State tax shelters and U.S. fiscal federalism.

I. INTRODUCTION

In his article, State Tax Shelters and the Competition for Capital, (1) Professor Joseph Bankman offers an insightful perspective on how the tax shelter game has played out at the state level. Bankman's analysis usefully connects the ongoing battles in the trenches (e.g., state court litigation over intangible holding companies) with the broader issues of tax competition, the Tiebout hypothesis, and difficulty of taxing capital in a multijurisdictional setting. For defenders of state corporate income taxes, Bankman's conclusions are not hopeful. "Despite the best efforts of state tax officials," he concludes, "competition will make the corporate tax harder and harder to implement." (2)

Similarly gloomy forecasts have appeared in my own work. (3) Indeed, when considering the problem of state tax shelters within the broader context of U.S. fiscal federalism, the image that comes to mind is "rearranging deck chairs on the Titanic." Corporate tax shelters are indeed a problem at the state level, but we would do well not to ignore more fundamental developments reshaping state taxation of corporate income. As lawyers continue to file their briefs in state courts around the country, defending and decrying tax shelter transactions, the corporate income tax is slowly sinking into insignificance as a source of state tax revenue.

II. STATE TAX SHELTERS

To illustrate my point, let me begin by focusing on the most recent rearranging of the deck chairs--the New Jersey Supreme Court's decision in Lanco, (4) which dealt another blow to the use of so-called intangible holding companies as a means of shifting corporate profits out of state. This is litigation going back to the 1980s; the first case, Geoffrey, Inc. v. South Carolina Tax Commission, (5) involved Toys 'R Us in South Carolina.

The intangible holding company transaction works like this. Let us assume that Company X, which is operating primarily in Michiana, transfers all of its trademarks to a wholly owned subsidiary, SubCo, incorporated in a state without a corporate income tax, such as Nevada, or a state that does not tax income derived from intangibles, such as Delaware. Company X then pays SubCo an annual license fee to use the trademarks SubCo now owns. The result is a deduction for Company X in Michiana, but no income for SubCo in its state of incorporation. Voila! With just a little tax advice, a good chunk of Company X income has mysteriously vanished from the tax system. It is really quite something. One half expects David Copperfield to show up and take a bow.

But does it work? When asked to opine on the validity of these transactions, will courts respect the form devised by taxpayers and their clever advisors? Or will they disregard the form and endorse an alternative tax treatment that better reflects the substance of the deals? Given our nation's dysfunctional system of adjudicating interstate tax controversies, it should come as no surprise that we have no answer to these questions. Or, better said, we have numerous answers--which is to say, we have no single, authoritative answer. In fact, we are now pushing up against two decades of litigation on the transaction described above and a resolution of the legal controversy does not seem to be forthcoming.

There are a number of possible dispositions of these cases. For example, courts could simply let the transaction stand with the tax minimizing results sought by taxpayers and their advisors. Alternatively, courts could either deny the deduction to Company X, tax the income of SubCo (as New Jersey did in Lanco), or perhaps force Company X and SubCo to file consolidated returns in Michiana. Actual court decisions over the past two decades reflect the full range of possible holdings. (6)

With Lanco, the U.S. Supreme Court will get another opportunity to jump into the controversy. Will they enter the fray? Some readers may recall that the Court booted the DaimlerChrysler v. Cuno (7) case last summer on standing grounds, so perhaps the Justices are hungry to reach the merits of a state tax case. Meanwhile, Congress is also weighing its options. In April 2005, Representatives Bob Goodlatte (R-VA) and Rick Boucher (D-VA) introduced the Business Activity Tax Simplification Act (BATSA), (8) which would limit states' ability to attack these transactions. It would do this primarily by prohibiting states from imposing an income tax or other business activity tax on any person "unless such person has a physical presence in the State during the taxable period with respect to which the tax is imposed." (9) Congress took no action on BATSA in 2005 or 2006, but could resuscitate the legislation when the 110th Congress convenes in early 2007. If the bill becomes law, then states would no longer have the authority to require out-of-state intangible holding companies to pay tax on their income.

