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You may have heard about Google Inc.’s restructuring last year, which resulted in the technology company becoming a wholly owned subsidiary of a new Delaware corporation called Alphabet Inc. What you may not know is how this restructuring can help the company potentially avoid millions in state taxes.
In a recent academic paper “Google’s ‘Alphabet Soup’ in Delaware”, the authors explain how Alphabet Inc. will allow Google to take advantage of the “Delaware loophole” to lower its corporate income tax. The Delaware loophole, which is detailed in the 2015 Institute on Taxation and Economic Policy (ITEP) report “Delaware: An Onshore Tax Haven”, is estimated to have cost states $9.5 billion in lost revenues over a 10-year period. It works like this:
A company sets up a “Delaware Holding Company,” which owns its intellectual property (IP), such as patents and trademarks. The company’s subsidiaries (in this case, Google Inc. and its affiliates) then pay royalties to the holding company (Alphabet Inc.) for the use of the IP. In Delaware tax law, corporations whose activities within the state consist only of managing “intangible investments” (including but not limited to stocks, bonds, patents, and trademarks) and collecting income from those investments are exempt from taxation on that income. At the same time, the corporation can deduct the royalty payments as a business expense on tax returns filed in other states where it has subsidiaries. Google’s restructuring provides Alphabet Inc. with the opportunity to exploit this strategy. For example, the company could artificially inflate the price of its IP and effectively shift all or most profits into Delaware where they won’t be taxed.
For states that use combined reporting, this profit shifting is not as worrying. The rule requires corporations with subsidiaries in multiple states to report the income of all of their subsidiaries for the purposes of determining their corporate income tax liability. In these states, Alphabet would have to report the royalty income of the Delaware holding company along with the income of all other subsidiaries, regardless of location, and apportion its total income among all the states where it is subject to tax. In contrast, states that use separate accounting, which allows corporations to report profits for each subsidiary independently, can see their tax bases significantly eroded as a result of corporations using this strategy. Adopting combined reporting is the best way that states can protect themselves from falling victim to the Delaware loophole and other tax-shifting strategies.
Should Google use this restructuring to avoid taxes, this wouldn’t be the first time it has employed complex accounting and paper work to reduce its tax bill: it funneled billions in profits to offshore tax havens through a series of foreign subsidiaries with a strategy that has been dubbed the “Double Irish With a Dutch Sandwich.” As of the end of 2015, Google had $58.3 billion in offshore “permanently reinvested” profits on which it pays no U.S. taxes, up from $47.4 billion in 2014.
In the press release announcing the restructuring last year, Google co-founder and Alphabet CEO Larry Page stated that the purpose of the restructuring was to allow more management scale and to “run things independently that aren’t very related.” Though we can only speculate about the degree to which the restructuring was motivated by tax considerations, it is undeniable that it has created new opportunities for tax avoidance.