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Profits and poodles: the story of a corporate tax loophole
by Jeff Horwich, Minnesota Public Radio
June 24, 2005

A Minnesota Supreme Court ruling this month sets a very relaxed standard for protecting income in a so-called "foreign operating corporation." Imagine your dog collar business is expanding into France... (Photo courtesy of ThePetProfessor.com)

A Minnesota Supreme Court decision this month could cost the state up to $300 million in corporate taxes over two years. The decision relates to how Minnesota taxes companies on their foreign operations. While the implications for state revenue are stark, the court decision itself is a thicket of details only an accountant could love. Nonetheless, the loophole opened up by the case is an important one.

St. Paul, Minn. — Suppose you're a company in Minnesota making, let's say, dog collars, and you want to break into the European market with a new line for French poodles. Getting a foothold in France is tough, though. You need to hire dozens of new people there to break into the market and sell the collars, and you have to buy office space for them to work in.

Expanding the dog collar business allows your company to grow; it's good for you and good for the Minnesota economy. Should the state tax you on all your foreign operations and income?

In 1988, state lawmakers essentially said, "No. Why should we 'ding' you for people and transactions that are somewhere else? As long as the bulk of your foreign operation is overseas, we'll tax you on only 20 percent of your foreign income."

Now suppose things are a little different. Your dog collars are selling in Europe like hot crêpes. But you hardly have to do a thing overseas. Let's say orders are coming in over the Internet. All you do is pop dog collars in the mail. You set up a separate division, but only on paper. You call it a foreign operation, but it's only there to help keep track of the money from abroad.

In this case, you don't have any foreign property or workers. Should you still get the big tax break?

This month, the Supreme Court of Minnesota said "yes." In fact, many experts agree that under the ruling you might not need any foreign operations at all. Even if you never sold a dog collar beyond Milwaukee, you could set up a paper subsidiary, label it a "foreign operating corporation," and find ways to run income through it to get the tax break -- legally.

Blame the 1988 Legislature for not being specific enough. Keith Getschel does. He's the assistant director of the Corporate and Sales Tax Division at the Minnesota Department of Revenue.

"The Supreme Court definitely expanded the definition of a Foreign Operating Corporation to include what we call PICs -- Passive Investment Corporations -- which can be merely set up for the intention of avoiding tax," Getschel says.

Minnesota law says income from a foreign operating subsidiary can qualify for the tax break if no more than 20 percent of its property and payroll are in the U.S. The court said since zero is less than 20 percent, a subsidiary with zero property or payroll anywhere could technically qualify.

Getschel thinks protecting these "shells" is not what lawmakers originally had in mind when they wrote the law. "A 'foreign operating corporation' -- I mean, the word "operating" seems to mean something, that there has to be have operations, which the Supreme Court didn't agree with."

Getschel isn't saying most companies are looking to slip through this loophole; only that they now can, and a certain number probably will. He says the Department of Revenue has up to $40 million in recent claims for refunds from companies that have recently discovered foreign operating corporation income. Those claims followed an earlier tax court ruling in the case. Getschel expects more claims are on the way now that the Supreme Court has given the final word -- some undoubtedly more legit than others.

The Supreme Court decision vindicates Hutchinson Technology, the Hutchinson, Minn.-based maker of parts for disk drives. The case related to a subsidiary the company started in the late 1980s to handle its growing income from Asia. The subsidiary -- HTI Export -- was not a pure shell, but there wasn't much to it. In some years it paid one foreign-based employee as much as $70,000 and spent $5,700 in promotional materials.

Company spokeswoman Connie Pautz says the Minnesota tax break -- and a similar one in federal law -- were originally intended to encourage exports. On that count, she says they were a success, and reduced the cost of competing abroad. Over 20 years Hutchinson Technology grew its Asian exports from 5 percent to 93 percent of its sales, adding jobs in Minnesota and around the world.

"Over 20 years ago HTI had over 30 U.S.-based competitors," Pautz says. "Today there are only two in the world and they're both located in Asia; both manufacture in China. And so we think certainly having a level playing field has helped us be competitive worldwide with competitors that are in Asia."

The Supreme Court has resolved that Hutchinson Technology did nothing wrong in seizing the opportunities available to it. But even some business interests are now uncomfortable with the loophole opened up by the decision. The Minnesota Chamber of Commerce supports a Pawlenty administration proposal to make sure subsidiaries don't get the tax break unless they have a certain amount of property and payroll abroad.

A DFL proposal goes even further in trying to assure foreign operations are really there to serve foreign markets -- and not to dodge the tax man.