When Wal-Mart used a complex web of companies to dodge state taxes, the North Carolina secretary of revenue had to send tax lawyers and auditors after the world's biggest retailer.
Auditors worked for three years before collecting $33.5 million in back taxes and penalties. Since then, state lawyers have spent four years fighting Wal-Mart's attempt to grab the money back. The cost of the legal battle is unknown, but the court documents on file at the Wake County Courthouse would measure 24 feet if stacked, suggesting that the fight has consumed thousands of hours.
There's a simpler way to make all multistate corporations pay their state taxes. A proposed "combined-reporting" law would require companies with multiple subsidiaries operating in several states to file tax returns as a single business.
Opponents of this legislation, however, have given lawmakers the shivers: the N.C. Chamber, which is the state's business lobby, and major companies such as AT&T, Bank of America, GlaxoSmithKline, Johnson & Johnson, PepsiCo, Pfizer and Smithfield Foods. It's rare for the legislature to act against the wishes of such a lineup.
But in the face of the state's biggest budget crisis since the Great Depression, combined reporting took a first step Tuesday toward becoming law. After a contentious House Finance Committee meeting that went in fits and starts from 8:30 a.m. until after 10 p.m., the Democrat-led committee voted along party lines to approve a larger tax package that includes combined reporting.
Advocates say the law would raise $100 million annually and level the playing field for small and mid-sized companies, which can't afford expensive advice about avoiding taxes. The General Assembly's fiscal staff projects less revenue, about $45 million a year. The proposal has strong support among good-government policy advocates: The N.C. Revenue Laws Commission has endorsed it, as has the national organization of state tax collectors.
An arduous path
But the measure must make its way through the full House and then survive the more pro-business culture of the state Senate.
"The North Carolina Chamber is dead against it," said state Sen. David Hoyle, a Gaston County Democrat. "The banks don't like this a bit."
Hoyle, who considers himself one of the most pro-business members of the General Assembly, said he understands the call for combined reporting. But the co-chairman of the Senate Finance Committee hasn't decided what he should do.
"It's a good idea for folks who purposefully ... avoid North Carolina taxes," Hoyle said. "But if this makes our companies less competitive, we'll have to tread carefully and cautiously."
North Carolina's tax structure is riddled with loopholes that help big companies avoid taxes or that help special interests. Buyers of manufactured homes get a sales-tax break of 2.25 percentage points. NASCAR teams pay no tax on fuel for their airplanes and pay half the sales tax on car parts. FedEx and Merck get tax refunds connected to new investment.
And despite the budget crunch, Gov. Beverly Perdue and the General Assembly have granted a tax break to Apple Computer worth $46 million over the next 10 years. Apple will build a giant warehouse with hundreds of computers but only 50 permanent employees.
Roland Stephen, an N.C. State professor and business development expert, said North Carolina has built a "goofy corporate tax structure" that he compared to barnacles attached to a boat.
"Once it's covered with barnacles, you can't go anywhere," Stephen said. "You scrape off the bottom, put the boat back in and the barnacles reattach."
Big money is at stake in combined reporting, which is used in 23 of 45 states that tax corporate income. States that have adopted it have seen a 10 percent to 20 percent increase in corporate income tax collection, according to Elaine Mejia of the N.C. Budget and Tax Center, which advocates fair treatment for low- and moderate-income people. (The Budget and Tax Center is part of the N.C. Justice Center; N&O President and Publisher Orage Quarles III is a member of the board.)
"The corporate income tax raises roughly $1 billion a year, then it's an extra $100 million in revenue," Mejia said. "And that is a low-end estimate."
The N.C. Chamber disagrees.
"I don't think there is any certainty that it will increase revenue for the state," said John McAlister, a lobbyist for the N.C. Chamber. "It's going to lead to more complex audits, appeals and litigation."
Follow the bouncing rent
There are many ways big companies can avoid taxes by pitting tax laws from various states against one another, but the basic strategy is the same: transfer an asset to a subsidiary and pay the subsidiary for goods or services.
Consider the intensely litigated case of Wal-Mart, North Carolina's biggest private employer.
For years, Wal-Mart ran some of its North Carolina income through a series of companies that existed only on paper to get the income back in a nontaxable form.
It began in 1995, when Wal-Mart hired the accounting firm Ernst & Young to restructure the retail giant. The work included a "local tax reduction strategy," according to court rulings. The strategy centered on Wal-Mart's renting its stores from itself. The company has 130 stores, 22 Sam's Clubs and three distribution centers in North Carolina.
