St. Paul, Minn. — In the late 1980s, the state Legislature added a new twist to Minnesota's tax code: the "foreign operating corporation," or FOC. Companies that created FOCs could take a substantial tax deduction on the income stream that those subsidiaries sent back to Minnesota. The deduction was meant to reflect that much of the FOC's business was conducted offshore and not properly considered Minnesota income. It also helped level the playing field between Minnesota companies and foreign competitors.
And finally, it was meant to encourage homegrown companies to enter the increasingly global marketplace. All good intentions, says Lynn Reed of the Minnesota Taxpayers Association.
"It just shows the difficulty of trying to get this right. When you try to correct one inequity, you can't anticipate every possible scenario. And then it might tilt another way."
The law says a company can qualify as an foreign operating corporation if it has less than 20 percent of its payroll and property in the U.S. That worked well until, just a few years ago, a judge ruled that a company with no domestic property and payroll clearly fit that definition.
The problem was the company in question had no property or payroll anywhere; it was a paper shell.
DFL Senate Taxes Committee Chair Larry Pogemiller of Minneapolis says clever accountants had found a way to exploit the FOC provisions, setting up bogus companies to shelter their income from the Department of Revenue.
"This is a cat-and-mouse game that goes on year after year where we have to sometimes tighten up the language in the law to make sure that intended types of taxation on corporations actually comes to fruition," Pogemiller says.
Pogemiller and his Senate colleagues say it's a simple matter to close that loophole. They'd require FOCs to demonstrate a real economic presence -- in this case, at least $2 million of property and $1 million of payroll overseas. That takes care of the paper tax shelters.
But Senate DFLers want to go even further than that. They also repeal the original dividend and royalty deductions even for FOCs that aren't paper shells. They say the change would generate $58 million and help Minnesota resolve its budget deficit.
Revenue Commissioner Dan Salomone says that goes beyond closing a loophole and is, in fact, a tax increase.
"The governor has said that. And to the extent that he's going well beyond the problem and sort of throwing the baby out with the bathwater on the FOCs, I think that's not an unfair characterization," according to Salamone.
Salomone says the governor has recommended an economic substance test that matches the DFL plan. He says that would address the immediate problem of phony tax shelters and boost tax collections by just over $1 million. But he says the deductions for legitimate foreign operating corporations continue to serve their intended purpose, and there's no reason to repeal them.
Business groups agree. Charlie Weaver, a former chief of staff to Gov. Tim Pawlenty who now heads the Minnesota Business Partnership, says following the Senate plan would encourage companies to abandon Minnesota.
"It would put Minnesota way out of the mainstream. It would be very easy just to either shut them down or move to Wisconsin, move to Iowa, move to any other state that offers most of these provisions," Weaver says.
Weaver argues that corporations are reluctant to discuss tax strategies or business plans in public. As a result, he says few of the businesses he represents are eager to play a visible role in the debate.
But Pogemiller says their silence suggests there are few legitimate uses of the FOC provisions. And he says he has little confidence that the current administration will address the problem.
"We need to help out the governor. If the governor doesn't have the courage to do this, then the state Senate's going to try to get it done. And we just look for the governor to be supportive of legitimate efforts to give integrity to our corporate tax code," he says.
Revenue Commissioner Salomone says if there are problems beyond the paper shelters, he's willing to discuss ways to address them. But he argues the Senate solution is too drastic and essentially paints all foreign operating corporations as abusive tax avoidance schemes.