State Corporate Tax Shelters and the Need for “Combined Reporting”
October 26, 2007
A growing number of states are adopting or considering a key corporate tax reform known as "combined reporting." Most large corporations consist of a parent corporation and its subsidiaries; combined reporting effectively treats the parent and most or all of its subsidiaries as a single corporation for state income tax purposes.
Almost half the states with corporate income taxes have adopted combined reporting. Five states have enacted the reform in the last three years, and several others have seriously considered doing so. A major reason for states' growing interest is their recognition of how badly corporate tax shelters that exploit the lack of combined reporting are eroding state corporate tax payments. Corporations have devised a wide variety of strategies to artificially shift profits to out-of-state subsidiaries. Combined reporting largely negates these strategies by enabling the state to tax a fair share of the profit shifted into a related, out-of-state corporation.
This report discusses some of the corporate tax-avoidance strategies to which non-combined reporting states are most vulnerable and explains how combined reporting can help a state preserve a strong and fair corporate income tax.
Reform Nullifies Three Common Tax Shelters
Three of the most common state corporate tax shelters rely on the creation of subsidiaries that are expressly or effectively exempt from corporate income taxes in the states in which they are formed. The types of subsidiaries are:
- Passive investment companies (PICs). PICs are set up to manage -- and collect income from -- intangible assets such as corporate trademarks, patents, stocks, and bonds. PICs are most often formed in Nevada and Delaware. Nevada has no state corporate income tax, and Delaware exempts from its state corporate income tax a corporation with income arising only from the ownership of intangible assets.
- Real Estate Investment Trusts (REITs). REITs are set up to manage -- and collect income from -- real estate and related financial instruments (such as mortgage loans). Under federal and state tax law, a REIT can deduct from its taxable income the dividends it pays to shareholders -- which means it is effectively tax-exempt. Most REITs are owned by thousands of shareholders and serve their intended goal of being the real-estate equivalent of a stock or bond mutual fund. However, they can also be used as a state tax shelter when they take the form of "captive REITs" effectively owned by a single corporation.
- Captive Insurance Companies ("captives"). A captive insurance company is a subsidiary set up by a corporation to insure the corporation against risks such as the loss of a product liability lawsuit. In most states, captives -- like regular insurance companies -- are exempt from state corporate income tax, which means their investment income is not taxed at all. In contrast to PICs and captive REITs, which clearly are established primarily as tax shelters, captives are often set up for legitimate self-insurance purposes, with the potential for tax sheltering a secondary benefit.
There are two basic ways in which corporations use these three kinds of subsidiaries to shelter corporate profits from state income taxation in states that do not have combined reporting:
Shifting taxable profits into a tax-haven subsidiary. This happens when the operational part of the corporate group pays the subsidiary for the right to use assets such as real estate or a trademark. This payment is tax deductible, so it reduces the taxable profit of the operational part of the corporate group. In addition, the resulting profit for the subsidiary is not taxed by the state in which the subsidiary is located, either because that state has no corporate income tax or because the state exempts that particular form of subsidiary from the tax.
For example, as recently described in the Wall Street Journal, Wal-Mart has transferred the ownership of its stores to a subsidiary that qualifies as a REIT. The parent corporation pays rent to the REIT for the right to use the stores, which reduces the taxable profit of stores located in non-combined reporting states. Wal-Mart saved $350 million in state corporate income taxes over the four-year period from 1998 to 2001 on $7.3 billion in rent paid by Wal-Mart and Sam's Club stores to the company's REIT, according to accountants consulted by the Journal.
"Stashing" corporate assets that earn income from outside the corporation. In addition to using PICs, REITs, and captive insurance companies to artificially shift income within the corporate group, corporations also use these entities as a place to stash a variety of assets that earn income from outside the corporate group.
For example, banks widely use PICs to keep income-earning assets away from taxation by non-combined reporting states. One such state, Wisconsin, has engaged in a four-year effort to force its in-state banks to pay taxes on assets they have "parked" in Nevada subsidiaries. The Wisconsin Department of Revenue believes that at least 250 of the state's 320 banks have Nevada PICs; thus far, it has reached settlements with 180 of them, collecting approximately $42 million in back-tax payments.
Similarly, a recent Business Week article highlighted Apple Computer's creation of a Nevada subsidiary to manage its $8.7 billion portfolio of cash and other "liquid" assets. Also, Microsoft's recent annual report to the Securities and Exchange Commission names 11 separate subsidiaries in Nevada, with names like "Microsoft Treasury, Inc." and "Microsoft Investments, Inc." -- strongly suggesting that at least some of them are PICs.