Rent paid to a third-party landlord is money out the door and therefore a tax-deductible business expense. Wal-Mart cycled its rent payments through a series of subsidiaries created after the Ernst & Young consultation.
One subsidiary, Wal-Mart East, paid 2.5 percent of store sales as rent to a second subsidiary, Wal-Mart Real Estate Business Trust. Wal-Mart East deducted the rent payments as a business expense.
The real estate trust transferred the rental income to a third subsidiary, Wal-Mart Property Company, incorporated in Delaware.
The property company paid no North Carolina taxes because it was registered in Delaware. It sent the rental income back as dividends to the first subsidiary, Wal-Mart East.
Wal-Mart East didn't have to pay taxes because dividends from a subsidiary aren't taxable.
The real estate trust and the property companies had no employees. Wal-Mart East and Wal-Mart Property Company had no significant activity other than the rent and dividend transactions. They had no effect on the daily management or operation of the stores.
Meanwhile, the parent company, Wal-Mart Stores Inc., managed all the money for the subsidiaries; its realty division managed and operated the stores.
To challenge this scheme, the North Carolina secretary of revenue in 2002 began auditing Wal-Mart and demanded more financial information. In 2005, the secretary of revenue requested that Wal-Mart file returns that combined the incomes of Wal-Mart East, the real estate trust and the property company. A similar order was issued to Sam's Club East and its subsidiaries.
After receiving the combined returns, the Department of Revenue ordered Wal-Mart to pay $28 million in back taxes and $5.5 million in penalties and interest.
Wal-Mart paid the taxes but filed a lawsuit in Wake County Superior Court demanding a refund. The lawsuit has chugged on for years. A trial judge and the N.C. Court of Appeals have ruled against the company, which can ask the state Supreme Court to review the case.
A missing $373 million
It's not clear how many businesses have operated schemes such as Wal-Mart's; taxes are confidential and become public only when companies challenge their tax bills in court, as Wal-Mart did.
As of October 2008, the Department of Revenue had identified an estimated $373 million underpaid in corporate returns, which includes the $33.5 million from Wal-Mart.
Advocates say a combined-reporting law would avoid costly litigation and would be fairer to businesses that operate only in North Carolina and to smaller companies that can't afford to hire law and accounting firms to devise tax-avoidance strategies.
"It's about fairness and equity," said Jack Cecil, president of Biltmore Farms in Asheville. "We are an Asheville-based company, with all of our assets here in North Carolina."
McAlister, of the N.C. Chamber, said combined reporting would be a disaster, chilling the state's economic development climate, hurting research and development, and creating uncertainty about what is owed. He also said it would make the legislature's revenue estimates shakier.
The law is unnecessary, McAlister said, because the secretary of revenue has the power to require combined reporting, as in the Wal-Mart case.
The secretary of revenue does have the power to require companies to file combined returns, but only on a case-by-case basis and only when the secretary has reason to believe that a corporation has not disclosed its true net income.
Michael Mazerov, an expert on combined reporting at the left-leaning Center on Budget and Policy Priorities, said the law would not impose extra burdens on companies. Of North Carolina's 75 biggest manufacturers, 60 have facilities in states where they are required to file combined returns, Mazerov said. Eighteen of these companies, including Cisco, Freightliner and Georgia-Pacific, have headquarters in combined-reporting states.
Two big opponents, Baxter Healthcare and Smithfield Foods, have facilities in numerous combined-reporting states, Mazerov said.
"Plus, that's exactly how companies file their federal tax returns," Mazerov said. "They file consolidated returns at the federal level."
The Wal-Mart case was not the first challenge to such loopholes. In the case of The Limited -- owner of Victoria's Secret, Structure and other popular mall stores -- the tax appeal lasted from 2000 to 2005.
The company created Delaware holding companies that owned Limited's trademarks and charged the retail companies a licensing fee for using the names. Victoria's Secret, for example, paid all of its income as royalties and interest to its holding company, eliminating its income tax burden. The Delaware companies paid no income tax in North Carolina.
The Department of Revenue eventually won that case, which was worth $2 million. The General Assembly passed a law to close the trademark loophole in 2001; it passed another law in 2007 to close the real estate loophole used by Wal-Mart.
Mejia, the low-income advocate, said the piecemeal patching of loopholes is ineffective; a combined-reporting regime, like that approved by the House Finance Committee on Tuesday, would patch all such loopholes at once, she said.
Hoyle, the pro-business senator, agreed: "It would be seamless," he said.
Coming Saturday: Forgotten money for a "hall of champions."
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