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Closing State Corporate Tax Loopholes: Combined Reporting

| Written by ILSR Admin | 4 Comments | Updated on Jun 2, 2010 The content that follows was originally published on the Institute for Local Self-Reliance website at http://ilsr.org/rule/combined-reporting/

Many retail chains earn profits at stores nationwide, but have developed an accounting scheme to evade paying their full share of state corporate income taxes. Tax experts believe the practice is costing states billions of dollars in lost revenue.  It has also given chains an advantage over locally owned businesses, which must pay state income tax on all of their earnings. Twenty-one states are not vulnerable to these tax-evasion schemes, because they have enacted a policy known as combined reporting.

How the Loophole Works

The way chain retailers are evading their state tax obligations is by transferring profits to certain types of subsidiaries.  One common approach is to establish a trademark holding company.  Another is to set up a real-estate investment trust, or REIT.

In the trademark holding company scheme, a chain sets up a subsidiary in a state that does not tax certain types of income, such as Delaware, Michigan, or Nevada. Home Depot, for example, has a Delaware-based subsidiary called Homer TLC Inc. The subsidiary, which consists of little more than an address, owns the company’s trademark. Home Depot stores in other states pay the subsidiary a hefty fee for using the trademark.  These fees are then deducted as business expenses from Home Depot’s tax returns in those states. Meanwhile, because Delaware does not levy corporate income taxes on earnings from intangible assets such as trademarks, the profits are not taxed in that state either.

Often the subsidiary will also lend money to the rest of the corporation, enabling a second stream of profits to be transferred free of state taxes through the payment of interest on the loan.

The REIT method has been widely used by large retailers, most notably Wal-Mart.

Established in the 1960s by Congress, REITs are exempt from paying taxes on dividends paid to their investors. Chain retailers have taken advantage of this by setting up their own REITs (often called “captive REITs”), which own the land and buildings that house their stores.  The chain then pays rent to the REIT and deducts the rent as a business expense from its state tax returns.  The REIT’s income is then paid back to the chain as a tax-free dividend.

This is how the Wall Street Journal explained Wal-Mart’s use of a captive REIT: “One Wal-Mart subsidiary pays the rent to a real-estate investment trust, or REIT, which is entitled to a tax break if it pays its profits out in dividends. The REIT is 99%-owned by another Wal-Mart subsidiary, which receives the REIT’s dividends tax-free. And Wal-Mart gets to deduct the rent from state taxes as a business expense, even though the money has stayed within the company.”  (“Wal-Mart Cuts Taxes By Paying Rent to Itself,” by Jesse Drucker, Feb. 1, 2007.)

To further complicate things, chains often set up these REITs in states with no corporate income tax on earnings from intangible assets (such as Nevada and Delaware).  This creates an additional obstacle for states to challenge this practice.

Using trademark or REIT subsidiaries in this manner to avoid state income taxes originated in the mid-1980s and grew rapidly in the 1990s. Several accounting firms market the service to their clients.  PriceWaterhouseCoopers, for example, provides its clients with a comprehensive plan entitled,”Utilization of an Investment Holding Company to Minimize State and Local Income Taxes.”  Ernst & Young LLP devised this plan to help Wal-Mart escape state and local taxes.

The Scope of the Problem

Companies known to evade state taxes through these accounting schemes include Circuit City, The Gap, Home Depot, Ikea, Kmart, Kohl’s, Limited Brands(which owns Bath & Body Works, Victoria’s Secret, The Limited, and other chains), Payless Shoes, Staples, Toys “R” Us, and Wal-Mart.

Because companies are not required to publicly disclose these transfers, it is not possible to determine exactly how much profit is being sheltered from state income tax.

However, tax experts believe these schemes are costing states billions of dollars in lost revenue and likely account for a sizeable share of the decline in state corporate income tax receipts that has occurred in recent years.  In 1977, corporate income taxes accounted for 9.7 percent of total state tax revenue.  By 2001, their share had fallen to 5.7 percent and had dropped to an estimated five percent by 2004 (see The State Corporate Income Tax: Recent Trends for a Troubled Tax).

Court cases filed by a few states have forced some chains to disclose evidence about the extent of their own tax avoidance.  One case revealed that  Toys “R” Us shifted $55 million to a Delaware subsidiary, Geoffrey, Inc., in 1990 alone.  Between 1992 and 1994, Limited Brands transferred more than $1.2 billion from its stores to Delaware subsidiaries. Kmart shifted $1.25 billion into its Michigan subsidiary, Kmart Properties, Inc., from 1991 to 1995.

More recently, evidence submitted in a case in North Carolina revealed that, in one four-year period, from 1998 to 2001, Wal-Mart and Sam’s Club stores across the country paid captive REITs a total of $7.27 billion in “rent.”  Based on an average state corporate income tax rate of 6.5 percent,  this enabled Wal-Mart to avoid about $350 million in state taxes over those four years, according to an analysis by three tax experts commissioned by the Wall Street Journal.

