July 18, 2002

Now, a Corporate Push to Avoid State and Local Taxes

By DAVID CAY JOHNSTON

As lawmakers debated in Washington yesterday how to close the loophole that allows companies to avoid United States taxes by acquiring a Bermuda mailbox, a bill advanced with a provision that state officials say would let companies avoid state and local taxes using some of the same techniques as the Bermuda loophole.

American Express, Walt Disney, Viacom, Cisco Systems, Eastman Kodak, Johnson & Johnson, the Limited, Lowe's and Microsoft are among the major corporations lobbying for the bill, which was approved by a House Judiciary subcommittee on Tuesday at a hearing held on such short notice that state officials said they could not attend. A full committee vote is expected soon.

The drive to restrict the authority of states and local governments to tax national companies comes as a study, to be released today by the Internal Revenue Service, shows that corporations gave themselves a huge tax cut beginning in 1996 by using tax shelters.

The legislation to restrict state and local taxing authority would cost the states $9 billion in annual revenue in the first few years, a figure that could quickly grow as companies adjust operations to make full use of the proposed loophole, according to the Multistate Tax Commission, which represents states on tax matters. Cities and counties stand to lose billions more.

The bill's promoters insist that if the bill becomes law, the obligation to pay state and local taxes will merely be shifted, benefiting only those places where the companies use state and local services because they have invested in offices, factories and computer servers.

"There need be not one penny less of state tax revenue collected," said Arthur R. Rosen, the head of state and local taxes at the law firm of McDermott, Will & Emery, which represents the companies supporting the bill.

Mr. Rosen acknowledged that taxes would be reduced or eliminated under the bill if companies arranged their operations to owe taxes in jurisdictions that imposed little or no tax, but said he had no dollar estimates.

Representatives Robert W. Goodlatte and Richard Boucher, Virginia Republicans who are co-chairmen of the Congressional Internet caucus, asserted that the bill was needed to stop abusive state tax practices.

"This bill targets states that have abused their authority to impose taxes," Mr. Goodlatte said yesterday. "It will curb the tax frenzy on the part of those states imposing unreasonable taxes" on companies that make sales, do nominal advertising or sell online in a state.

But Elizabeth Harchenko, chairwoman of the Multistate Tax Commission and director of the Oregon revenue department, wrote yesterday to the House Judiciary Committee that the bill "would legalize and expand abusive corporate tax sheltering that undermines state business activity taxes."

"In recent years," Ms. Harchenko wrote, "several states have undertaken efforts to curtail aggressive tax shelter activity. This legislation would pre-empt those state efforts to ensure that those who do business within a state pay a fair share of state and local taxes."

She and others said that under the bill a company could use interest payments, royalties and management fees to transfer taxable income in one state to its headquarters in a state where corporate profits are not taxed. That is the same technique that companies use to avoid federal taxes when they acquire a Bermuda mailbox and hold an annual board meeting in Barbados.

Mr. Rosen said "the states have all the authority they need to stop profit shifting" and that if individual state legislatures fail to do so it is their problem, not that of his clients.

The bill to restrict the power of states and cities to tax companies is being driven in large part by the growth of electronic commerce and the sale of products and services that are called intangibles because they cannot be measured easily like a crate of oranges. Some corporations oppose state and local efforts to capture revenue from the digital economy.

The pressure for reduced state taxes on national companies is coming despite a sharp drop in their tax bill. State corporate business activity and related taxes equaled 5.2 percent of company profits in 2000, down from 9.6 percent in 1980, the Multistate Tax Commission said.

This lower effective tax rate meant companies paid $32 billion in such taxes instead of about $60 billion. But tax breaks enacted by state legislatures explain only about $5.6 billion, or 20 percent, of this drop in corporate taxes. This suggests that the use of tax shelters is costing the states and also that companies have increased efforts to shift revenue and profits from states that tax to those that do not.

The effect of tax shelters on federal revenue is examined in a study that the I.R.S. will publish today in the quarterly Statistics of Income Bulletin.

Untaxed corporate profits rose to 24 percent of the profits reported to shareholders in 1998, up from 14 percent in 1996, an increase of two-thirds. This increase meant that the amount of corporate profit not taxed rose by $66.5 billion from 1996 to 1998.

The I.R.S. analysis follows a March study by a Harvard economist, Mihir A. Desai, who sifted through reports to shareholders to determine whether the use of tax shelters was a significant issue and found evidence that the problem was much larger than the I.R.S. study.

In 1988, less than 62 cents of each dollar of shareholder profit turned up on tax returns, down from 84 cents in 1996, Professor Desai said. Untaxed corporate profits totaled $247 billion in 1998, Professor Desai found, but deductions for stock options and other known legitimate deductions explained only about $88 billion of this amount.

His study suggests that in 1998 $155 billion or so of corporate profits were hidden from the I.R.S. in tax shelters, costing the government as much as $54 billion in taxes. That figure is more than five times the $10 billion cost of abusive tax shelters cited by in 1999 by Lawrence H. Summers, who as Treasury secretary then started a campaign to crack down on tax avoidance and evasion by large companies.

Professor Desai said his analysis of shareholder and taxable profits from 1998 to 2000 found that until 1995 the relative difference was stable and followed expected shifts caused by tax rules. But starting in 1996, he said, the gap between taxable profits and those reported to shareholders began to widen apparently because of tax shelters.


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