What is the Delaware Holding Company Loophole?

"Loophole comes from the Dutch word 'liupen', meaning 'to peer'. Loopholes were a vertical slit or opening in the wall of a fortification such as a castle, allowing a defender to look out or shoot while remaining protected. Metaphorically, therefore, the word means a gap, omission, error, ambiguity that one can exploit."

-- Nishant Choudhary, Alwar, India

Legislation has been proposed in the Pennsylvania House of Representatives to amend the Pennsylvania Corporate Net Income Tax and abolish the Delaware Holding Company loophole. What is that loophole?

Delaware actually has a corporate net income tax of 8.87%. Companies based there pay it on profits earned there. (No state taxes revenue earned in other states.) But Delaware does not impose its corporate net income tax on income earned from trademarks, patents, stocks, bonds or other investments or intangible assets.

Companies from outside of Delaware, especially large retail chains, set up holding companies there. The holding companies, commonly known as "passive investment companies" or "intangible holding companies", are allowed to control trademarks, patents and other investments. The Delaware holding company that owns the intangible assets charges its parent company operating in a state like Pennsylvania, a royalty for using, for example, a trademarked name or other intangible asset. This allows the Pennsylvania-based company to treat the royalty payment as a business expense which it may deduct from its income on its Pennsylvania corporate net income tax returns, thus, reducing its tax in Pennsylvania and incurring no tax in Delaware since that income is not taxable in Delaware.

Pennsylvania state officials say the Delaware loophole costs the state $450 million a year in corporate net income taxes and forces it to rely more on taxpayers and small business owners who earn far less than multibillion-dollar, multinational corporations.

Here is an example published by the Scranton Times-Tribune: In 1990, the Delaware holding company of Toys "R" Us earned $55 million in income by charging all of the company's stores for using the Toys "R" Us name, trademarks, such as its Geoffrey giraffe logo, and "merchandising skills."

According to Eric Epstein, author of an open piece for the Patriot-News, Comcast, Crown Cork, Toys "R" Us, Wal-Mart and most Marcellus Shale exploration companies are among the corporations that deflect their Pennsylvania income tax contributions through "intangible holding companies." For small businesses without interstate operations, the Delaware loophole is not an option.

In 2004, the governor's Business Tax Reform Commission released a bipartisan report recommending changes to Pennsylvania's tax structure. The commission recommended numerous measures including eliminating the Delaware loophole. Despite bi-partisan support the measure has not succeeded.

Many other states have closed the loophole either by legislation or litigation. Thirty-five of the 45 states that levy corporate income taxes have taken steps to crack down on tax loopholes through add-back rules or unitary combined reporting.

For example, in 2004, the Maryland legislature abolished that state's Delaware loop-hole. Philadelphia-based Crown Cork & Seal appealed the constitutionality of the legislation. Crown Cork had used the Delaware holding company to shelter income from Maryland state taxes. The Maryland Court of Appeals ruled against Crown Cork, thereby subjecting the income to Maryland tax, by holding that the intangible property management companies in Delaware were phantom corporations and were, in fact, subject to Maryland income tax regardless of the so-called Delaware loophole. The United States Supreme Court declined to take Crown Cork's appeal.

Here in Pennsylvania, House Bill 2150, sponsored by Pennsylvania Representative David Reed (R-Indiana), would amend the Pennsylvania Corporate Net Income Tax and close the Delaware loophole by disallowing the deduction that the parent operating corporation claims for the royalty payments made to its Delaware Holding Company ("DHC"). It was passed by the House. So far no go in the Senate.

Another major feature of House Bill 2150 would reduce the flat corporate income tax to 6.99% from 9.99%. The gradual phase down would occur over six years, beginning in 2014. Pennsylvania's current corporate income tax rate is second only to Iowa (12% top rate) and contributes to its ranking of 44th in the corporate income tax section of the Tax Foundation's State Business Tax Climate Index (it is 19th overall). Proponents of the bill argue that savings made by closing loopholes will make up for the reduction in rates.

"Companies are able to turn taxable income into tax-exempt income in Delaware and then use it to reduce their tax bills in other states," said Bradley P. Lindsey, an accounting professor at North Carolina State University and one of three authors of a 2011 study titled Exploring the Role Delaware Plays as a Domestic Tax Haven. Delaware does not tax certain income generating intangible items like trademarks, royalties, leases and copyrights. Yet those same intangibles can be part of a tax strategy that allows them to be classified as deductions in other states, reducing a company's tax bill there. "Delaware serves as a domestic tax haven, much like the Cayman Islands serves as an offshore foreign tax haven, and offers a similar level of tax avoidance," the report states.

Let's close the Delaware loophole.