States take aim at ‘Geoffrey’ tax loophole

The "Geoffrey Loophole," named after the familiar giraffe mascot of Toys "R" Us (TOY), is no fun for state taxing authorities.

Under the loophole, local outlets of large national chain stores pay royalties to sister companies in other states, claiming the payments as business expenses then deduct them from state income taxes.

By Alan Sayre, Associated Press

http://www.usatoday.com/money/companies/regulation/2004-06-24-geoffrey-tax-loophole_x.htm

It’s difficult to determine how much the states are losing each year. But it’s a sore spot with states trying to balance budgets.

The Maryland Legislature voted this year to prohibit companies doing business in Maryland from transferring part of their profits to holding companies chartered in Delaware, where the money is not taxed. Gov. Robert Ehrlich allowed the bill to go into law without his signature.

For a second straight year, a proposal to close the loophole failed in Missouri. While the Republican-led legislature and Democratic Gov. Bob Holden both said the loophole should be closed, they could not agree on how to do it.

The Missouri House passed a bill that would have imposed state income taxes on such royalty payments, but only if the out-of-state corporation was set up for the "primary purpose" of dodging taxes. Critics said the bill would provide a blueprint on how to dodge Missouri income taxes.

The Multistate Tax Commission, which studies state tax issues, estimates that various corporate tax shelters, including the Geoffrey loophole, cost states between $3 billion and $7.1 billion in 2001.

According to the Washington-based Center on Budget and Policy Priorities, 16 states have adopted a reporting system that treats related corporate entities as one, using a formula to figure the amount of in-state taxable income.

Other attempts to close the loophole have failed in Rhode Island, Pennsylvania, Tennessee, Texas and Wisconsin, the center says.

In Louisiana, where the state had to fill a $500 million budget gap this year, action against the Geoffrey loophole is taking place in court.

The state and Wal-Mart Stores (WMT) are involved in a $15.4 million dispute that covers three years. Wal-Mart paid the taxes under protest, but claims it is due a refund. A trial date has not been set.

Louisiana also is pursuing an $800,000 claim from Toys "R" Us and a $975,000 claim from The Gap (GPS), along with suits against smaller chain outlets.

The loophole is named after Geoffrey Inc., a company owned by Toys "R" Us. Geoffrey owns the rights to the chain’s mascot, a giraffe by the same name, along with trademarks and other properties used by the stores.

What happens is this: A local store pays a certain percentage of its profits to the out-of-state sister company — such as Geoffrey — that holds rights to the use of trademarks and other intangibles. That payment is recorded as a business expense — and the store does not pay state income tax on the money.

For example, if a chain store in Louisiana makes a profit equal to 6% of its sales, but pays 3% of its sales to a sister company, it can cut its state income taxes by half.

The sister company holding the trademark rights is usually located in a state such as Delaware or Nevada that does not tax royalty payments. Thus, the process increases overall corporate profits.

The court dispute in Louisiana centers on the 1992 Quill decision by the U.S. Supreme Court, which was handed down in a sales tax dispute over out-of-state catalog sales. The high court ruled that states cannot tax out-of-state corporations unless they have a physical presence in the state that’s trying to collect the tax.

Corporations say the use of a trademark owned by an out-of-state company does not meet the Supreme Court’s standard. But Curtis Nelson, an attorney for the Louisiana Department of Revenue, says the Supreme Court indicated its ruling applies only to sales taxes — not income taxes.

"We’re arguing economic presence instead of physical presence," Nelson says.

But Robert Nuzum, an attorney who represents companies in Geoffrey disputes, contends Quill should apply to all state taxes.

Nuzum says using sister companies to hold trademarks and other intangibles is a legal tax-planning move, as well as a sensible way to protect trademarks.

"In the trademark area, to isolate those assets in one corporate entity is a valid business move," Nuzum says. "You shield them from creditors so if the operations of one aspect of the business result in lawsuits or claims, you can keep your trademarks out of it."

Wal-Mart declined comment on the Louisiana dispute, citing the pending lawsuit.

Nelson predicts the question will eventually be decided by the U.S. Supreme Court. Nuzum says the Supreme Court has declined several chances to take up Geoffrey disputes and Congress might have to handle a solution.

"It could be that the Supreme Court wanted Congress to step in in 1993, and that’s why they aren’t taking these state tax cases like they once did," Nuzum says.
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