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Florida tax laws and intellectual property

One of the most infamous tax strategies of all time began in 1984. Toys “R” Us, the bankrupt chain that once dominated children’s retail, set up a subsidiary in Delaware. The company transferred to that subsidiary the rights to its most valuable intellectual property, the Toys “R” Us name and the Geoffrey the Giraffe mascot. It named the new subsidiary “Geoffrey Inc.”

Toys “R” Us then made its stores pay royalties to Geoffrey Inc. for the rights to use those trademarks. The stores typically paid Geoffrey between 1% and 3% of their total sales and deducted those royalties when they filed their state income taxes. Geoffrey, which didn’t own any physical property or employ any full-time workers, didn’t pay any state income taxes at all.

By 1990, Geoffrey Inc. was taking in $55 million a year and paying nothing in state income taxes.

Many more businesses soon followed that model. “This used to be all the rage, these Delaware holding companies,” says David Brunori, a tax attorney and research professor at George Washington University Law School in Washington, D.C.

States eventually caught on. Some fought the companies in court — Toys “R” Us alone faced lawsuits in at least South Carolina, Oklahoma, Massachusetts and Louisiana. Many changed their income tax laws. As a result, the use of intangible holding companies like Geoffrey Inc. has declined.

“They’re not used nearly as much as they were 15 years ago,” Brunori says. “You’d never be able to really identify the number. But everything I’ve seen and heard from talking to practitioners and state folks about this is that they’re still used, but much less so today.”

But while the strategy may no longer be very effective in most parts of the country, it’s still thriving in Florida.

Last year, for instance, a subsidiary of Whole Foods Markets sued the Florida Department of Revenue, seeking a refund of $1.4 million worth of corporate income taxes it paid to the state between 2011 and 2014.

The grocery chain, which was bought in 2017 by Amazon, had been using the Toys “R” Us playbook. The company arranged its business so that all of its roughly 500 stores paid a percentage of their revenue to “Whole Foods Markets IP,” a Delaware subsidiary created to hold its trademarks. In 2013 alone, Whole Foods stores around the country, including 19 in Florida, paid approximately $340 million in royalties to Whole Foods Markets IP, according to litigation records.

Whole Foods has been using its intangible holding company to reduce its income tax payments in various states for more than 15 years. It had been paying at least some income tax in Florida until last year, when Whole Foods Markets IP sued the Florida Department of Revenue, demanding a refund of all the income taxes it paid the state between 2011 and 2014. Whole Foods — which was bought in 2017 by Amazon, which is known for its aggressive tax strategies, says in the lawsuit that it “became aware that it did not lawfully owe any” Florida tax on its royalty income. Its holding company had paid the state more than $1.4 million in tax over the four-year period, or about $350,000 annually.

Whole Foods bases that claim, in large part, on a court case the state of Florida lost in late 2011 that exposed what a judge called a loophole in state law.

When crafting the original 1971 corporate income tax law, the Legislature instructed companies to exclude royalties from their sales calculations, partly because it could be difficult to determine a physical location for intangible property. But they made an exception for the mining industry because those royalties could easily be tied to a physical location.

But now companies that have created these holding companies argue that the Florida Legislature clearly only intended to count royalties when taxing mining companies.

The argument has been tested exactly once in a Florida court — in a case involving Circle K. The convenience store chain, which used an intangible holding company to avoid $3 million in Florida taxes over a three-year period, won that case in December 2011 because of the mining industry provision.

Since the Circle K ruling, further litigation has turned up more companies using the strategy in Florida. For instance, the packaged food giant that once combined both Kraft Foods, the maker of macaroni and cheese, and Mondelez International, the maker of Oreo cookies, used an intangible holding company to avoid nearly $2.6 million a year in Florida income taxes between 2008 and 2012.

Meanwhile, Aaron’s, the furniture, appliance and electronics rental company, cut its Florida tax bill by more than $100,000 a year between 2003 and 2011. Even before the Circle K case, litigation revealed cigarette maker Reynolds American avoiding more than $1.1 million a year in Florida taxes, Microsoft avoiding more than $800,000 a year and Best Buy avoiding about $600,000 annually. All of the cases were settled.

Technically, the Florida Department of Revenue maintains that these kind of royalty payments are taxable under existing state law. But the reality is that the agency is virtually powerless to stop it. Documents produced in the Circle K case showed that the department was regularly settling audit disputes over the use of intangible holding companies for 30% or less of the amount of tax in dispute. Tax attorneys say the agency’s “recovery rate” has shrunk even further since the Circle K decision.

Easy fix

The Florida Legislature could stop companies from using this tax strategy by adding language clarifying that it is not only mining companies that must count royalties when calculating their income taxes.

More broadly, some other states have enacted “add back” laws in which companies can be required to add back any deductions they have taken for royalties paid to their own holding companies.

And earlier this year, New Mexico became the 28th state — plus the District of Columbia — to adopt what’s known as “combined reporting” or “unitary reporting,” which requires companies to file a single, comprehensive tax return for all their subsidiaries when they calculate their taxes. The goal is to eliminate the impact of large companies moving money between subsidiaries — whether that takes the form of royalties paid for the right to use trademarks, interest paid on internal loans, management fees or any other form of transfer payment.

Florida, by contrast, remains a separate return state, allowing companies the option of filing different tax returns for different subsidiaries.

“Florida is definitely a laggard,” says Michael Mazerov, a senior fellow at the Washington-based Center on Budget and Policy Priorities, which supports combined reporting.

Mazerov says Florida is now one of six states with a corporate income tax that hasn’t adopted an add-back law or combined reporting. And two of those six states have won court decisions ruling that they can tax intangible holding companies — Oklahoma and South Carolina, both of whom won suits against Toys “R” Us.

“So, really, Florida is one of only four states in which elected officials have chosen to leave the state completely vulnerable to the intangible holding company tax avoidance scheme,” Mazerov says.

One reason the Florida Legislature hasn’t made any changes: Opposition from the state’s largest businesses, which don’t want to pay additional income taxes.

That opposition is unyielding. Every year, for instance, Associated Industries of Florida vows to fight “any structural changes” to the state’s corporate income tax law — including combined reporting, an add-back law or “any other ‘loophole’ issues.”

The opposition is also sometimes misleading. During the legislative session earlier this year, the Florida Senate’s commerce and tourism committee held a rare hearing on a combined reporting bill. The bill failed on a 2-2 party line vote after a series of business groups testified in opposition, including AIF, Florida TaxWatch, the Florida Bankers Association and the Florida Chamber of Commerce.

French Brown, a Tallahassee attorney who began his career at the Florida Department of Revenue and is now a tax law lobbyist for the Florida Chamber and other clients, told the senators on the panel a cautionary tale about combined reporting and industrial giant General Electric.

“I will just add one other example. In 2015, the state of Connecticut passed mandatory combined reporting — and that year GE decided to move their corporate headquarters from Connecticut to Boston,” Brown said. He added, for emphasis, “Boston, tax-chusetts.”

“French, I’ve got a quick question for you,” responded Sen. Joe Gruters, a Sarasota County Republican and chairman of the Senate’s commerce and tourism committee. “When GE moved their headquarters, did they specifically mention that bill passing as the reason why they were leaving?”

“You’re absolutely correct,” Brown answered. “They did.”

What neither of them mentioned is that Massachusetts, too, is a combined reporting state.

 

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