III. THE DECLINE OF THE STATE CORPORATE INCOME TAX

To be sure, a Supreme Court decision in Lanco, congressional enactment of BATSA, or some other system-wide approach to the intangible holding companies problem would all be important developments for the field of state corporate income taxation. Still, when one steps back from the details of these controversies and considers them within the context of broader structural changes to the American system of fiscal federalism, it is hard to avoid coming back to the image of rearranging deck chairs on the Titanic.

Over roughly the same period as the intangible holding company litigation (i.e., the 1980s to the present), state corporate income tax revenues have undergone a steady decline. One of the best studies on the subject is a paper from the National Tax Journal co-authored by Gary Cornia, Kelly Edmiston, David Sjoquist and Sally Wallace, titled The Disappearing State Corporate Income Tax. (10) The analysis of Cornia et al. shows that in 1980 state corporate income tax revenues made up 9.4 percent of total state tax revenue, while in 2002 they accounted for only 5 percent. From an alternative perspective, state corporate income tax revenue as a percentage of corporate profits has dropped from 6.6 percent in 1980 to 4.0 percent in 2000, reaching a low of 3.5 percent in 1997. (11) This is a significant decline, which perhaps accounts for the flurry of articles with titles not unlike the Cornia study, including The State Corporate Income Tax: Recent Trends for a Troubled Tax, Tax Incentives and the Disappearing State Corporate Income Tax, Gone with the Wind: Massachusetts' Vanishing Corporate Income Tax, to name just a few. (12)

One possible explanation for declining state corporate income tax revenues is a decline in corporate income. As the Cornia et al. study shows, however, corporate profits as a share of national income have actually increased since 1980. so if anything one would expect the share of tax revenues derived from the state corporate income tax to increase as well. As mentioned above, this has not been the case.

What, then, accounts for this persistent and dramatic decline in state corporate income tax revenues? As it turns out, this is a notoriously difficult question to answer. A number of possible explanations come to mind. One possibility is tax shelters or tax planning of the Lanco variety. After all, if these transactions are upheld, the effect is a reduction in the corporate taxpayer's tax liability in one state without any corresponding increase in another state. Unfortunately, it is not possible to pin down the revenue loss from these transactions due to the confidentiality of the data required to make the calculations. Michael Mazerov of the Center for Budget and Policy Priorities has suggested that "the sums involved may be enormous." (13)

An additional reason for the decline in corporate income tax revenues may be the increased reliance on pass-through entities, such as S corporations and limited liability companies (LLCs). Because S corporations and LLCs are not themselves taxpaying entities, changes within a state's business community regarding choice of entity decisions would naturally influence state corporate income tax receipts. In a study published in Public Finance Review in 2005, William Fox and LeAnn Luna concluded that, for the average state, "a 10 percent increase in the number of LLCs would decrease the average state's corporate tax revenues by 3.6 percent." (14) One would also expect a decline in corporate income tax revenues due to conversions from C corporation to S corporation status. (15)

Yet another factor reducing state corporate income tax revenues is the proliferation of business tax incentives, including provisions such as the investment tax credit at issue in the DaimlerChrysler v. Cuno litigation. (16) Relatedly, the decline in corporate income tax receipts may be due to changes in the apportionment formulas that states use. Roughly a half-century ago, most states adopted the so-called Uniform Division of Income for Tax Purposes Act (UDITPA), (17) which incorporated a three-factor formulary apportionment methodology based on the physical location of the taxpayer's property, payroll and sales. Over the past quarter century, however, the UDITPA system has begun to unravel, as state lawmakers have reduced the weight on the property and payroll factors in an effort to encourage businesses to invest in their states. (18) Research by Peter Fisher has sought to quantify the effects of state tax incentives on corporate income tax receipts. Fisher's study shows a substantial increase in reliance on tax incentives for manufacturing firms during the 1990s. (19)