Bear Left!

Corporate Tax Games, Delaware Style
Tim Francis-Wright

A recent ruling by the Massachusetts State Judicial Court could pave the way to allowing large corporations to reduce their income tax bill in many states to minuscule levels. The ruling comes at a time when state governments can least afford bad news. The stagnant economy has already depressed tax revenues. In addition, corporations are employing stratagems, from the illegal to the merely dodgy, to deduce their federal and state tax bills. Now, simply by organizing their subsidiaries correctly, large corporations can reduce their tax bills even further.

Virtually lost in the political coverage in the American media during the past two weeks was a stunning admission by Charles Rossotti, the outgoing Internal Revenue Service Commissioner, that the federal government was losing the battle to prevent individuals and corporations from cheating on their income taxes. Several corporations (including, infamously, Arrow Plastics) have seized upon the febrile notion that wages from domestic corporations are exempt from income taxes, so they have neither paid taxes nor withheld taxes from their worker's paychecks for years. Even though the IRS has ample precedent to get judgements against companies like Arrow, it lacks the budget to prosecute them.

The state of the battle to corral tax cheats is a direct result of the actions by Republicans in the Senate in 1997 and 1998 to rein in what they deemed "excesses" of the IRS. Senators decried IRS practices that were mostly isolated and sometimes fabricated, and forced the Taxpayers' Bill of Rights into law. While Rossotti tried throughout his term, with limited success, to expand his enforcement and audit staff in the face of tax avoidance schemes that grew in number and complexity, Congress demanded that he devote a growing number of resources to limit cheating on the Earned Income Tax Credit, one of the few explicit tax breaks for the working poor.

One of the newest forms of tax evasion is unique to corporations. Large accounting firms are advising their corporate clients to undergo "inversions." In an inversion, a firm moves its nominal headquarters to a noted business center like Bermuda or the Cayman Islands, neither of which has a corporate income tax. In some cases, companies set up their headquarters in Barbados or Luxembourg, which have minimal corporate income taxes and, more importantly, tax treaties with the United States, then have a separate entity reside in Bermuda. In either case, the actual work done in Bermuda or Luxembourg or Barbados is minimal or even nonexistent. A Bermuda company can operate out of a post office box or a file folder. Accenture, the former Andersen Consulting, took this advice to heart, and PriceWaterhouseCoopers had plans to follow suit, until it agreed instead to a purchase by IBM.

Generally, the offshore "headquarters" of an inverted company collects royalties from its American subsidiaries, which deduct those payments from their gross income. Even though the company has real American profits, on the books of the parent company those profits are really Bermuda profits. Corporations and their apologists, such as Paul O'Neill, the Secretary of the Treasury, argue that there is nothing wrong with this structure. But there is something quite wrong indeed. The transaction makes no sense without the tax benefits, although some countries like Bermuda provide companies from pesky American rules about shareholder rights. Tyco, for example, holds its annual meeting in Hamilton, Bermuda every year. This year, despite horrible news about massive corporate malfeasance, the meeting was a sparsely-attended, placid, affair that took less than an hour to complete.

More generally, corporations and their apologists argue that American corporate income taxes put American firms at a disadvantage, and that inversions are merely good business. In fact, American corporate tax rates are similar to those in Europe, and corporations do not pay income taxes on their foreign profits until and unless those profits are repatriated. The purpose of inversions is to eliminate taxation of domestic sales. If not for the tax benefits, few companies would invert themselves. When companies ask shareholders for approval of inversions, the tax savings has been the paramount reason offered by management.

The Republican Party is so wedded to the needs of large businesses that it has done nothing to block more inversions from happening in the future. Corporations have the right to organize themselves to pay a minimum of taxes. And the federal government can and should have a tax code that rewards certain behavior by corporations and individuals. But two otherwise identical companies ought to be paying the same in taxes, regardless of whether the company uses a Hamilton solicitor's office as its nominal headquarters. To the Bush administration, corporate inversions are merely annoying, because Bush and his financial mavens have proclaimed a goal of eliminating federal corporate taxation altogether.

