Ending the Corporate Shell Game

Ending the Corporate Shell Game

- in Weekly Briefing

Will Lawmakers Make Big Companies Honestly Report Their Taxes?

By Rob Schofield

 Quick Take:

  • North Carolina’s tax on corporate profits (aka the corporate income tax) is currently 6.9% — a lower rate than is paid by the average middle class family.
  • In recent years, tax loopholes have allowed a large and growing number of big, profitable companies to avoid paying even that rate. Some pay no North Carolina tax at all.
  • In response, many state officials and legislators are pushing for the adoption of a loophole closing policy called “combined reporting” – what some are calling “honest reporting.”

For many decades in North Carolina, few, if any, other taxes provided more revenue for state government than the tax on corporate profits. In recent decades, however, this situation has changed dramatically. According to the most recent data, the corporate profits tax provides only around 7% of General Fund revenues. (It should be noted, however, that this still amounts to a critically important $1.2 billion in recurring funds).  

The reasons for the decline are complex. Much of the change is attributable to the state’s dramatic progress of the last half of the 20th century. As North Carolinians came to realize the critical role that public institutions could play in leading the state out of its overwhelmingly rural, segregated, and impoverished past, state government grew at a healthy clip. This growth, in turn, required policymakers to turn to new, somewhat more reliable sources like the personal income and sales taxes. Though still important, corporate taxes declined as a share of the pie.

Another big reason for the decline – particularly in recent years — has been the explosive growth in the use of loopholes, shelters and other tax avoidance techniques. When this development is combined with the state’s ever-expanding use of so-called “tax incentives” (i.e., selective tax cuts and rebates for favored companies or groups of companies), it is no surprise that corporate tax revenues have stagnated.  

Today’s Favored Tax Dodge – The Corporate Shell Game         

Perhaps the most important development in the exploitation of tax loopholes by corporations in recent years involves the use of a shell game in which large corporations attribute profits to subsidiaries they’ve set up in tax haven states like Delaware and Nevada. The following excerpt from a report by the experts at the Washington, D.C.-based Center on Budget and Policy Priorities explains the scam:

“[The] tax shelter is frequently referred to as the ‘Delaware Holding Company’ or ‘Passive Investment Company’ (PIC). It is based on a corporation’s transferring ownership of its trademarks and patents to a subsidiary corporation located in a state that does not tax royalties, interest, or similar types of ‘intangible income,’ such as Delaware and Nevada. Profits of the operational part of a business that otherwise would be taxable by the state(s) in which the company is located are siphoned out of such states by having the tax-haven subsidiary charge a royalty to the rest of the business for the use of the trademark or patent. The royalty is a deductible expense for the corporation paying it, and so reduces the amount of profit such a corporation has in the states in which it does business and is taxable.”

Many of the companies even have the nerve to “loan” the profits of the PIC right back to the rest of the corporation. This allows a secondary siphoning of income to occur through the payment of deductible “interest” on the loan. Another similar tactic favored by Wal-Mart is known as the “captive Real Estate Investment Trust” (REIT).

The Shell Game Solution: Honest Reporting

The widespread use of the corporate shell game and other loopholes has given rise to a national movement dedicated to reining in the abuse. More than a third of the states in the nation have now adopted a fairly simple and straightforward rule that nullifies the abusive use of PIC’s and captive REIT’s known as “combined” (or “honest”) reporting.

With honest reporting, the parent corporation and most of its subsidiaries are treated as one corporation for state income tax purposes. Nationwide profits are added together (i.e., “combined”) and the state then taxes a share of that combined income. The share is honestly calculated by a formula that takes into account the corporate group’s level of activity in the state as compared to its activity in other states.

With honest reporting, states are able to put an end to the absurd situation in which giant and highly profitable corporations like Wal-Mart pay little or no state tax on their profits. For North Carolina, honest reporting would mean millions in new, recurring state revenues (as much as $120 million or more).

A Matter of Fairness

For all of the new and critical state revenues that would result from honest reporting, the chief benefit of such a policy is fairness – fairness for individuals and fairness for small and mid-sized businesses. Honest reporting helps to “level the playing field” by ensuring that large multi-state corporations do not pay lower rates than small businesses.

As one newspaper in another state put it:

“The appropriate tax rate of business certainly is debatable, but everyone should agree those companies should pay the full taxes they owe, and multi-state corporations shouldn’t have a tax advantage over wholly local corporations…. Ensuring taxes are collected by closing a loophole that’s unfair to [locally] based businesses should be a bipartisan no-brainer.”

Some North Carolina lawmakers have proposed pairing the adoption of honest reporting with an across-the-board reduction in the overall corporate income tax rate in order to keep adoption of the rule “revenue neutral.” Other supporters, however, question the wisdom of cutting corporate taxes at a time in which North Carolina’s public needs are great and is already consistently rated as one of the nation’s most business-friendly states.    

The Outlook in North Carolina: Hopeful

Though a proposal to adopt honest reporting during the current legislative session enjoys the support of Governor Easley, Revenue Secretary Tolson and several prominent legislators, passage is not a forgone conclusion. Reports from the state Legislative Building indicate that large corporate interests are lobbying aggressively behind the scenes to torpedo the proposal. The principal collective mouthpiece for these interests, the NC Chamber, has stated that it is opposed to the two main honest reporting bills. Moreover, the small and mid-sized business interests – the groups that stand to benefit the most directly from the adoption of honest reporting – have yet to make their position clear.

Groups supporting reform, however, are starting to mobilize. North Carolinians for Fair and Adequate State Taxes (NC FAST), a coalition that includes several large membership groups including the N.C. Association of Educators, AARP North Carolina, the State Employees Association, the state AFL-CIO, and N.C. Council of Churches, has taken a strong position in support of modernization and reform.

These groups argue persuasively that it is patently unfair for North Carolina lawmakers to skimp on essential public services (in public education, mental health, children’s health and other essential human services) or to consider new and regressive tax hikes that disproportionately impact low and moderate income families at the same time that highly profitable, multi-billion dollar corporations are paying only a tiny fraction of their lawful tax obligation. They promise an aggressive lobbying campaign to convince lawmakers to adopt honest reporting before the end of the session.

According to insiders at the General Assembly, the debate over honest/combined reporting could begin in the state Senate as soon as this week. The result of that debate is likely to impact the fairness (and adequacy) of North Carolina’s tax code for decades to come. ##

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