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As someone that does battle in the state corporate income tax realm every day, I understand the reactions of lawmakers and citizens to reports like the one recently in Maryland that stated that 68 out of the 132 largest employers paid no corporate income tax. That statistic alone, though, is misleading because, as the Tax Foundation so eloquently pointed out there are a myriad of perfectly logical ways that a corporation could owe no state income tax.

I don’t agree entirely to the Tax Foundation’s response, however. The Tax Foundation is dismissive of combined reporting for corporations.  Combined reporting is where a state requires companies to file as one economic unit rather than separately for each legal entity. A lot of the state tax shelters that corporations have used (and I consider to be abusive) would be eliminated under a combined reporting model. 

One of the biggest abuses is the trademark subsidiary shelter (known popularly as the “Geoffrey” shelter after the first state case to attack this filing method). Basically, a company sets up a dummy corporation in Delaware and transfers all of its trademarks to that subsidiary. The company then “pays” the subsidiary to “use” the trademark. The subsidiary is all profit, so the subsidiary then “dividends” the profits back to the parent company. Because of a mix of Federal and state tax law, this essentially eliminates all state income taxes in states that still use the separate company filing method.

States have (rightfully) attacked this shelter in a number of ways including through the use of combined reporting (Vermont, Michigan, Texas) and through special laws trying to eliminate the advantage (Maryland, Ohio, Virginia, and others). This is where the Tax Foundation runs into trouble.

Combined reporting is terribly unpopular with businesses because they feel like it’s an attempt by states to tax income that Federal law prohibits the states from taxing. While there is some truth to this (and it’s often portrayed by lawmakers as a way to tax out-of-state companies only) it’s conceptually a fairer way to tax companies. Taxing companies on a legal entity basis allows companies to use (perfectly legal) tricks such as the Geoffrey shelter to reduce state income taxes. It allows bigger companies with more resources to artificially generate deductions that small businesses could never attain. This is inherently unfair as two businesses may be taxed differently simply because one can afford to take steps to reduce taxes.

The Tax Foundation lists two of its guiding principles as simplicity and neutrality. Combined reporting allows for both. I’ve shown the neutrality argument above, but the simplicity argument fits as well.

As I noted above, the only way besides combined reporting that states can fight these tax shelters is to try and impose laws to deny deductions for these types of shelters. These laws are massive, riddled with problems, and differ from state to state. They add unnecessary complexity to state taxing systems when combined reporting would be a simpler and more theoretically sound method for combating these tax shelters which truly are abusive to states. They disallow deductions for legitimate transactions (such as consolidated treasury functions) because the statutes cannot differentiate between abusive and legitimate transactions. They are a nuclear weapon to take out a flea.

However, because the Tax Foundation is a pro-business lobbying group they cannot possibly lobby for combined reporting, and that’s where they get stuck. The Tax Foundation likes to call corporate income taxes 20th century taxes in a 21st century economy and they are partially right. Separate company filing methods used by many states are 20th century tax systems that need to be modernized. Combined reporting is a way to modernize those systems to the business situation in the 21st century. Gone are the days when subsidiaries were only set up to separate a business by product or geography. Subsidiaries are set up for all sorts of reasons, including legal evasion of state taxes. By keeping the walled gardens states are simply ignoring the fact that business has changed in the last half century. And without changes the states will simply lose their ability to tax large companies on the money that they earn in the state.

For a general primer on Corporate Income Taxes see this Tax Foundation report.