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The state targeted a loophole that companies use to create income tax havens abroad. As overall tax revenue continues to slump, will other states do the same?
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Welcome back to Route Fifty’s Public Finance Update! I’m Liz Farmer and this week, I’m writing about U.S.-based companies and their international tax havens. It’s estimated that states lose $17 billion in revenue each year due to firms sending profits earned here to their holdings overseas. Minnesota’s recent corporate tax reform illustrates the challenges in getting that money back.
Late last month, Minnesota was poised to become the first state to seal off a loophole that companies have used to create income tax havens abroad. The state legislature had narrowly passed so-called “worldwide combined reporting,” which requires a company filing taxes in the state to include income from its global subsidiaries. But in the final budget negotiations for a $3 billion tax relief package, the requirement was stripped and the law was pared down to change just some aspects of how multinational corporations report their overseas income.
Opponents of the broader proposal warned it could negatively impact revenue at a time when the global economy is slowing. Because companies are allowed to report losses over multiple years, Minnesota “could see a significant decrease in revenue from its corporate income tax,” warned an op-ed by tax lawyers Stephen P. Kranz, Michael J. Hilkin and Diann Smith.
Moreover, worldwide combined reporting would also stand Minnesota apart from the international tax rules the Organization for Economic Co-operation and Development (OECD) is encouraging nations to follow. Corporations “would have every incentive to either avoid or decrease connections with the state” thanks to a higher income tax burden and potentially onerous compliance process, the op-ed argued, adding that “any attempt to impose mandatory worldwide combined reporting is likely to cause an international backlash, along with potential federal action and litigation.”
Minnesota’s budget compromise steps the state back from this precipice and instead
conforms with federal tax law on “global intangible low-tax income,” usually referred to by the acronym GILTI. The practice taxes any income related to intangible assets—like trademarks or other intellectual property rights—that is earned in a country with tax rates below the U.S. corporate tax rate. Minnesota’s adoption is estimated to bring $437 million more to the state’s coffers during the 2024-25 biennium.
With this approach, Minnesota joins 10 other states in taxing GILTI at the highest level while other states tax it to some degree. Still, it has many opponents who say it is complex and uncompetitive because the rules vary between states.
Matt Gardner, a senior fellow at the left-leaning Institute on Taxation and Economic Policy (ITEP), dismisses those claims as scare tactics commonly used by business lobbyists for any proposed tax change. “Businesses setting up this structure know how much income they’re allocating on paper and how much income is properly attributable,” he said. “So the idea that this imposes a gigantic administrative requirement on these companies is ridiculous. They know exactly what they’re doing.”
Taxing an Intangible Asset
So how does a company earn money on an intangible asset such as a logo as opposed to a tangible asset like a shoe or toy?
Let’s look at one of the most well-known examples. In the mid-1980s, Toys “R” Us set up a subsidiary in Delaware that held the rights to its mascot, Geoffrey the Giraffe. The company then made its stores pay a percentage of total sales in royalties to the subsidiary, Geoffrey Inc. Royalty fees are a tax deductible expense, so the stores could dramatically lower their state income tax liability while the Delaware-based Geoffrey Inc. didn’t pay any state income taxes at all. By 1990, the subsidiary was taking in $55 million a year.
States caught on and banned the practice. It is no longer allowed in 28 states, which adopted combined reporting laws aimed, in part, at closing the Delaware loophole. In those states, a parent corporation and its many subsidiaries around the nation are treated as a single entity for tax purposes.
Still, that leaves more than a dozen other states that tax income and haven’t closed the loophole. Companies in those places still have plenty of incentive to maintain a corporate address in Delaware. In fact, one building in Wilmington is home to more than 300,000 companies.
Opening the Door
Minnesota’s move on tax havens comes as Republican lawmakers at the national level are pushing for less tax enforcement.
The debt ceiling deal signed last week by President Joe Biden, claws back about one-quarter of the $80 billion Congress approved last year for an IRS expansion. The deal rescinds nearly $1.4 billion of the money allocated to the IRS this year and a separate deal would repurpose $20 billion for fiscal years 2024 and 2025.
On balance, however, the IRS expansion is still expected to result in more federal action against the top 1% of Americans who may be dodging as much as $163 billion in annual taxes, according to the U.S. Department of the Treasury.
ITEP’s Gardner says that between the IRS funding, the GILTI regime passed as part of the 2017 Tax Cuts and Jobs Act, and the work with OECD to establish a global minimum tax, the federal government has signaled that it will not tolerate profit shifting by multinational firms.
He believes that the worldwide combined reporting approach considered in Minnesota has opened the door for other states—especially as overall tax revenue continues to drag.
“The fact that Minnesota has taken this so seriously will make it easier for the next state, and then the next, and so on,” Gardner said. “States with Democrat trifectas or visionary leadership in their Department of Revenue that find themselves in budget holes are going to think about this going forward.”
Correction 6/7/23: An earlier version of this story erroneously stated that Minnesota was the first state to adopt the federal tax law on global intangible low-tax income (GILTI). The text has been updated to correct this mistake and give additional information on GILTI and Minnesota's corporate tax reform law.