Corporate tax loophole is costing states revenue

State governments annually collect about $35 billion in corporate income taxes, which account for a bit more than 5 percent of state tax revenue. 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 is 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 through a combination of lobbying for beneficial changes in tax codes and skillful exploitation of loopholes in those codes.

I thought I understood the depths to which companies would go to avoid paying taxes. But then I read an article in State Tax Notes about consulting firm KPMG LLP, which had advised its clients to sell 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 by creating a company to hold its “management foresight.” That $20 billion deduction saved WorldCom $350 million in state taxes. But it is costing the rest of us. States are offsetting the revenue loss by reducing public services or raising other taxes and fees.

David Brunori, author of the State Tax Notes article, wanted to know where the outrage over this was. Brunori needn’t look far. Twenty-one states are considering legal action against WorldCom to recover their money.

Yet, broader grassroots action needs to be taken so state lawmakers address the root of this practice: the “passive investment company” loophole, known generically as the Delaware holding company loophole and colloquially as the Geoffrey-the-Giraffe loophole.

Hundreds of U.S. companies have created wholly owned subsidiaries in Delaware to hold their patents and trademarks because the state does not tax corporate profits from the sale of intellectual property. The parent companies then pay a fee to these Delaware-based 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 use of this loophole is the Toys “R” Us corporate symbol, Geoffrey the Giraffe. Geoffrey is the property of Geoffrey Inc., a Delaware company totally owned by Toys “R” Us, which pays Geoffrey Inc. a fee for the use of the giraffe. Toys “R” Us 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.

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 took application of the loophole to a new level, advising WorldCom that it could sell itself its own business acumen: “management foresight.”

AFT affiliates in Maryland, New York and several other states have been involved in campaigns to close the passive investment company loophole, which may be easier to do now, thanks to KPMG and WorldCom.