Many retail chains, including Victoria’s Secret and Toys “R” Us, earn profits at stores nationwide, but have developed an accounting scheme to evade paying their full-share of corporate income taxes in more than half the states.
Tax experts believe the practice is costing states billions of dollars in lost revenue. It is likely one factor behind the decline in state corporate income tax receipts. Between 1979 and 2000, the share of total state tax revenue contributed by corporate income tax fell from 10.2 to 6.3 percent.
The practice has also given major retail chains an advantage over locally owned businesses that pay state income tax on all of their earnings.
Here’s how it works: A chain sets up a subsidiary in a tax haven state 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 turn pay the subsidiary a hefty fee for using the trademark, effectively shifting profits out of other states and into the Delaware subsidiary. Because Delaware does not levy corporate income taxes on earnings from intangible assets such as trademarks, profits transferred in this manner are free of state corporate income taxes.
Often the subsidiary will also lend money to the rest of the corporation, enabling a second stream of profit transfer through the payment of interest on the loan.
The practice originated in the mid 1980s and grew rapidly in the 1990s. Because companies are not required to publicly disclose these transfers, it is not possible to determine how much profit is being sheltered in this manner. Companies known to engage in the practice include Circuit City, The Gap, Home Depot, Ikea, Kmart, Kohl’s, Limited Brands (which owns Bath & Body Works, Victoria’s Secret, The Limited, and several other chains), Payless Shoes, Sherwin Williams, Staples, and Toys “R” Us.
Court cases brought by states against some of these retailers have revealed more details about the scope of the transfers. For example, in 1990 alone, Toys “R” Us shifted $55 million to its Delaware subsidiary, Geoffrey, Inc. Between 1992 and 1994, Limited Brands transferred more than $1.2 billion from its retail chains into Delaware subsidiaries. Kmart shifted $1.25 billion into its Michigan subsidiary, Kmart Properties, Inc., from 1991 to 1995.
The court cases, in which states have alleged that the schemes are illegal tax-evasion scams, have produced mixed results. Many state courts have sided with the corporations and ruled that the practice is legal. A few have ruled in favor of the states, including most recently the Maryland Supreme Court. That case is likely to be appealed to the U.S. Supreme Court.
Rather than sporadic and costly court challenges, a better approach—though one that requires overcoming the corporate lobby—is to change state tax law. Sixteen states are not vulnerable to tax-evasion transfers, because they have enacted a policy known as “combined reporting” (also referred to as taxing companies on a “unitary basis”).
Combined reporting requires that companies combine profits from all related subsidiaries before determining what portion of their profits are taxable in that state. (To determine how much of their total 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.
In addition, seven states have laws that prevent tax evasion based on profit transfers to trademark-holding companies. The downside of these laws is that, unlike combined reporting, they do not account for other ways that corporations can transfer profits to subsidiaries, for example, through the payment of interest on loans.
The remaining twenty-two states with corporate income taxes (five states do not tax corporate income), plus the District of Columbia, are vulnerable to profit transfers, which reduce state tax revenue and place local retailers at a competitive disadvantage. These states are Arkansas, Delaware, Florida, Georgia, Indiana, Iowa, Kentucky, Louisiana, Maryland, Missouri, New Mexico, New York, Oklahoma, Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Vermont, Virginia, West Virginia, and Wisconsin, plus the District of Columbia.
The current state budget shortfalls provide an excellent opportunity for citizens and small businesses to push for an end to these loopholes. Wisconsin, for example, would generate an estimated $70 million in added tax revenue annually by adopting combined reporting, while Pennsylvania would gain $100 million.
- For links to more resources, including two excellent reports by Michael Mazerov of the Center on Budget and Policy Priorities, see combined reporting
- Also, check out our page on Throwback Rules, which counter a similar state tax evasion scheme, but one that pertains more to manufacturers than retailers: