Corporate Tax Reform Bill Opens Loopholes, Makes it Easier to Hide Profits Overseas

The Corporation Business Tax changes being proposed in A-5323/S-3737 are extremely complicated. Many of them are positive, but the removal of key anti-abuse provisions leaves gaping holes in preventing corporate tax avoidance through offshore subsidiaries, specifically the decoupling of GILTI conformity from federal rules, and the reopening of the related-entity royalty/interest payment loophole.

Although NJPP supports many provisions in this bill, including the important switch to the Finnigan method of counting corporate profits, the organization cannot support the bill in its current form.

The bill opens and re-opens far too many tax loopholes, which allow corporations to supercharge their tax avoidance schemes and reward them for foreign offshoring of profits and phantom transactions to artificially reduce their corporate incomes.^[i] With more than one trillion dollars in corporate profits now flowing offshore to tax havens, New Jersey must do all that it can to ensure that the corporations who earn profits off of in-state consumers and workers cannot shirk their duty to pay taxes through elaborate financial trickery.

Because this is a highly complex bill with many moving parts, I have attempted to organize the sections the legislature should remove, amend, or protect, as well as a few suggestions for provisions to add.

As an aside, I urge the legislature and Treasury Department to add section numbers and descriptive headings to help the public understand what is contained in the bill.

The Problem: Foreign Tax Avoidance 

• Companies want to shift their profits overseas to avoid taxation
• Mobile capital makes it easy for corporations to avoid paying their fair share of tax liability by artificially lowering their profits here
• New Jersey tax law can’t “see” these corporate entities, because our CBT only looks at US-based subsidiaries
• Foreign tax avoidance cost New Jersey roughly $714 million in lost tax revenue in 2018, with corporate profits (and tax avoidance in foreign subsidiaries) rising substantially since then.^[ii] In 2018 that would have amounted to nearly 25 percent of all CBT revenue.
• As a result, any tax code change that creates incentives to move profits abroad runs the risk of eroding profits stateside and eroding the revenues that should accompany them.

Two Key Loopholes for Abuse That Must Be Removed

Removing interest/royalty anti-abuse provisions (S-3737, p. 6, lines 6-48, p. 7, lines 1-5).

• What it does: Currently the law only allows corporations to claim a deduction for royalty or interest payments to a related member if they can demonstrate that the purpose of the payments was not to avoid taxes.
• The abuse potential: Corporations can create third-party foreign shell corporations, transfer intellectual property and license it back to their US subsidiaries and/or borrow money from these shells, then claim the interest or royalty payments as a loss, artificially lowering their US profits.
• Why it must be removed: Because New Jersey can’t see foreign subsidiaries, the profits shifted abroad would avoid taxation, leaving Treasury to chase after the money after-the-fact through auditing, rather than preventing the offshoring abuse from happening in the first place.
• Note: This provision is NOT included in the Treasury score sheet, but could have serious long-term potential for exploitation and revenue reduction.

Eliminating GILTI deduction and treating GILTI as dividend (S-3737, p.10, lines 18-22).

• What it does: Currently the law treats foreign global intangible low-taxed income (GILTI) in conformity with the federal internal revenue code, roughly taxing it at 50 percent of the CBT rate. This provision would instead treat GILTI as dividend income, effectively taxing it at 5 percent.
• The abuse potential: Despite the name, GILTI includes a wide range of profits earned by overseas corporations and slashing the amount of GILTI in state corporate taxation will further induce corporations to shift profit-generating assets to foreign subsidiaries.
• Why it must be removed: Given that corporate taxpayers already need to report this income at the federal level, treating it in conformity with the federal government ensures that New Jersey revenue collection is protected against additional erosion through offshoring. Companies declared nearly $350 billion in GILTI in 2018. Conforming with federal law will ensure that New Jersey can keep its revenues robust in the face of additional profit offshoring.
• Note: NJPP believes an estimate of ~$50M in revenue loss to be overly optimistic. Recent research has shown that foreign profit shifting behavior by corporations remained unchanged after the Trump Tax Cuts and Jobs Act (2017), with a stable 50 percent of US multinational profits claimed abroad.

Provisions to Protect

Reorganization discretion by the Director to force worldwide combined reporting (S-3737, pp.41-42, lines 20-48, 1-31).

• What it does: Expands the power of the Director of the Division of Taxation to explicitly require a corporate filer to file a world-wide combined filing.
• How it reduces abuse: Without the “stick” to force corporations to disclose their global holdings in order to unveil any tax avoidance schemes, there is nothing to stop corporations from testing the limits of tax law and hope to tie up disputes in litigation. Any weakening of the anti-abuse provisions as detailed above will require a backstop to ensure that companies cannot abuse tax law and the discretion in the Director is critical to deter companies from tax avoidance schemes. Note that worldwide combined reporting (see below) would help solve many of these problems of foreign offshoring by forcing companies to report all their profits and losses from all foreign subsidiaries as one combined return.
• Note: The section uses “taxpayers” instead of “affiliates” or other terms. Yet this may limit the scope of this section only to organizations that have enough connection to New Jersey to trigger taxation, rather than affiliates who would not ordinarily be subject to New Jersey tax.

Close the captive Real Estate Investment Trust (REIT) loophole (S-3737, pp.25-27).

