Large corporations are not paying their way in Virginia’s tax system.

According to census data, in 1979 the corporate income tax accounted for 7.7 percent of total state revenue in Virginia. By 1989 that share had shrunk to 5.2 percent, and data from 2000 — a year of healthy corporate profits before the current recession hit — shows a further drop to 4.5 percent.

That means that the share of tax revenue from other sources has taken up the slack. As individuals, all of us are paying more than we should in sales tax, personal income tax and user fees in order to make up for the shrinking contribution of business to the common good.

But the Virginia corporate income tax rate has remained steady at 6 percent of profits for many years. What accounts for the decline in tax revenue?

Special exemptions and other tax breaks have caused corporations’ fair share of the decline, but corporations have also become more adept at avoiding taxes through loopholes and dodges. In fact, a large consulting industry has developed which focuses solely on helping corporations escape paying taxes. Small businesses rarely have the money or volume to take advantage of these loopholes, so these tax dodges go primarily to multi-state corporations.

Three changes to Virginia’s corporate tax law would raise approximately $92 million in new revenue, take effect relatively quickly, and require only minor adjustments to the current system. Also, all three of these changes would bring in revenue from corporate profits that are currently escaping taxation altogether.

Institute a throwback rule

The first change involves corporations that produce and sell products in more than one state. Their profits are usually divided, or apportioned, between the various states to be taxed. The problem is there is a federal law that says that the corporate presence — via sales or manufacturing — in a state must reach a certain level before the corporation can be subject to taxes there. As a result, the fair share of corporate profits apportioned to many states where the corporations only sell products becomes “nowhere income,” untaxed by any state.

The Throwback Rule corrects this loophole. The corporation’s home state would get to tax the “nowhere income.”

“The throwback rule effectively allows a state in which a corporation produces its wares to tax the profit on any sales made by the corporation into states in which the corporation has insufficient presence to be subjected to a tax on its profit from those sales,” said Michael Mazerov of the Center on Budget and Policy Priorities.

Virginia does not have a throwback rule. As a result, as much as 50 percent of the profit of a resident corporation can go untaxed.

The throwback rule could be put in place by a simple, one sentence addition to state code: “Sales of tangible personal property are in this State if the property is shipped from an office, store, warehouse, factory, or other place of storage in this State and the taxpayer is not taxable in the State of the purchaser.”

Block the passive investment company (PIC) loophole

Large corporations often open subsidiary corporations — ones that they own but that have a separate incorporation — in states like Delaware and Nevada that do not tax royalties, interest and other intangible income. These corporations are often called “passive investment companies.” The parent corporations then give ownership of their trademarks and patents to these PICs.

Each time the parent corporation uses the trademark, they must pay a royalty to the PIC, their own subsidiary. In this way, they can shift large chunks of their profit to the PIC’s state, where it is not taxed. Then the PIC loans its shadow profits back to the parent company, which can make a further tax deduction based on interest on the loan.

Isn’t that clever? Massive amounts of corporate income escape taxation by flowing through this loophole. A few examples have emerged from lawsuits brought by states against particular corporations.

• Toys R’ Us paid royalties on their Geoffrey character trademark to their Delaware PIC in the amount of $55 million in 1990 alone.
• The Limited/Victoria’s Secret/Lane Bryant/Express clothing retailer paid $949 million to their Delaware PIC between 1992 and 1994.

In June of this year, the Maryland State Court of Appeals ruled that companies doing business in Maryland couldn’t take advantage of this loophole by sending their profits to Delaware subsidiaries. Hopefully, other states will take advantage of this legal precedent to reclaim tax dollars due to them.

“The average homeowner can’t just take out a post office box in Delaware to cheat on their state taxes, but we’ve allowed every corporation to do that for years,” Tom Hucker, director of the grassroots group Progressive Maryland, said.

A few figures will help show the extent of the problem. Approximately 6,000 PICs had been incorporated in Delaware alone by the end of 1998 and new ones were arriving at around 600-800 per year. On the 13th floor of a single, high-rise building in Wilmington, Delaware, over 500 corporations have an “office.” Corporations which have been hit with lawsuits by states for using PICs include Dress Barn, Gap, Kohl’s, Tyson Foods, Radio Shack, Burger King, Kmart and many more.

Two solutions, one short-term and one more comprehensive, could be adopted by the 22 states — including Virginia — with no laws limiting the loophole.

First, like seven other states including Alabama and North Carolina, they could simply deny deductions on royalties and other interest paid to related corporations.

Second, like 16 other states, they could demand “combined reporting” from corporations. This would require corporations to add together profits from the PIC and the corporation paying the royalty or interest for tax purposes. The advantage of combined reporting is that it also blocks other income-shifting schemes used by many corporations.

Within legal limits, tax all “non-business” corporate profits

Remember back to the discussion of the Throwback Rule when we described how corporate profits get divided up between the states in which they operate? The Supreme Court has ruled that some kinds of profit fall outside those apportionments. Most states refer to those profits as “non-business income.” Instead, they are assigned to the state where the assets that generated them are managed, usually the corporation’s home state.

Most of this non-business income comes from the sales of property that are “irregular” or not part of the company’s regular transactions. For example, the sale of a factory and the equipment inside it are irregular occurrences and thus defined as non-business income.

But 13 states, including Virginia, have decided to treat all corporate profits as if they were regular business income. This blocks the loophole for all out-of-state corporations. Unfortunately, it creates a new loophole for companies headquartered within Virginia. Since it treats all profits as business income which should be apportioned to all the states in which the company operates, it cannot fully tax corporate profits which would legitimately be called non-business income and thus return entirely to Virginia to be taxed.

Here is an example. Say a fictitious corporation named T-G, Inc. sold a factory in Richmond for a $100 million profit. That sale is an irregular transaction and thus non-business income, so Virginia is legally entitled to tax the entire $100 million. Instead, Virginia treats it as if it was business income. If our apportionment calculation finds that 35 percent of the profit should be taxed here and 65 percent should be taxed elsewhere, then Virginia will only tax $35 million of the profit. The other $65 million becomes “nowhere income” for T-G, Inc. You can be sure that the owner, Mr. T-G, knows this and will take advantage of the tax dodge.

The solution is to change our tax law so that Virginia makes a distinction between business and non-business income and then to amend our tax definitions with the phrase, “‘Business income’ means all income which is apportionable under the Constitution of the United States.”

Won’t closing loopholes drive corporations to other states?

This question always arises when the topic of corporate accountability comes up. And indeed, the answer is crucial if we want to make our state attractive for economic development.

Among many studies that have been done on this issue, most show that tax burden plays a relatively small role in corporate decisions to locate one place or another. Other factors such as the education of the potential labor-force, adequacy of the transportation network and basic quality of life play a far greater part.

For example, Robert Tannenwald of the Boston Federal Reserve Bank recently studied 22 states and the effect of state tax policy on economic development. He found no statistically meaningful connection between business tax burden and the location decisions of corporations. That being the case, closing these three loopholes in our corporate tax law should have little effect on Virginia’s economic development efforts.

Finally, Michael Mazerov’s study shows that states that closed the first two loopholes actually lead others in manufacturing job increases during the 1990’s. Of the top 12 states, all but three have both a throwback rule and combined reporting included in their tax law. Virginia ranks 31st on the list.

Much of the substance of this article comes from “Closing Three Common Corporate Income Tax Loopholes Could Raise Additional Revenue for Many States,” written by Michael Mazerov of the Center on Budget and Policy Priorities. Many thanks to him. You can find this and other articles on state fiscal policy at www.cbpp.org/pubs/sfp.htm.