Formation of a Delaware Investment Holding Company - PDF

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					              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

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[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:

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        “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.
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       •   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

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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.
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