Every politician knows that the best way to push a tax increase through is to rebrand it as a “loophole closer” that just happens to raise revenue. If you can claim with a straight face that the alleged loophole “unfairly” benefits large and remote multinational corporations, rather than benevolent local employers, so much the better.
But the reality is almost always more complicated. Take, for example, the latest proposal to have New Jersey impose mandatory unitary combined reporting on corporate taxpayers. Notwithstanding legislators’ and editorialists’ breathless claims that this simple and “fair” loophole closer would “recoup” up to $200 million for our cash-strapped state, mandatory combined reporting is no mere technical loophole closer. In fact, it would mark a profound change in New Jersey’s approach to corporate taxation, one that requires careful thought and study.
So, what the heck is “combined reporting” and what would it mean for New Jersey?
Let’s start with a little primer on state corporate income taxation.
Approximately 43 out the 50 states tax corporate income. The basic legal justification is that a state may impose a tax for the privilege of exercising a corporate franchise or doing business in that state.
Things get complicated when a corporation does business or earns income in more than one state. As a matter of constitutional law, and to avoid double taxation, each state may only tax that portion of a multistate corporation’s income that is earned in that state. Although that sounds simple enough, it is anything but, because states have different laws or rules for assigning or “apportioning” corporate income.
Until recently, the most common approach was to use a three-factor formula based on the proportion of a corporation’s property, payroll, and sales attributable to a particular state. Thus, if Corporation A had 50 percent of the value of its assets (buildings, equipment, etc.), 75 percent of its gross payroll (employees), and 25 percent of its sales located in or attributed to State X, State X would apply its corporate tax to 50 percent ((0.50+0.75+0.25)/3) of the corporation’s income. This made some sense as a rough approximation of the extent to which a particular corporation was doing business in a particular state.
Alas, ongoing interstate competition for economic development has resulted in numerous complicating exceptions to the traditional three-factor formula approach. Some states now double-weight the sales factor, while others have elected to drop the property and payroll factors altogether, claiming somewhat disingenuously that “we don’t tax investment and jobs in our state.” The interstate competition extends beyond the factor level as many states have adopted permissive “sourcing” rules designed to reduce the proportion of a resident corporation’s sales receipts that are attributable to, and thus taxable by, a particular state. For example, a state with a large population of global financial services firms might adopt a rule that makes it clear that revenue from trading securities should be sourced according to the location of the (out-of-state) client rather than the location of the trading floor or the firm’s computer terminals.
All this gets even more complicated when you take into account the fact that many multistate corporations actually consist of a web of affiliated and/or subsidiary corporations that do business with one another. While there are many legitimate business reasons to set up multiple corporate entities within a larger group, multinational corporations have become amazingly sophisticated over the past few decades in using complex transactions between separate but affiliated entities (“intercompany transactions”) to reduce their state corporate tax liabilities, generally by shifting taxable income to low-tax states and useable tax losses to offset income in high-tax states.
How does this work? At the risk of gross oversimplification, most multistate tax-planning strategies involving intercompany transactions boil down to one or another form of price manipulation among and between taxing jurisdictions, otherwise known as income-stripping or transfer pricing.
What is transfer pricing? A basic example might help. Assume Marketing Co., a company located in high-tax State X, markets and sells widgets it buys from its subsidiary Manufacturing Co. located in low-tax State Y. To minimize the corporate group’s overall tax liability, Manufacturing Co. could charge Marketing Co. an artificially high price for the widgets, thus lowering Marketing Co.’s margins and taxable income in State X while maximizing Manufacturing’s margins and taxable income in State Y. For the price of a little legal representation, corporations routinely use similar strategies to minimize tax exposure along the entire supply chain; particularly notorious examples include intercompany loans and assigning valuable patents and trademarks, and thus related royalty payments, to a subsidiary based in Delaware, which does not have a corporate income tax.
Of course, states can and do challenge transfer pricing using one or both of two general lines of attack, one more tactical and the other more strategic.
In the more tactical and traditional approach, state revenue agencies have challenged intercompany transactions that “distort” reported gains or losses or do not reflect a true “arms-length” negotiation between two independent parties acting in their own economic best interests. Unfortunately, determining what is or isn’t distortive or arms-length pricing is inherently fact-specific. Litigation is time-consuming and expensive, with both sides typically employing an army of lawyers and costly independent expert witnesses. In most instances, large corporations can easily outgun and outlast a typical state revenue agency.
In response, some states like New Jersey have adopted laws that require corporate taxpayers to disregard or “addback” specific kinds of transactions (such as rent, interest, or royalty payments) between related entities in computing their taxable income.
Although most experts believe that addback statutes are fairly effective in preventing the most egregious forms of income-stripping abuse, about half of the states including California and New York have opted for a more strategic and arguably more aggressive approach: mandatory combined reporting. In general, combined reporting means that all related corporate entities that together comprise a “unitary business” must file a single tax return on a combined basis as if they were a single taxpayer in the state. In essence, this approach ignores the existence of separate legal entities and thus completely obviates the tax impact of intercompany transactions.
Which brings us back to the question at hand: Should New Jersey adopt mandatory combined reporting? The answer is “yes,” with several important caveats.
First, combined reporting probably won’t raise much corporate tax revenue. As noted, New Jersey already has an addback statute that is an effective weapon against the most egregious forms of transfer-pricing abuse. Best advice: don’t count on recouping anything like $200 million.
Second, the state should brace itself for yet more litigation as the big corporate players will not roll over and play dead. True, the state won’t have to challenge intercompany transactions on the basis of arms-length pricing, but determining what corporate entities are or are not part of a “unitary business” is a frequent focus of complex and fact-intensive litigation in other states. Tax lawyers and expert witnesses face little risk of professional obsolescence.
Third, some corporate groups with legitimate business reasons for maintaining multiple separate legal entities may decide against locating or doing business in New Jersey. New Jersey’s business climate already ranks toward the bottom among the states.
Fourth, beware of unintended consequences. For example, it is highly likely that there will be “winners” and “losers,” sometimes within the same industry, if New Jersey adopts mandatory combined reporting. How will the state ensure a smooth transition and fair treatment?
Fifth, the state should study and anticipate the delicate interaction between combined reporting and the state’s various economic development-tax incentives. In simple terms, corporations weigh their potential participation in incentive programs on various assumptions, including projected effective tax rates and after-tax income; combined reporting will necessarily impact these and other key assumptions and thus potentially upend some outstanding incentive deals.
Finally, whether or not mandatory combined reporting would be good incremental policy for New Jersey — and it may well be, regardless of potential revenue impacts — the current debate ignores the proverbial 800-pound gorilla in the room: traditional state corporate income taxes have become increasingly anachronistic and unworkable in the face of a global, digitized economy that often eschews traditional corporate business formations in favor of pass-through entities that are not subject to corporate income tax. There is a reason why corporate income taxes are extremely volatile and have contributed a steadily declining share of state revenue in recent decades.
The fact is that the traditional state corporate income tax is dying a slow and fitful death. Instead of attempting to squeeze more revenue crumbs from the ever-smaller number of traditional resident corporations that cannot move out of state or do not have access to sophisticated tax planning, New Jersey’s policymakers might do well to start considering serious options for adjusting to a post-corporate economic future.