A properly conceived and drafted combined reporting law would nullify such uses of these subsidiaries to avoid state income taxes. Combined reporting eliminates the tax benefit of artificially shifting income into one of these entities because it counts the subsidiary's income in the calculation of the corporation's total income, of which the state can then tax its appropriate share.
Reform Also Effective Against Other Tax-Avoidance Strategies
One of the most basic strategies corporations use to minimize their income tax liability is to "wall off" as much of the corporation's profit as possible in a subsidiary that is not taxable in the state(s) where the subsidiary's customers are located. This is known as "nexus isolation." ("Nexus" is a legal term that means "engaging in sufficient activities in a state to become subject to a tax in that state.")
Manufacturers are particularly well positioned to engage in nexus isolation. They can take advantage of a little-known federal law that sets a nexus threshold for state corporate income taxes. The law bars states from taxing the income of out-of-state corporations if the firms limit their activities within the state to "solicitation of orders."
Ordinarily, if a manufacturer repairs its products at the customers' locations, supervises installation of the products, or trains its customers' employees in how to use them, these activities would "create nexus" for the manufacturer in its customers' states and subject a share of its profits to taxation in each one. Because of the federal law, however, the manufacturer has another option. It can create a subsidiary to conduct such activities in its customers' states, while limiting the activities of the parent corporation in these states to soliciting orders. The customers' states will now be able to tax the (likely nominal) profits of the subsidiary, but the vast bulk of the corporation's profits -- those derived from the sale of the products -- will have been walled off in the parent corporation, which the customers' states cannot tax.
A widely used handbook on multistate corporate income tax laws recommends this nexus isolation strategy:
"When nexus is created by sales representatives performing repair and maintenance services in the state, one strategy would be to separately incorporate the sales division that operates in the state. This would prevent a nonunitary state [i.e., one without combined reporting] from taxing the profits attributable to the parent corporation's out-of-state assets and activities..."
Combined-reporting states are much less vulnerable than other states to this form of corporate tax avoidance. Once a combined-reporting state has nexus over one subsidiary in a corporate group, the subsidiary must calculate its tax on the basis of the corporate group's combined profit. This eliminates much of the tax savings from isolating profits in out-of-state subsidiaries, since those profits are added back into the taxable base of the in-state entity -- of which the state then taxes its fair share.
Combined reporting also counters a related tax-avoidance strategy called "transfer pricing," in which a parent corporation sells its products to an out-of-state subsidiary, which in turn sells them to the final customers. If the parent does no more than solicit orders from its own subsidiary, it is not taxable in the state in which the subsidiary is located. Moreover, the parent has substantial leeway to manipulate the prices (called "transfer prices") at which it sells its products to the subsidiary in order to minimize its nationwide state corporate tax liability.
For example, if corporate taxes are higher in the state where the manufacturing plant is located than in most states where customers are located, the corporation can set the transfer price at an artificially low level. This will reduce the corporation's overall state income tax bill by shifting part of the corporation's profits from a higher-tax state (where the manufacturing plant is located) to lower-tax states (where the subsidiaries are located).
In combined-reporting states, however, corporate manipulation of transfer prices does not affect state corporate tax revenues. Since the profits of a corporation's components are added together to determine the corporation's taxable base, the allocation of those profits within the corporation is irrelevant.
Combined Reporting More Effective Than Attacking Tax Shelters Individually
Some non-combined reporting states have tried to challenge the tax-avoidance strategies discussed above with ad hoc litigation based on general anti-tax-avoidance language in their statutes. Other states have enacted targeted legislation to close these shelters individually. Such approaches can be useful stop-gaps, but they are inferior to combined reporting for a number of reasons:
- Case-by-case litigation and settlement negotiation is both labor intensive and time consuming.
- Some of the targeted anti-tax shelter legislation as drafted contains loopholes or may be vulnerable to legal challenges.
- Corporations can hire the best legal and accounting talent in the country and are likely to remain one step ahead of state tax administrators in formulating tax-avoidance techniques.
- Most importantly, some tax-avoidance strategies can only be addressed effectively by combined reporting. For example, there is no practical alternative to combined reporting to address nexus isolation and transfer pricing; non-combined reporting states are effectively defenseless against them.
Combined reporting is not a panacea for the erosion of the state corporate income tax. Some combined-reporting laws themselves contain loopholes, and most combined-reporting states are vulnerable to tax shelters formed outside the United States. Nonetheless, many large and small states alike have used combined reporting successfully for decades, and the U.S. Supreme Court has twice upheld its legality. Thus, while taxing the profits of sophisticated multistate corporations will always be challenging, combined reporting is a critical element in maintaining a fair and effective state corporate income tax.