• What it does: Includes REIT and Regulated Investment Companies (RICs) in the combined group and does not give them the deduction on dividends-paid. This (mostly) closes the loophole on the captive REIT tax avoidance strategy, which worked as follows:
  • Corporation owns lots of branches/locations, then transfers ownership to the REIT that it controls 90% of.
  • The REIT charges rent to the corporation, which the corporation can take as a deduction.
  • The REIT then pays out dividends to its shareholders (90% of whom are the corporation). The REIT then takes a deduction for dividends paid.
  • The corporation ALSO takes a dividends received deduction for the dividend payments from the REIT.
• How it reduces abuse: By treating REITs and RICs as part of the corporate group, these payments cancel out, and the dividends-paid deduction is eliminated. In doing so, the tax code reduces the opportunity to abuse these schemes by eliminating much of the financial incentive for setting up these in the first place.
• Caveat: The REITs and RICs can still be hidden through ownership by other types of corporate entities, such as life insurance company segregated asset accounts or Australian Property Trusts. The exclusion of these types of avoidance schemes (detailed on lines 40-42 on p. 25) suggests that this may simply move these schemes to more exotic foreign-controlled corporate entities. This loophole should be closed quickly and simply, so all REITs no matter how owned are included in the taxable group.

Formalize switch to Finnigan rule for taxable groups.

• What it does: The Finnigan rule, named for a California court case, treats a corporation as taxable as long as any member of its unitary group is taxable. That means that corporate subsidiaries and related groups that do not claim nexus in New Jersey are taxable as part of one taxable group.
• How it reduces abuse: Various tax schemes rely on related corporations that are outside the scope of New Jersey’s corporate tax system. New Jersey has moved towards combined reporting and has recognized that including all subsidiaries and related corporations is necessary to collapse some of these avoidance schemes.

Broader Solutions: Provisions to Add

Tax haven list (not currently included in the bill).

• What it does: Requires that corporations report subsidiary and associated corporations as part of their combined reporting if they are incorporated in specific tax haven jurisdictions. For example, Montana requires that corporations in a unitary relationship with the taxpayer incorporated in countries like the British Virgin Islands, the Isle of Man, and Luxembourg must be included in a combined return. See Code 15-31-322(f).^[iii]
• How it reduces abuse: Nearly $1 trillion in global profits was collected in tax havens in 2019. Requiring corporations to report the profits generated by the worst-offender tax havens allows New Jersey to recoup some the income being lost to this tax avoidance, as well as protect legitimate offshore income generated by businesses abroad that do not have a connection with New Jersey.

Mandatory worldwide combined reporting (not currently included in the bill).

• What it does: Requires that corporations report income on all their worldwide subsidiaries and controlled corporations as one unit. Subsequently, New Jersey can apply its apportionment formula to ensure only the profits attributable to the state are counted.
• How it reduces abuse: Allowing corporations to simply elect whether to report their foreign subsidiaries allows corporations to hide their profits abroad and fail to report their income stateside. It also makes the tax avoidance schemes described above much easier to undertake (such as the royalty/interest deduction loophole or the REIT “rent” deduction) because the profit half of the ledger can be hidden in another country. Inevitably, the only way to stave off foreign profit offshoring to avoid taxation is to require true world-wide unitary combination. Although this will have additional administrative challenges, such as the fair allocation of foreign profits to New Jersey, shifting to mandatory world-wide reporting largely ends the game of whack-a-mole to chase down foreign profit-shifting tax avoidance schemes.

Final Note: More Auditors Needed

Treasury needs a ramp-up in the number of auditors to combat corporate tax flight.

• What it does: Annual US corporate profits have more than tripled since 2003 (from $811 billion to $2.9 trillion), but the number of auditors projected for FY2023 is actually lower than the state had in 2003 (a decrease from 428 to 365). The increasing complexity of corporate tax structures and the sophistication of tax avoidance schemes requires sufficient staffing.
• How it reduces abuse: With much of the enforcement power of the tax agency dependent on the audit power (and the reorganization discretion of the Director), the need for a strong auditor workforce is critical to ensure that the state can enforce its tax laws against the world’s largest and wealthiest corporations, who have substantial interest in lowering their tax liability. The federal IRS recently saw an increase in its workforce as part of the Inflation Reduction Act.

NJPP cannot support the bill in its current form, though with amendments, it could be a robust force against tax avoidance schemes.

End Notes

^[i] Ludvig Wier and Gabriel Zucman, Global Profit Shifting, 1975-2019, United Nations University-WIDER Working Paper 2022:121, https://www.wider.unu.edu/sites/default/files/Publications/Working-paper/PDF/wp2022-121-global-profit-shifting-1975-2019.pdf

^[ii] Ricahrd Philips, Institute on Taxation and Economic Policy, A Simple Fix for a $17 Billion Loophole: How States Can Reclaim Revenue Lost to Tax Havens (Jan. 17, 2019), https://itep.org/a-simple-fix-for-a-17-billion-loophole/.

^[iii] See also Jane G. Gravelle, Congressional Research Service, Report R40623, Tax Havens: International Tax Avoidance and Evasion (Jan.  6, 2022) p. 4, https://sgp.fas.org/crs/misc/R40623.pdf.