Closing State Corporate Tax Loopholes: Combined Reporting

Last Updated: December 2015

Many retail chains earn profits at stores nationwide, but have developed accounting schemes to evade paying their full share of state corporate income taxes. Tax experts believe the practice costs states billions of dollars in lost revenue.  It also gives chains an advantage over locally owned businesses, which must pay state income tax on all of their earnings. Twenty-five states have protected themselves against these tax-evasion schemes by enacting a policy known as combined reporting.

How the Loophole Works

In order to evade their state tax obligations, many chain retailers transfer their 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, and Home Depot stores in other states pay the subsidiary a hefty fee for using the trademark.  Home Depot then deducts those fees as business expenses from its 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.

Another method, the REIT scheme, has been widely used by large retailers, notably, Walmart.

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 Walmart’s use of a captive REIT: “One Walmart 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 Walmart subsidiary, which receives the REIT’s dividends tax-free. And Walmart gets to deduct the rent from state taxes as a business expense, even though the money has stayed within the company.”  (“Walmart Cuts Taxes By Paying Rent to Itself,” 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 Walmart escape state and local taxes.

The Scope of the Problem

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

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” [PDF]).

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.

Evidence submitted in a case in North Carolina revealed that, in one four-year period, from 1998 to 2001, Walmart 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 Walmart 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 Walmart’s tax avoidance schemes helped cut its payments to state governments almost in half between 1999 and 2005. Over those seven years, Walmart 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 Walmart paid taxes at the statutory state corporate tax rates for the same period, it would have paid $4.7 billion in state income taxes.

More recently, at the end of 2013, the Arizona Court of Appeals ruled that Home Depot had shielded $4.7 billion in taxable income through its trademark subsidiary, Homer TLC. During the three years that the court reviewed, Home Depot paid 4 percent of its total revenue as a “licensing fee” to this affiliate, giving Homer TLC revenue of $4.7 billion. Over the same three-year period, Home Depot itself reported a profit of $3.8 billion. In other words, in states vulnerable to this kind of tax dodging scheme, Home Depot was shielding more than half of its profits from taxes. (For further reading, see the Court’s opinion [PDF] and an amicus brief [PDF] filed by the Multistate Tax Commission in support of the Arizona Department of Revenue.)

The Arizona Court of Appeals ruling found that Home Depot had to pay taxes on that income, and file a combined tax return with Homer TLC. The court was able to do this because of a simple solution on the books in Arizona—and available to all states—known as taxing companies on a unitary basis, or “combined reporting.”

The Solution: Combined Reporting

Some states have attempted to thwart these schemes through court challenges, arguing that they constitute illegal tax-evasion scams, rather than legitimate tax-reduction strategies. 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 Walmart, 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.

As of December 2015, 25 states, along with the District of Columbia, have adopted combined reporting.  These states are: Alaska, Arizona, California, Colorado, Connecticut, Hawaii, Idaho, Illinois, Kansas, Maine, Massachusetts, Michigan, Minnesota, Montana, Nebraska, New Hampshire, New York, North Dakota, Oregon, Rhode Island, 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 20 states, as of December 2015, 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, Delaware, Florida, Georgia, Indiana, Iowa, Kentucky, Louisiana, Maryland, Mississippi, Missouri, New Mexico, New Jersey, North Carolina, Ohio, Oklahoma, Pennsylvania, South Carolina, Tennessee, and Virginia.

Worldwide Combined Reporting

Combined reporting can capture the profits that companies shift around within the U.S. Yet as companies increasingly incorporate subsidies around the world and shield their profits overseas, the gold standard for closing the loophole on these accounting schemes is a measure known as worldwide combined reporting. The reform requires corporations to account for profits earned in the state but shifted to international subsidiaries.

States first began adopting worldwide combined reporting in the 1970s and 1980s, and the U.S. Supreme Court upheld it in two decisions in 1983 and 1994. Nevertheless, after strong pushback from other countries and a threat by Congress to intervene in 1985, states have migrated away from this approach. California is one of a handful of states that still has a worldwide combined reporting law on its books, though corporate lobbying has introduced a number of loopholes into the law that limits its efficacy. Another state, Alaska, requires worldwide combined reporting for oil companies only.

Some states have now instead adopted a modified type of worldwide combined reporting known as “water’s edge” reporting, which requires corporations to file joint tax returns with subsidiaries that are incorporated in countries that meet criteria for being a tax haven. Water’s edge combined reporting exists in several of the states that once had stronger worldwide combined reporting standards, as well as in three states, Montana, Oregon, and Rhode Island, that have adopted it directly, in addition to Washington, D.C.

Montana’s water’s edge combined reporting reform allowed it to collect $7.2 million in corporate taxes in 2010 that would have otherwise gone uncollected, finds a report from U.S. PIRG. In Oregon, which passed a water’s edge law in 2013, the Legislative Revenue Office expects the state will collect an additional $42 million in corporate taxes in the 2015-2017 biennium.



  • Connecticut — In 2015, Connecticut enacted combined reporting. View the full text of Connecticut Public Act 15-244, Sec. 138.
  • Rhode Island — In 2014, Rhode Island passed changes to its Business Corporation Tax that included mandatory unity combined reporting and water’s edge combined reporting, effective at the beginning of 2015. View the full text of Rhode Island H.B. 7133, Sec. 15 [PDF].
  • Washington, D.C. — In 2009, Washington, D.C. enacted a water’s edge combined reporting law that took effect at the beginning of 2011. View the full text of D.C. Official Code Statute 47-1801.04 and Statute 47-1805.02a.
  • West Virginia — In 2007, West Virginia implemented combined reporting.  View Full Text of SB 749.
  • Vermont — In 2004, Vermont enacted combined reporting legislation. The preamble to the bill notes, “Vermont’s separate accounting system is inadequate to measure accurately the income of a corporation with non-Vermont affiliates and creates tax disadvantages for Vermont corporations which compete with multistate and multinational corporations doing business in Vermont….it is the intent of the general assembly, in adopting a unitary combined system, to put all corporations doing business in Vermont on an equal income tax footing.” View full text of Vermont’s Act 152.


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Stacy Mitchell

Stacy Mitchell is co-director of the Institute for Local Self-Reliance and directs its Independent Business Initiative, which produces research and designs policy to counter concentrated corporate power and strengthen local economies.