ANALYSIS OF HB 191 – CORPORATE INCOME TAX CHANGES: DELAWARE HOLDING COMPANY LOOPHOLE AND SINGLE SALES FACTOR APPORTIONMENT FORMULA Background The corporate income tax imposes a six-percent flat rate on the taxable income of domestic and foreign corporations doing business in Georgia. Corporate income tax collections have been decreasing steadily over the last 10 years, in part due to various corporate tax “loopholes.” Collections comprised 3.4% of total revenues in FY 2004, significantly lower than the 1980’s and 1990’s average of 7.2%. HB191attempts to close the “Delaware Holding Company” loophole, while simultaneously extending a large tax cut to certain businesses through adjusting the formula that determines Georgia taxable income. These are two separate and unrelated issues that are combined in one bill. Delaware Holding Company Loophole HB 191 seeks to close loopholes associated with passive investment corporations. These are also commonly referred to as Delaware Holding Companies (DHCs), named for the state in which they are most frequently established. DHCs are devices used to shift income from corporations taxable in Georgia to out-of-state subsidiaries in an effort to avoid corporate income taxation of income actually earned in Georgia. DHCs are subsidiaries that are established in states that do not tax royalties, interest, and other types of “intangible” income received from the licensing of trademarks, patents, and other types of “intangible assets.” The main corporation can shift income to the Delaware subsidiary by first transferring its intangible assets to the subsidiary and then licensing back the right to use the trademark or patent in exchange for the payment of royalties (and associated interest). Since the royalty/interest payment is a deductible expense for Georgia tax purposes, the payment of the royalty/interest reduces the corporation’s Georgia taxable income. By effectively disallowing the deductions (by requiring that they be added back to taxable income after being deducted), HB 191 attempts to close this loophole, enhance corporate income tax compliance, and thus make a more fair corporate income tax. Despite the intent, the language in HB 191 concerning the Delaware Holding Company loophole is flawed and leaves the loophole in place for DHCs actually established in Delaware — as most are. The most serious flaw arises from Section 48-7-28.3(d)(2) of the bill. This section states that royalties and interest paid by a Georgia-taxable corporation to a DHC need not be added back to Georgia taxable income if the royalties and interest “are received in a arm’s length transaction by the 1 [DCH]” and are “allocated or apportioned, or both, to and taxed by…another state that imposes a tax on…the income of the [DCH].” Both of these conditions will be easy to satisfy, meaning that it will be easy for corporations to continue to deduct the royalties and interest from their Georgia taxable incomes: • The “arm’s length royalty requirement” (Section 48-7-28.3 (d)(2)(A)) – To avoid challenges by other states to their DHC arrangements, large corporations already routinely hire accounting or economic consulting firms to do studies to determine the arm’s-length royalty rate that should be charged by the DHC to the operational part of the corporation for use of the trademark or patent. Therefore, it is likely that most royalties paid by Georgia corporations to their DHCs already satisfy this “arm’s length” requirement. Even if Georgia tax auditors suspected that the royalty being deducted by a Georgia corporation was excessively large, a serious question arises as to whether Georgia would have the legal or economic resources to challenge it. • Royalty/interest income is not taxable income (need not be added back) if such income is apportioned to and taxed in another state (Section 49-7-28.3 (d)(2)(B)) – Up until 2004, Delaware law held that DHCs were completely tax-exempt — meaning that this second condition could not be met and that HB191 would be effective in stopping the revenue loss from the DHC loophole. However, last year Delaware amended its DHC law to provide for the formation of a new entity called a “Headquarters Management Corporation” (HMC). An HMC, like the original DHC, must largely limit its activities to owning, managing, and collecting income from intangible assets like trademarks and patents. Unlike DHCs, HMCs are not tax exempt. HMC’s have a Delaware tax liability of 8.7 percent of income from headquarters services plus 4.0 percent of their royalty and interest income, with a minimum tax of $5,000. However, the HMC can receive a Delaware tax credit of up to 20 percent per employee. In other words, if an HMC has a staff of five it would have a tax liability to Delaware of the $5,000 minimum. Thus, the current language in HB 191 would allow a Georgia corporation paying royalties to an HMC with a staff of five to pay the $5,000 minimum Delaware tax and continue to deduct all of its royalties from its Georgia taxable income. The add-back provision in Section 49-7-28.3(d)(2) is completely self-enforcing. There is no requirement that corporations get advance approval from the Department of Revenue to continue