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Time to Close Corporate Tax Loopholes

April 29, 2010 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis
A little understood provision of Minnesota tax law is permitting some Minnesota corporations to reduce their corporate income tax liability by 80 percent.  Whenever some businesses are able to avoid taxes in this manner, more of the cost of public services and infrastructure is shifted on to other Minnesota taxpayers.

There is significant evidence that multi-national corporations are shifting profits to low-tax foreign "tax haven" countries without actually locating a substantial portion of their business in these countries.  By some reports, U.S. corporate profits reported in tax haven nations can exceed the entire gross domestic product of these nations by 300 percent or more.  Among the largest tax havens for U.S. multi-national corporations are Bermuda, the Cayman Islands, and the British Virgin Islands.

How is it possible for corporate profits within a country to be multiple times greater than the entire GDP of the country?  In reality, it isn't.  What's happening is that corporations are artificially exporting income to these tax havens--thereby creating the illusion of economic activity far greater than what is actually occurring--in order to take advantage of low tax rates in these countries and to avoid federal and state taxes in the U.S.

Another tax avoidance scheme is the "foreign royalty subtraction," which allows foreign operating corporations (FOCs) to shelter 80 percent of their income from Minnesota taxation.  Effectively, this means that these corporations are being taxed at only one-fifth of the rate applied to other corporations.  Efforts made to end abuse of FOC provisions during the 2008 legislative session were not entirely successful.

These loopholes are bad public policy for multiple reasons.  They create perverse incentives for corporations to "game the system" by reporting income not based on where it is actually produced, but based on where tax rates are lowest.  In addition, these loopholes create an unfair competitive advantage for some business over others.  The winners are large multi-national corporations who have the resources and clout to take advantage of these highly complex tax provisions; the losers are everyone else, from purely domestic corporations to small businesses to the average taxpayer, who must pay higher taxes to make up for the lower taxes paid by multi-nationals.

State lawmakers should put an end to these unfair tax breaks by treating businesses that are incorporated in tax haven countries the same as domestic corporations if a significant portion of the corporation's income is sourced to the tax haven country.  In addition, lawmakers should eliminate the foreign royalty subtraction.  According to estimates from the Minnesota Department of Revenue, these steps would generate approximately $400 million over the next three years.

Minnesota is confronting massive budget deficits in both the current biennium and the next.  While Minnesotans should not be deluded into thinking that the state will be able to get out of its fiscal mess entirely through tax increases, neither should we entirely take tax increases off the table.  The elimination of unproductive and unfair corporate loopholes should be one tax measure that state lawmakers can come together on during the 2010 legislative session.

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