| From the West Virginia Blue archives, here's another greatest hit, deep cut, or timeless classic... Antipode makes the complex subject of combined reporting easily understandable. Originally posted on Feb 19, 2007.
A 2003 study by the Multistate Tax Commission (MTC) suggests that states lost as much as $7.1 billion in corporate income tax revenue in fiscal year 2001 due to aggressive tax avoidance strategies on the part of large, multi-state corporations. This study also estimated that West Virginia lost 58 percent of its corporate income tax collections (as a share of revenue) in 2001 due to tax shelters, the highest in the nation. The estimated revenue lost due to domestic tax sheltering alone was between $17 and $36 million in 2001.
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| One of the major reasons this is happening is because large, multi-state corporations have implemented a tax avoidance strategy that is based on transferring ownership of the corporation's trademarks and patents to a subsidiary corporation located in a state that does not tax royalties, interest, or similar types of intangible income. The PICs act as "fronts," or facades, for large multi-state corporations to hide their taxable income.
The most popular example of a passive investment company is Geoffrey Inc., a subsidiary of Toys "R" Us, located in Delaware. Geoffrey Inc. is a shell corporation; they have no real staff, and their only function is to serve as a tax-free haven for corporate profits.
Here's how the tax loophole works. Toys "R" Us is required to pay West Virginia corporate income taxes on the profits it makes from its stores in West Virginia. Toys "R" Us deducts from its profits the royalties its West Virginia stores pay to Geoffrey for use of the Toys "R" Us name. Thus, part of the Toys "R" Us profits earned in West Virginia disappear, and part of its West Virginia tax burden goes with it. Geoffrey Inc. and hundreds of other PICs have been established in Delaware, where they can shift profits that would have been taxable in West Virginia and many other states. Toys "R" Us is not the only culprit here. A recent Wall Street Journal investigation also showed the existence of 50 such companies engaging in similar arrangements, including Home Depot, Staples, Burger King, Gap, and many other big names.
Combined Reporting Forces Tax-Dodgers to Pay Up
So far, 17 states have closed the PIC or Geoffrey loophole by requiring "combined reporting" of profits. Under combined reporting, all profits from the in-state business (such as the Toys "R" Us stores) and any out-of-state subsidiaries (such as Geoffrey Inc.) must be combined and reported on the West Virginia return, including any royalties earned by the PIC subsidiaries. The royalty deduction no longer reduces the company's taxable profits because it is added back in as income for the subsidiary. Toys "R" Us then is taxed fairly on the legitimate profits made in the state.
An example of how the PIC loophole shifts profits and reduces taxes, and how this benefit is eliminated through combined reporting, let's imagine a company named Shoes R Us that has several stores located in West Virginia and has a subsidiary in Delaware named Happy Feet that owns the royalties on its trademark. Let's say Shoe R Us had $50 million in gross profits in West Virginia, but paid $20 million in royalty fees to Happy Feet. The profits taxable in West Virginia would be $30 million, instead of $50 million because this loophole allows Shoes R Us to reduce its taxes by shifting its profits. If we applied West Virginia's current corporate net income tax rate to this scenario, the revenue collected would $2.65 million instead of $4.4 million, a difference of $1.75 million. If West Virginia had combined reporting, Shoes R Us would have to pay taxes on all $50 million in profits. See above image.
Unfortunately, the PIC loophole is one of just many tax avoidance techniques available to corporations operating in West Virginia. For example, a February 2007 Wall Street Journal article notes that Wal-Mart may have been able to avoid as much as $350 million in state corporate income taxes between 1998 and 2001 due to another, similar loophole know as "captive real estate investment trusts (REITs)."
If West Virginia adopted combined reporting multi-state corporations would be required to report profits from related entities, including any subsidiaries. Currently in West Virginia corporate taxpayers use "separate accounting," where businesses report profits only to the extent the business is located in the state. This limitation, as shown above, creates an open invitation to tax avoidance. According to testimony given by state fiscal policy director Mark Muchow, mandating combined reporting could boost income tax receipts by $25-$35 million in West Virginia over the long-term.
While combined reporting will not solve all problems associated with corporate tax avoidance, it's the single best short-term option available to lawmakers that will not only give the state additional revenue without raising taxes, but level the playing field by requiring multi-state corporations to pay the same tax rate as West Virginia homegrown businesses. |