deducting their royalty and interest payments to HMCs. As long as they believe that the royalty/interest paid satisfies an “arm’s-length” standard and that the tax payment by the HMC satisfies the requirement that the royalty/interest income be “taxed by…another state that imposes a tax on…the income of the [DHC],” they will deduct it. It will be up to Georgia to discover through an audit that the corporation has made that judgment, to disallow the deductions, and to be prepared to defend the disallowance through its administrative appeals procedures and the courts. Given the current wording of HB191, it seems highly questionable that the state would be able to sustain a claim that royalty payments to HMCs are not deductible. Single-Sales Factor Apportionment Formula Georgia currently apportions corporate income using a formula based on payroll, property, and sales, with a double weight on sales. The majority of states with a corporate income tax continue to use a formula based on these three factors, especially those in the Southeast. Variations of the three factor formula have been in use since the 1950s when it was created by the Uniform Division of Income for Tax Purposes Act (UDITPA). According to the Institute on Economic and Taxation Policy: 2 “The main rationale for using these three factors to determine taxable income was that companies benefit from a state’s public services in a variety of ways, including owning property in a state, making sales within a state, and having an in-state employee base.”1 Only ten states levying a corporate tax do not include all three factors in their apportionment formula.2 HB 191 would change the apportionment formula by phasing out property and payroll factors, and moving to a single-sales factor formula. This measure would have a significant impact on Georgia corporations whose property and payroll are in-state and whose sales are primarily out-of-state. For example, if a Georgia-based corporation made 3% of its sales in Georgia, the current apportionment formula would be ((100 + 100 + 3 + 3)/4) = 51.5%. Thus, 51.5% of income would be subject to the corporate income tax. Under HB 191’s single-sales factor formula, only 3% of the corporation’s income would be apportioned to Georgia. This is a drastic reduction in the income tax burden for such firms. Based on the example above, it is not surprising that several states have experienced revenue loss due to changing their apportionment to a sales only formula. According to a review of single-sales apportionment studies by the Center on Budget and Policy Priorities, eight states have reported revenue loss of between 1.4 percent and 14.8 percent of total state corporate income tax revenues due to a change to single-sales factor.3 In addition to revenue loss to the state, there are several policy reasons for maintaining the current double-weighted apportionment formula. • Corporations should contribute to the state for the benefits they incur from state services. The fundamental principle of corporate taxation is to make businesses pay for the services from which they benefit. Georgia corporations benefit from the state’s infrastructure and marketplace including police and fire protection, the court system, and transportation infrastructure. Changing to a single-sales formula allows certain in-state corporations to escape their payment for services, and places a heavier burden on out-of- state corporations who benefit less from state services than in-state corporations. • If the single-sales factor apportionment reduces the corporate tax burden, Georgia residents will have to shoulder a higher tax burden. Currently, the cost of providing services is paid by both individuals and corporations. A lowering of the corporate tax burden through a single-sales factor formula effectively shifts the cost of government more heavily onto individual taxpayers. • Single-sales factor apportionment gives a tax credit without any inherent benefit to the state. In-state corporations that make a considerable amount of sales in other states would receive an immediate tax break without creating new jobs or making new investments in Georgia. This tax give-away goes against Georgia’s economic development initiatives which seek to link the costs of economic development incentives with benefits such as job creation. 1 “Corporate Income Tax Apportionment and the ‘Single-Sales Factor.’” Institute on Taxation and Economic Policy, Policy Brief #11. July 2004. 2 States with a single sales factor formula for all corporations or manufactures are: Iowa, Missouri (election), Maryland, Massachusetts, Nebraska, Texas, Illinois, Oregon, Wisconsin, Connecticut. (Wisconsin and Oregon are in the process of phasing in the single-sales factor formula.) 