Now in Legal Rebels:
Posted Apr 01, 2004 05:17 pm CST
To legions of youngsters, Geoffrey, the Toys “R” Us giraffe, represents toy-filled fantasies. To state revenue authorities, however, the corporate mascot symbolizes a vexing tax-shelter problem.
Some states are cracking down on the so-called Geoffrey loophole and suing Toys “R” Us and other corporations over what they say is a questionable accounting device that is siphoning billions from state coffers.
Under the tax structure, national corporations set up subsidiaries in no- or low-income tax jurisdictions like Delaware or Nevada to hold intellectual property. In exchange for royalties on the use of the intellectual property, the corporations’ state entities license from the subsidiaries the trademarks, trade names and other intangibles. They then deduct those payments as business expenses from gross income, reducing state income tax liability.
Louisiana became the latest to test the validity of the tax shelter when it sued Toys “R” Us last year to collect income tax from an out-of-state subsidiary. The state is pressing similar suits against other businesses, including Home Depot, Wal-Mart and The Gap. In December, a judge hearing the cases against Toys “R” Us and The Gap allowed the state to proceed over defense objections to jurisdiction.
“It’s a serious problem. It is believed that nearly all, if not all, of the Fortune 500 have a holding company located in a low- or no-tax jurisdiction, and the potential loss in state tax revenue because of this strategy is probably quite significant,” says University of Connecticut law professor Richard Pomp, a state taxation expert.
OPINIONS SPLIT ON LEGALITY
In a July study, the Multistate Tax Commission, a Washington, D.C.-based compact of states that oversees tax laws, estimated that nearly $12.5 billion was sheltered from state income taxes through these devices in 2001.
But, Pomp says, “There is nothing illegal, immoral or unethical about the use of these holding companies.”
Courts are divided over the issue. South Carolina was the first to test the waters in a landmark suit against Toys “R” Us that has become known as the Geoffrey case. In 1993 the state supreme court sided with the state’s revenue department and ruled that, while the Geoffrey subsidiary had no physical presence, it was still subject to state income tax. The ruling was appealed to the U.S. Supreme Court, which denied review.
Since then, courts in Maryland, New York, New Jersey, New Mexico, Missouri and Tennessee have come to different conclusions. Some have sided with the corporations, agreeing with a 1992 Supreme Court decision, Quill v. North Dakota, 504 U.S. 298, that an out-of-state entity could not be forced to collect sales tax absent some showing of physical presence in the state.
That applies to the Geoffrey situation because the holding companies are not physically in the states, says New York City corporate tax lawyer Paul Frankel, who is representing Toys “R” Us and The Gap in Louisiana.
Revenue authorities there and in other states don’t argue with Quill. Rather, they say, the holding companies are doing business in their states, says New Orleans lawyer Jack Altmont, who represents the Louisiana revenue department. Other states claim that Quill doesn’t apply because it deals with sales tax, not income tax, Altmont says.
Pomp notes that states could rectify the situation by enacting a method of taxation used by California and other states that “undoes the use of subsidiaries for tax avoidance purposes.”
“The only issue is whether a legislature has the political backbone to adopt it,” Pomp says. Many states tout their tax laws to lure and keep businesses.
Frank Katz, Multistate Tax Commission general counsel, says the changing nature of business demands it. Requiring physical presence for jurisdiction “makes even less sense today when so much of commerce does not have a physical presence,” he says. “It seems really dumb to say that the basis of taxation is physical presence. But that is how it works.”