In addition to corporate inversions involving other countries, a number of large corporations have quietly practiced a form of inversion within the United States. While some states like California use "unitary" taxation, taxing corporations based on the ratio of their in-state activity to their overall domestic activity, many states look at in-state activity in isolation.

To take advantage of this focus, many states set up a shell corporation or partnership in a low-tax state like Nevada or Delaware. The shell entity collects royalties for the use of trademarks and the like from a company's offices or stores in states with high corporate income taxes. In those states, the company reports the royalties as deductions. The shell entity in the low-tax state pays little or no taxes on the royalty payments, and returns the funds to the parent company, often in the form of operating loans. These shell companies explain why Toys 'R' Us and Home Depot advertisements mention Geoffrey, Inc. and Homer TLC, Inc., respectively. Earlier this year, the Wall Street Journal reported that a slew of companies use shell companies in this way. Furthermore, using a Delaware shell does not require shareholder approval, or make a company seem unpatriotic. The popularity of this sort of scheme is one reason that corporate income taxes make up a smaller and smaller fraction of total state tax receipts.

Massachusetts does not use unitary taxation, but the Department of Revenue has consistently argued that companies could not avoid state corporate income tax using a Delaware shell company because the nexus of the business activity was still in Massachusetts. The company's corporate profits from that nexus were, therefore, taxable. The Massachusetts Supreme Judicial Court had ruled that the Syms Corporation, a clothing retailer, could not avoid taxes by paying royalities to a Delaware shell that funneled royalties immediately back to the parent company. Last month, however, the same court approved a scheme by Sherwin-Williams take puts barely a fig leaf on the same sort of shenanigans.

Sherwin-Williams set up a Delaware entity to collect royalties from its various stores, including stores in Massachusetts, and deducted the royalty payments from its Massachusetts income. The Department of Revenue disallowed the deductions, but Sherwin-Williams sued to have the deductions reinstated. The Supreme Judicial Court ruled that the deductions were legal because the Delaware entity was more than just a shell. Instead, it collected the royalty payments, then invested them in various ways.

The difference is important because federal case law has established that the IRS can disregard as shams most investments made solely for their tax benefits. On the other hand, investments that make some sense without the tax benefits stand as legitimate. What the Massachusetts court missed in the Sherwin-Williams case was that the parent company would be investing the profits from its Massachusetts stores in any case, whether through its ultimate corporate parent or through a Delaware subsidiary. Sherwin-Williams gained nothing, except for tax benefits, from the peculiar nature of its corporate organization.

Now that Sherwin-Williams has official permission to dodge the Massachusetts corporate income tax laws, a host of other companies are preparing to replicate its structure for collecting royalties. And the arguments that prevailed in court in this case will surely find their way into courtrooms in other jurisdictions as well. In states like Massachusetts, paying corporate income taxes to the state will soon become an act of altriusm, not an act of paying a company's fair share. Of course, states can copy California and tax companies in a unitary basis, but doing so inevitably brings the wrath of business lobbyists, who surely know a good thing for the state when they see one.

The sorts of tax games that Sherwin-Williams is playing only adds to the pain felt by state revenue departments. Any problems that the IRS faces in collecting taxes and stopping fraud affects most states, because they have income taxes that rely in large part on federal tax law. Corporations and individuals who rip off the federal government usually rip off at least one state government as well. Further, revenue shortfalls of any kind hurt state governments more than the federal government. The federal government can borrow money on excellent terms to fund any budget deficits. A state government, by contrast, borrows money on rates largely determined by its bond rating, which takes into account the level of the current budget deficit and the states's overall debt burden. Even if ordinary citizens do not pay more in taxes when corporations get let off the hook, we pay the consequences when states get worse terms on their bonds.