Looking beyond tax break bill

By Sean Hao
Advertiser Staff Writer

In the upcoming debate over the state's controversial technology tax incentives, the issue won't be how to tweak Act 221, but how to craft its replacement.

Mike Rosenman is the director of engineering for Hoana Medical Research and Development Center, a maker of medical imaging devices. The company is one of many beneficiaries of Act 221 tax credits. Rebecca Breyer • The Honolulu Advertiser

Last spring, the two sides staged a contentious face-off over the generous tax credits, which were intended to foster Hawai'i's fledgling technology industry.

However, in addition to helping technology companies land much-needed investment capital, the tax-credit program passed in 2001 had unintended consequences. They included use of Act 221 to finance one-shot movie deals, the leveraging of tax credits into claims as large as four times the original value of the 100-percent tax credit, and the program's unexpectedly high cost.

Through fiscal years 2002 and 2003, the program's estimated cost to the taxpayers has amounted to $70.3 million, and the program has about two more years before it expires.

As a result, Lingle wanted legislators to make two changes: tightening the language of the law, which now requires that it be liberally interpreted, and limiting the value of the act's research credits to increases in a company's research and development spending rather than its ongoing expenditures. The Legislature balked at both ideas.

Meanwhile, because of the continuing debate, a cloud of uncertainty hangs over the program, one that both sides agree makes it difficult for legitimate businesses to attract private capital using Act 221 as a lure.

The solution may lie in creating a replacement statute that would incorporate lessons learned from Act 221, said state Rep. Brian Schatz, D-25th (Makiki, Tantalus). The new incentives, essentially, could replace Act 221 before it expires in 2005 while extending technology tax credits several years beyond the scheduled expiration.

"I think that's the direction that we'll be moving in," Schatz said. "Even if we were to amend 221, the amendments won't be effective for one more year," meaning the changes made in 2004 would only apply to Act 221's final year.

A first important step will be to tone down the rhetoric, which at times earlier this year was highly political, said Schatz, chairman of the House Committee on Economic Development and Business Concerns.

"I think what we have could fairly be characterized as a cease-fire," Schatz said. "It's important for the state and its political leadership that we move beyond the 221 fight and into a broader discussion about economic diversification.

"It's really time for us to move on."

Ted Liu, director of the state Department of Business, Economic Development and Tourism, agreed.

"What we want to do is move beyond Act 221 into the whole issue of capital formation — not just venture capital and startups, but (helping) small and medium-sized companies overall," he said.

Act "221 was a first step — a bold first step, and as with a lot of first steps, we didn't know what we were stepping into," Liu said. "We now have the benefit of experience."

In advocating changes to Act 221 in the last session, Lingle's administration blamed the state's budget woes on the cost of the credits and concerns they were being abused. But an ongoing audit of Act 221 claims has yet to support claims of widespread abuse, and the state's financial picture has improved somewhat since spring.

The state Council on Revenues, whose forecasts are used to craft the state budget, now projects general-fund tax revenues will grow by 6.2 percent this fiscal year, although total tax collections through the first four months of this fiscal year are up just 3.4 percent from last year's level.

As it stands, Act 221 is considered among the most generous technology tax incentives in the nation. The research credit provision alone provides a refund valued at 20 percent of a company's qualifying research and development expenses. However, because the law isn't restricted to technology companies, about $10 million — or more than two-thirds — of the $14.5 million in research tax credits claimed for 2001 went to nontechnology companies.

Among the changes to the research credit likely to be discussed is limiting the credit to targeted industries such as technology, biotechnology, diversified agriculture and commercial uses of military technology, Schatz said.

Liu said the governor still would like to see the research credit be made nonrefundable and only apply to increased research and development expenses. Part of the current credit's problem is that it is so generous that companies are less disciplined than they should be in developing the commercial potential of their research, he said.

Satisfying such concerns will be key in deciding how long to extend technology tax credits beyond 2005, Liu said.

The other major component of Act 221 is a 100 percent investment tax credit for investors in qualified high-tech companies. There has been great concern that many of the claims are made through transactions specifically designed to avoid state taxes.

For example, as it stands, the investment tax credit is limited to $2 million per investor, so someone investing $10 million in a company could only claim a $2 million credit. However, if that person invests through a partnership, those unused credits can be shifted to others in the group who invest less than $2 million. In essence, the total tax credits claimed increases without resulting in the infusion of additional investment capital.

Liu said there are legitimate uses for that so-called "credit shift." However, policing the use of credits is difficult because state tax officials are required to interpret Act 221 liberally.

Other changes Liu would like to see are new incentives that would boost the creation of intellectual property by creating a closer connection between University of Hawai'i research and the private sector.

In addition, there is universal agreement that better accountability of the act's benefits and costs is needed. After three years of the program, state officials have only a rough idea of its cost and even less data on the number of jobs the incentives are creating. The tax department said it plans at least to have compiled figures on the jobs and salaries created under Act 221 in its first year before the Legislature convenes in January.

Meanwhile, technology companies benefiting from Act 221 maintain the program is crucial to their efforts to assure the industry a firmer foothold in Hawai'i. Among the companies are Oceanit and its spin-off medical device maker Hoana Medical, which raised $5 million in capital partly because of Act 221, said Patrick Sullivan, chairman of Oceanit and chief executive of Hoana Medical.

Act 221 could be replaced with an incentive that better targets technology, Sullivan said. Ways to make the credit better while satisfying concerns about abuses and costs include capping the investment tax credit at no more than two times a person's original investment. Another change could limit the research credit to technology companies, but possibly keeping it at $1 million or $2 million a year per company.

"Other than that, I think it's a brilliant idea," Sullivan said of 221. "For legitimate companies, it's a big benefit.

"The real technology companies need this and can use this," but "it's clear that certain people are manipulating it."

Reach Sean Hao at shao@honoluluadvertiser.com or 525-8093.