Technology Tax Credit/VC program comes under question in Hawaii

"BLUE CRUSH’ BLUES
Critics of Hawaii law raise red flag after film reaps benefits of generous state tax credit

Carrie Kirby, Chronicle Staff Writer

Honolulu — Rob Romero appeared tense as he stood before a group of venture capitalists and startup advisers in a conference room with a view of Waikiki.

The entrepreneur’s plan to move his wireless startup, PacifiCall, from Palo Alto to Hawaii was being threatened by the summer film "Blue Crush."

How could a movie about tough surfer girls throw Hawaii’s fledgling technology industry and Romero into rough waters?

Here’s how: The movie was the 2001 top beneficiary of Hawaii’s unusually generous 100 percent technology tax credit, a program designed to grow a technology industry in a state known more for beachwear than software. The movie raised eyebrows because the program allowed its production to garner more than $15 million in local investment.

Critics say extending the largest tax credit to a film production in the first year of the program violates the spirit of the legislation.

"I’m not sure the law contemplated the dollar amounts that are going into movies, which are then taking those dollars away from high-tech and biotech companies," said David Watumull, president and CEO of Hawaii Biotech. "I’m also not sure that the law contemplated the short-term nature of movie projects."

Industry observers say the controversy stirred by the funding for "Blue Crush" has caused the state’s Tax Department to move slowly on new applications under the program.

That’s bad news for Romero because his potential local investor, an insurance firm, wants to clear his application with the Tax Department before sinking $2 million into PacifiCall.

Hawaii’s Tax Department officials deny a slowdown. They say they are short staffed and expect to have a tough time processing an anticipated year-end rush of applications.

GOVERNOR WANTS CHANGES

Some, including Gov. Benjamin Cayetano, are pushing for changes in the law that set up the program. They want tighter controls on what companies can get funding.

Technology industry supporters, though, warn that changing the program now will freeze the flow of venture capital and tech startups from the mainland.

State officials don’t have a statistical breakout on the $25 million the bill raised last year in its first year, nor do they know how many of the 100- plus companies that have qualified come from the mainland.

Anecdotal evidence suggests that much of the investment and many of the technology companies have come from Silicon Valley. For instance, several members of the Hawaii Business and Entrepreneur Acceleration Mentors, also known as HI-BEAM, the advisory group that Romero addressed in that Honolulu high-rise, are from the valley.

In addition, Menlo Park’s International Venture Fund has invested in five Hawaii companies, including Hawaii Biotech and 4Charity, a San Francisco firm that develops software for organizations that want to collect donations online.

4Charity has software developers working in Honolulu.

Hawaii’s Act 221, with its 100 percent tax incentive for potential investors, passed in summer 2001 after the failure of other efforts to build a technology industry in Hawaii.

"We needed something pretty drastic to get people to consider non-real estate investments," said Ray Kamikawa, a former state tax director who worked with the technology industry to push the bill after his term ended.

DETAILS OF TAX PROGRAM

Here’s how the tax incentive works:

A Hawaii taxpayer, be it a wealthy individual, an insurance company or a bank, invests in a company that meets the program’s requirements calling for more than half the company’s work to be qualified research and more than 75 percent of that research to go on in Hawaii.

That qualified research includes work in such categories as software, biotech, earth and space sciences, sensor and optics technology, alternative fuels, pure scientific research and performing arts.

The investor can use up to $2 million of the investment as a tax credit that can reduce his state tax bill during the next five years.

Investors from outside Hawaii can also reap benefits from the tax credits generated from their investments. Although they can’t use the credits directly because they don’t pay Hawaii state taxes, mainland investors may transfer the credits to Hawaii investors, usually in exchange for a larger stake in a company.

4Charity, whose software developers were based in San Francisco before the passage of Act 221, raised $1 million in just this fashion last year. "This new law has been terrific in terms of creating an environment where startups can grow," said Tracey Pettengill, 4Charity’s chief executive officer.

Act 221 funding for "Blue Crush" was made possible because the state law includes performing arts ventures within its definition of qualified high-tech businesses.

In this case, the film’s producers set up a venture with local investors and told state tax officials that the venture would stay in Hawaii as an ongoing concern.

Spokesmen for Universal Studios, which made "Blue Crush," did not respond to calls for comment.

There are also concerns that the tax incentive program is being exploited by investors in Hawaii who are getting more than their share of tax credits from mainland investors, say Joseph Blanco, the governor’s technology adviser, and Barry Weinman, a Silicon Valley venture capitalist who belongs to HI-BEAM, the advisory group.

For example, mainland investors setting up shop in Hawaii could come in with $2 million. An investor in Hawaii kicks in another $250,000. Because the mainland financiers do not pay taxes in Hawaii, they can transfer a $2 million tax credit to the island backer — who gets eight times the value of his investment in write-offs.

DISINCENTIVE FOR STATE INVESTORS

Weinman, managing director of Palo Alto VC firm Allegis Capital, finds that scenario troublesome because local investors in Hawaii might have less incentive to investigate the feasibility of a project or company if they receive the state tax credits up front.

In addition, Blanco says that allowing local investors to get such a high return in tax credits shortchanges the technology companies that are supposed to benefit from the law.

Blanco said Cayetano’s proposed changes would encourage investors to care more about the long-term health of the companies they invest in by extending the tax credits over seven years instead of five years. The thinking is that this would give investors an incentive to choose companies that are likely to survive for seven years.

According to Blanco, the governor also wants to increase the amount of money the government could take back if the company fails or leaves Hawaii. Currently, an investor in that situation can get up to 60 percent of the tax credit in the first two calendar years, and the state can recapture only 10 percent.

It could be tough for Cayetano to introduce legislation to amend Act 221 because his term ends at year’s end. The candidates in position to replace him seem reluctant to tinker with a bill that seems to be improving the local business climate.

Both the Democratic candidate, Lt. Gov. Mazie Hirono, and Republican candidate, Linda Lingle, favor having the Tax Department write guidelines to prevent misuse of the bill instead of changing the law, their representatives said. That plan also is supported by many in the tech industry who lobbied for the bill.

"We just got it passed, for goodness’ sake," said Ann Chung, executive director of the Hawaii Technology Trade Association, one of the bill’s main backers. Changing it "would send the wrong message out there to the nation."

Chronicle staff writer Vanessa Hua contributed to this report. / E-mail Carrie Kirby at [email protected].

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