A penny--make that $350 million--for your thoughts

by Ed Muir
 

State governments annually collect about $35 billion in corporate income taxes, which account for a bit more than 5 percent of state tax revenue. From the corporate perspective, that’s too much. Yet one corporate tax policy expert I know characterizes the taxes as “the last charitable contribution that American companies choose to make each year.” Another analyst (formerly in state government) says it’s only through a failure of imagination that any company pays state corporate taxes at all!

In the early 1990s, corporate taxes provided state governments with almost 8 percent of their income, down from 10 percent in 1979. Corporations have reduced their share of the burden of paying for public services in the states by about half. Some of this is the result of lobbying for beneficial changes in tax codes, and some is the skillful exploitation of loopholes in those codes by accountants and lawyers who specialize in tax sheltering and avoidance.

I thought I understood the depths to which companies would go to find legal ways to avoid paying taxes. But then I opened my copy of a publication called State Tax Notes and read about the consulting firm KPMG LLP, which had advised its clients to sell to themselves their own thoughts and call it a tax-deductible business expense. One of the firm’s clients, WorldCom, deducted $20 billion from its income—saving the firm $350 million in state taxes—by creating a company to hold its “management foresight” and selling it back to the parent company. It’s only through the WorldCom bankruptcy proceedings that this scandal has been brought to light. The author of the State Tax Notes article, David Brunori, wanted to know where the outrage over this was. Here it is.

First some context: Corporate tax laws are detailed, complicated and vary from state to state. Companies seek to take advantage of this and work to create changes in state tax codes that will allow them to lower their overall tax burden. This is not surprising, nor is it outrageous. It is simply life in the fast lane.

One common loophole is known technically as the “passive investment company” loophole, generically as the Delaware holding company loophole and colloquially as the Geoffrey-the-Giraffe loophole. Delaware’s corporate law is constructed so that profits from the sale of intellectual property—trademarks and patents—are not subject to Delaware tax. Hundreds of U.S. companies have created wholly owned subsidiaries in Delaware to hold their patents and trademarks. The parent companies then pay a fee to these subsidiaries. Revenue earned by the parent company is then sent to the Delaware subsidiary. As such, this revenue no longer is a taxable profit in the state where it was earned but is instead a business expense. The profit accrues in Delaware, where it is not subject to tax.

The most widely known example of this comes from Toys “R” Us. The company’s corporate symbol is Geoffrey the Giraffe. You’ve seen him in the commercials. But Geoffrey isn’t the property of Toys “R”  Us. He belongs to Geoffrey Inc., a Delaware company that is totally owned by Toys “R”  Us, which pays Geoffrey Inc. a fee for the use of the giraffe and which takes a write-off on this cost in its tax returns in the many states where it is legal to do so. Geoffrey Inc. pays no taxes because it only makes sales in Delaware where sales of intellectual property are not subject to tax. The effect is the same as being able to take a tax deduction by shifting your wallet from your left pocket to your right. Surprising? Outrageous? Yes, but also legal. AFT affiliates in Maryland, New York and several other states have been involved in campaigns to close this loophole.

Heretofore, companies using the passive-investment corporation maneuver have focused on actual patents or trademarks. The transaction involved the sale or lease of something intangible but still definable as property. KPMG has taken this to a new level. Rather than license a trademark, the company advised WorldCom that it could sell itself its own business acumen—“management foresight.” While management foresight is intangible in a way that, say, management respiration or digestion is not, this is an interpretation of the law pulled out of thin air. Good vibrations, positive thoughts and management prayer could all be considered business expenses under these rather generous interpretations of the rules.

Laughable, yet it cost states $350 million in much needed cold, hard cash that is being offset by reduced public services or higher taxes for the rest of us. Twenty-one states are considering legal action to recover their money.

Ed Muir, an assistant director of AFT research and information services, specializes in state funding and policy.

Ed Muir, an assistant director of AFT research and information services, specializes in state funding and policy. This column is intended to demystify state tax structures and spotlight efforts to achieve tax reform--an activity high on the agenda of labor and our state federations. Send comments to emuir@aft.org.

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