A report by Citizens for Tax Justice, a Washington-based nonpartisan group, and Change to Win, a labor coalition that represents 6 million workers, estimated that Wal-Mart’s tax avoidance schemes helped cut its payments to state governments almost in half between 1999 and 2005. Over those seven years, Wal-Mart reported $77.4 billion in pretax U.S. profits. But it reported a total state income tax bill of only $2.4 billion, or 3.16 percent of those profits. The researchers’ report said that if Wal-Mart paid taxes at the statutory state corporate tax rates for the same period, it would have paid $4.7 billion in state income taxes.

The Solution: Combined Reporting

Several court cases have dealt with the question of whether this practice constitutes a legitimate tax-reduction strategy or an illegal tax-evasion scam.  But the cases have produced mixed results.  Some courts have sided with the corporations and ruled that the practice is legal. Others have favored the states. A January 2008 decision by a North Carolina district court ruled that the state was right to collect an additional $33.5 million in taxes from Wal-Mart, which the chain had tried to avoid paying through a captive REIT scheme.

Rather than undertaking the expense and uncertainty of a lawsuit, a better way for states to block these tax-evasion schemes and level the playing field for local retailers is to enact a relatively straight-forward revision to the state tax code, known as “combined reporting” (and sometimes referred to as taxing companies on a “unitary basis”).

Combined reporting requires that companies combine profits from all related subsidiaries, including captive REITs and trademark holding companies, before determining what portion of their profits are taxable in that state. (To determine how much of their total worldwide earnings are taxable in each state in which they operate, multi-state companies must apportion their profits according to formulas which consider how much of the firm’s property, payroll, and sales are in each state.)

States with combined reporting are effectively able to tax the percentage of an out-of-state subsidiary’s profits that can legitimately be attributed to a firm’s in-state operations. Combined reporting has been upheld by the U.S. Supreme Court.

(During the 1970s and 1980s, some states adopted worldwide combined reporting, which required corporations to account for profits earned in the state but shifted to a subsidiary overseas.  The Supreme Court upheld worldwide combined reporting in two decisions in 1983 and 1994.  Nevertheless, after strong push-back from other countries and a threat by Congress to intervene in 1985,  states migrated away from this approach and, for the most part, now limit combined reporting to the “water’s edge,” even as a growing number of corporations shield profits overseas.)

As of November 2010, twenty-three states have adopted combined reporting.  These states are: Alaska, Arizona, California, Colorado, Hawaii, Idaho, Illinois, Kansas, Maine, Massachusetts, Michigan, Minnesota, Montana, Nebraska, New Hampshire, New York, North Dakota, Oregon, Texas, Utah, Vermont, West Virginia, and Wisconsin.

Lack of corporate income taxes makes combined reporting irrelevant in four states: Nevada, South Dakota, Washington, and Wyoming.

The remaining twenty-two states (as of November 2010), plus the District of Columbia, have not adopted combined reporting and are vulnerable to chains escaping their state tax obligations by shifting income to subsidiaries.  These states are Alabama, Arkansas, Connecticut, Delaware, Florida, Georgia, Indiana, Iowa, Kentucky, Louisiana, Maryland, Mississippi, Missouri, New Mexico, New Jersey, North Carolina, Ohio, Oklahoma, Pennsylvania, Rhode Island, South Carolina, Tennessee, and Virginia.

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  • Amanda

    Tax evasion and trying to cheat the system only end up making things much more difficult for those who actually follow the rules and try to do the right thing. The more people that attempt to cheat the system, the tougher the system gets. The money has to be found somewhere and when there are those taking it then the "takers" find other ways to get it back!

  • Jon of Short Sale Way

    REITs have been hit extremely hard in the past couple years. They were once paying the biggest dividends to investors and all that has changed. I have never heard about the tax loopholes that are available to these funds. It is unfortunate that some companies were taking advantage of this. As with anything and especially when it comes to taxes there will be some that take full advantage of the system.

  • Anonymous

    But what about foreign corporations doing business in the US? If combined reporting is restricted to waters’ edge (US domestic operations), profits shifted/transferred offshore/overseas escape taxation AND it makes the playing field less level – discriminating against US based corporations while favoring foreign corporations conducting business in the US!

  • smitchell

    Anonymous: States can and do adopt worldwide combined reporting that requires companies to account for the income of both domestic and foreign subsidiaries. Many of these states have, however, caved to corporate lobbies and carved out various “water’s edge” exceptions to this. Some of the reports in the list above have good discussions of this. We favor moving toward a level playing field where all corporate profits are fairly accounted for and equitably taxed.