Maryland needs to close out-of-state tax loophole

February 05, 2003|By JAY HANCOCK

IN 1984, the soon-to-be amazingly profitable Toys `R' Us Inc. set up a Delaware-based subsidiary called Geoffrey Inc., named after a cartoon giraffe. Geoffrey became the owner of the Toys `R' Us name and several other trademarks.

There was no logical reason to legally separate the Toys `R' Us name from the Toys `R' Us stores, which engage in the same business and are owned by the same people. But there were tax reasons, which often have little to do with logic.

After creating Geoffrey, Toys `R' Us was able to spirit profits earned in Maryland and dozens of other states into Delaware, a Cayman Islands-style tax haven near Philadelphia, where they were largely bulletproof against William Donald Schaefer and other state taxmasters.

It worked like this. Toys `R' Us signed a license with Geoffrey for the right to use the Toys `R' Us name and the other Geoffrey assets. Once a year, according to South Carolina court documents, Toys `R' Us paid Geoffrey a royalty of 1 percent of sales, which was wired from a corporate account in Pennsylvania to a Geoffrey account in New York.

Because the royalty fees showed up as deductible costs in Maryland and elsewhere, they cut Toys `R' Us' taxable profits at the states' level by millions of dollars. Because Delaware doesn't tax royalty income from trademarks and other intangible property, the profits weren't taxed there, either.

And because Geoffrey is wholly owned by Toys `R' Us -- ta da! -- Toys `R' Us shareholders got the money anyway.

Many companies have engaged in this sort of dodge over the past two decades, simultaneously financing mansions for countless tax consultants while depriving states of billions in tax revenue. Toys `R' Us still does.

A common variation on the Geoffrey finagle is for a firm to "borrow" money from an out-of-state affiliate, deducting the "interest" expense from in-state profits.

The scholarly literature shows that states raked in only 4.6 percent of corporate profits through income taxes in 2000, down from more than 7 percent in the early 1980s. In Maryland, the corporate income-tax take fell from 5.5 percent of general-fund revenues in 1980 to 4.5 percent in 2000, says David F. Roose, director of the Board of Revenue Estimates.

There are many reasons for the drop, including economic-development tax breaks, changing tax formulas and a decline in federal corporate taxes, on which state taxes are often based. But the Delaware two-step shuffle is certainly a big factor, and now Maryland, Ohio, Connecticut and other states are talking about attacking it head on.

A bill introduced this week by Maryland Sen. Paul G. Pinsky, a Prince George's Democrat, would require many companies to add back the interest and royalty expense they now deduct from in-state income. Such a measure might add more than $100 million to state revenues, and "it's quite possible that that's a conservative number," says Steve Hill, an analyst with the Maryland Budget & Tax Policy Institute.

Such bills are already being denounced as "anti-business."

"Closing tax loopholes, one of my favorite terms," taunted Gov. Robert L. Ehrlich Jr. last week. "Otherwise known as raising taxes."

Well, yes, Governor. If you look at it that way, monitoring companies for tax compliance and prosecuting them for violations also raises taxes. Let's fire all the auditors. It would be very business-friendly.

In fact, both sides carelessly spout the term "loophole." Ehrlich seems to think there's no such thing. Some General Assembly Democrats apparently see a corporate loophole in every other paragraph of the tax statutes.

A true tax loophole violates a legislature's intent, generally by spawning shell companies and other absurd economic activity that wouldn't otherwise occur.

In the past, Annapolis has exempted Maryland manufacturers from paying sales tax on many of their supplies and materials, granted large tax credits for renovating historic properties and changed the formula for determining how profit from large manufacturers is taxed in Maryland.

These measures, all under siege lately, are not loopholes. These are policies, for better or worse. They did what they were supposed to.

Here, on the other hand, is evidence of a real loophole: companies, thousands of them, that are supposed to exist in Delaware but actually exist only on paper. They have no Delaware offices. They may not even have a mailing address or a bank account there or pay the tiny Delaware franchise tax.

Shut the loophole.

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