3 Mazerov, Michael. “The ‘Single Sales Factor’ Formula for State Corporate Taxes: A Boon to Economic Development or a Costly Giveaway?” Center on Budget and Policy Priorities, September 2001. www.cbpp.org/3-27-01sfp.pdf. 3 • This will be a tax increase for some corporations. Corporations with little property and payroll in Georgia, but with a significant amount of sales, will experience a tax increase under the single-sales factor apportionment formula. • The use of single-sales factor apportionment can be an investment disincentive for certain corporations. A corporation must establish a certain level of nexus, or presence, in a state before becoming subject to taxation. Under single-sales factor, corporations could have a disincentive to locate payroll and property in Georgia if they have a significant amount of sales in the state. Making a small investment in Georgia could lead to taxation of their sales under the heavily-weighted single-sales apportionment formula. • Without a throwback rule, Georgia’s enactment of a single-sales factor would be even more damaging. As noted above, corporations must have a level of nexus to be taxed by a state. If the corporation does not reach this level of nexus, then the income produced in that state goes untaxed and becomes “nowhere income.” A throwback rule corrects this problem by allowing the production state to tax profits that are not taxed in the seller, or customer, state. Since Georgia does not have a throwback rule, corporations making considerable sales outside of Georgia, without creating nexus in the seller state, have income which is not subject to tax in any state. A change in the apportionment formula, coupled with Georgia’s lack of a throwback rule, would increase this “nowhere income” by apportioning less of the corporation’s income to Georgia and more to states where it will not be taxed. Fiscal Impact The Fiscal note for HB 191 estimates that: • Closing the Delaware-Holding Company loophole will result in corporate tax revenue increasing by $38.5 million in FY 2006 and $505 million over 10 years. The accuracy of this section of the fiscal note needs to be questioned in light of Section 48-7-28.3(d)(2) being included in the bill. It seems highly unlikely that the state would receive the projected revenues. • Total revenues from moving to the single factor apportionment formula will decline by $18.1 million in FY 2006 and $276 million over 10 years. Switching to a single factor apportionment formula will result in revenues from the corporate income tax declining by $39.8 million in FY 06 and $972 million over 10 years. Personal income tax revenue is estimated to increase by $21.7 million in FY 06 and $696 million over 10 years. Conclusion HB 191 addresses two separate issues in the corporate income tax, closing the Delaware-Holding Company loophole and enacting a large tax cut to businesses through adjusting the formula that determines Georgia taxable income. Closing the Delaware-Holding Company loophole is a compliance issue. There is little debate as to the merits of ensuring that Georgia corporations not evade the intent of Georgia law. However, it is questionable as to whether HB 191 as written would actually close this loophole. To fully close the Delaware-Holding Company loophole Section 49-7-28.3(d) should be eliminated from the bill. In regards to moving towards a single sales factor apportionment formula for determining taxable income, it is also important to consider the appropriateness of enacting a corporate tax cut within the current state budget climate. The quality of the Georgia’s education, healthcare, and public safety 4 systems are as great a consideration for economic development as taxes. Among the many current and future budget needs of the state are: • The Governor’s budget proposal still contains a $380 million austerity reduction in education; • The Revenue Shortfall Reserve contains only $51 Million; • Waiting lists for services for the disabled and elderly are long and getting longer; • PeachCare cuts have resulted in over 45,000 children losing health insurance for at least 3 months; and • The Child Protective Services system is universally acknowledged to be under-funded. According to the Georgia State University Fiscal Research Center, moving to a single sales factor apportionment formula will lead to a cumulative corporate income tax revenue loss of almost $1 billion over the next ten years. Although the Georgia State University Fiscal Research Center also projects a corresponding increase of almost $700 million in personal income taxes due to job growth, other research on the affects of single-factor apportionment formula leaves open the question as to such a positive economic impact. Many studies have shown no or minimal economic gain.4 The one thing that is certain is that HB 191 as written will result in several major corporations receiving immediate sizable tax cuts with no corresponding requirement for job growth. Before the state takes a $1 billion gamble, a thoughtful study should be undertaken after this legislative session to answer the following questions: • What do studies show about the level of corporate taxation and economic development? • How many and what type of jobs can we expect from this change? • What has been the experience of the 10 states that have implemented the single factor formula? 4 Mazerov, Michael. “The ‘Single Sales Factor’ Formula for State Corporate Taxes: A Boon to Economic Development or a Costly Giveaway?” Center on Budget and Policy Priorities, September 2001. www.cbpp.org/3-27-01sfp.pdf. 5
"Formation of a Delaware Investment Holding Company - PDF"