

Tax department and Cayetano administration officials defend the decision, saying the "Blue Crush" investment was legal and accusations of abuse are without merit.

Deputy state tax director Grant Tanimoto and Joseph Blanco, technology adviser to the governor, said Beach Orchid represented itself as a "going concern" that would stay in the state for several projects.

If that proves false, Tanimoto said the government will try to "recapture" a portion of the money under Act 221, which lets the government charge a 10 percent penalty if the company stops doing business in the first year of operation.

Still, Tanimoto says that the wording of the legislation is a challenge and has been left to the Department of Taxation to determine what types of businesses fall within the eight categories.

With only two tax officials assigned to deal with dozens of credit requests, the state tax department is forced to make decisions on the fly, Tanimoto said.

He said the department has approved more than 100 companies as eligible for the credits.

"There's not much guidance to us, and we have very limited resources," he said. "But we have to try to administer the law the best we can given the circumstances."

While defending the investments made so far, Blanco acknowledges that some companies have tried to abuse the law. Some businesses have tried to spin off their data-processing centers as separate "technology companies," a move that would essentially let them pay for normal operating costs with taxpayers' money.

"The tax department has been very cautious in watching for those things," he said. "In some cases you clearly can see the intent to take advantage of Act 221 and not create a new industry."

Blanco said Cayetano wants to beef up the "recapture" clause, letting the government take back more money over a longer period if a business loses its tax-credit status. The governor also has sought to tighten the definition of a qualifying performing arts company by requiring that at least half of the work on a film or television show be performed in Hawai'i.

Blanco said a bill to amend Act 221 likely will be introduced this fall in the last legislative session under Cayetano.

That possibility has many technology industry backers calling for patience amid concern that political momentum will shift against Act 221 leading to major changes in a law that is too new to be conclusively praised or criticized. They say the risks of precipitous change are too great and could scare away would-be investors.

"If you were to write the bill from scratch, you may want to tweak it a bit," said Robert Robinson, a University of Hawai'i business professor and investing expert who has helped start an "angel investing" group of wealthy Hawai'i residents. "But if you mess with it now, you're giving a huge disincentive to investors.

"Give it a few years and then assess it. Right now it's a very fragile thing."

Enterprise Honolulu's Fitzgerald said a stable tax-credit law will likely lead to significant, legitimate investments within a few years.

"It's worth it to trade off perfection to keep the thing in business," Fitzgerald said. "If we give this a shot, the real investors, creating real jobs, will overwhelmingly outnumber any abuses.

"The real money hasn't come in yet. Most investors are waiting to see if the Legislature will start tinkering, or if they'll leave it alone long enough to (let investors) do a deal."

Reach John Duchemin by e-mail at jduchemin@honoluluadvertiser.com or by phone at 525-8062.