Facing budget deficits and shrinking corporate tax revenues, government officials from the United States and other foreign countries are closely monitoring the Organization for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting project. The OECD indicates on its website that a primary focus of the project “is looking at whether, and if so why, [multinational firms’] taxable profits are being allocated to locations different from those where the actual business activity takes place.” In short, the OECD is examining whether and how profits earned in high-tax countries are being siphoned away into foreign tax havens, with the shift in profits generally having little to do with operations.

The state income tax landscape in many ways mirrors the multinational tax setting. With variation in state income tax rules, rates, and apportionment formulas, U.S. firms operating in multiple states have the same tax-motivated incentives to shift profits out of high-tax states and into low-tax states to reduce their overall state income tax burden. While many states have sought to attract corporations through lower state income taxes and other tax incentives, Delaware remains the leader. This article explores in detail one Delaware state tax planning strategy, the passive investment company (PIC), reviews academic research on the benefits that accrue to U.S. businesses and Delaware itself when U.S. companies employ it, and examines competing states’ efforts to counteract it.

The Passive Investment Company

On its face, Delaware seems like an unlikely candidate for the tax-friendly subsidiary incorporation location of choice. The Delaware corporate tax rate is 8.7%, higher than the average state corporate tax rate across the United States. Not all income, however, is taxed at this rate in Delaware. Section 1902(b) of the Delaware General Corporation Law (DGCL) specifically exempts from corporate taxation any income from “corporations whose activities within the state are confined to the maintenance and management of their intangible investments … and the collection and the distribution of the income from such investments.” Thus, income generated on intangible assets located in Delaware is exempt from state taxation, allowing a business to reduce its overall state income tax burden. The Delaware entity holding such assets is the PIC.

A business needs to meet the following statutory requirements to generate tax savings from the Delaware PIC strategy:

  • Intangible assets owned in Delaware
  • A Delaware subsidiary incorporated solely to manage the collection and distribution of royalties
  • Subsidiaries located in high-tax states with state income tax rules conducive to allowing the Delaware PIC benefit
  • Nontrivial apportionment factors attributed to the high-tax states

To implement the strategy, a company typically incorporates a new Delaware subsidiary, the PIC, and transfers ownership of an intangible asset to it. The company then directs one or more separate subsidiaries in high-tax states to make a royalty payment to the PIC for use of the intangible asset. In certain states, the royalty payment is even deductible from the company’s income tax liability, and the company does not pay taxes to any state on the income shifted to the PIC.

Given that intangible assets are a necessary ingredient in the Delaware PIC strategy, DGCL section 1902(b) defines qualifying intangible investments as “investments in stocks, bonds, notes, and other debt obligations (including debt obligations of affiliated corporations), patents, patent applications, trademarks, traded names, and similar types of intangible assets.” Although this allows companies broad latitude in selecting the assets to transfer to the PIC, the tax savings are derived from the value of those assets. The more valuable the intangible assets, the higher the royalty payments and the greater the tax savings.

Delaware also accrues substantial benefits through this strategy by collecting corporate tax receipts from out-of-state companies that would not generally choose to do business in Delaware, which receipts make up a sizable portion of its state budget. During the last several years, franchise taxes and other fees from subsidiary incorporations generated between $600 and $700 million for Delaware, which represented approximately 18–22% of its annual revenues (Francis Pileggi, “Why Delaware Courts Are America’s Most Important to Businesses,” Delaware Corporate & Commercial Litigation Blog, Sept. 2, 2007, http://bit.ly/2cjtvKF; Jonathan Starkey, “Revenues Keep Dropping in Key State Income Source,” Wilmington News Journal, Apr. 8, 2012, http://bit.ly/2d3Kqjc). The costs to competing states and their residents of the Delaware PIC strategy are also potentially substantial, as the other states and their residents lose the state corporate tax revenues on those profits that would have been collected otherwise.

Tax Benefits of the Delaware PIC Strategy

Recent academic research sheds light on the prevalence and estimated state tax savings of the Delaware PIC strategy (Scott D. Dyreng, Bradley P. Lindsey, and Jacob R. Thornock, “Exploring the Role Delaware Plays as a Domestic Tax Haven,” Journal of Financial Economics, June 2013, http://bit.ly/2ccxYNn). The authors found that over 51% of all U.S. subsidiaries of U.S. public companies from 1995 through 2009 are incorporated in Delaware. In contrast, Delaware accounts for approximately 0.5% of the United States’ Gross Domestic Product.

The authors also show that companies with a Delaware PIC strategy in place have a 15–24% lower state income tax burden compared to those without, which translates into millions of dollars of lost corporate tax revenues to other states. Focusing on industries, the authors found that the computer, machinery, metal, and pharmaceutical industries generate the greatest tax savings, resulting in an effective state tax rate reduction of 1.0–2.5 percentage points from the 4.6% average state effective tax rate.

States’ Efforts to Combat the Delaware PIC Strategy

To successfully implement the Delaware PIC strategy, a business must have operations in other high-tax states with tax rules that allow the tax savings to be realized. These “separate filing” states enable the PIC strategy because they require only those legal entities that have established a physical presence in the state to pay taxes. The amount of the tax savings is generally a function of the value of the intangible asset located in Delaware and the difference between sales, property, and payroll taxes in the separate filing state and those in non–separate filing states with tax rules that do not provide the same latitude.

Other states are aware of the lost state tax revenues associated with the Delaware PIC strategy. As a result, some have counteracted the Delaware PIC strategy (and other multistate tax avoidance tactics) using several different methods. The first method is a filing requirement called combined reporting, which forces companies to include the net profits of all domestic entities in the consolidated or combined firm on the state tax return. Instead of apportioning the net profits of a single entity, the net profits of the combined group are apportioned using the combined groups’ sales, property, and payroll. As a result, the company must include the royalty deduction on the same tax return as the royalty income, eliminating any tax benefits from the Delaware PIC strategy.

Combined reporting is a hotly debated topic among policymakers and academics. Researchers and practitioners have documented the advantages and disadvantages of combined reporting (Robert Cline, “Understanding the Revenue and Competitive Effects of Combined Reporting,” Council on State Taxation, May 2008, http://bit.ly/2c51p4G; William Fox and LeAnn Luna, “Combined Reporting with the Corporate Income Tax,” National Conference of State Legislatures, November 2010, http://bit.ly/2bJMUTm). On one hand, combined reporting helps to close tax loopholes and the associated tax revenues lost from the Delaware PIC strategy. On the other hand, combined reporting might cause businesses to relocate to a different, more tax-friendly state.

In addition to combined reporting, states can invoke the economic nexus doctrine to combat the Delaware PIC strategy. Under the economic nexus doctrine, a state asserts the right to tax income earned by corporations with a sufficient economic footprint in the state regardless of physical presence. In general, a corporation with a physical presence via property or payroll has a clear obligation to file and pay taxes in a state; however, the state tax obligation for a firm with a substantial but nonphysical presence is less clear. Regarding the PIC strategy specifically, the economic nexus doctrine allows states to claim the right to tax the Delaware PIC royalty income that escapes taxation in Delaware. Thus economic nexus, when enforceable, has the potential to severely limit or eliminate the state tax savings of the Delaware PIC strategy.

South Carolina was one of the first states to assert an economic nexus doctrine. Toys “R” Us had established a PIC in the state of Delaware and transferred ownership of its trademark giraffe mascot Geoffrey into the PIC. Toys “R” Us then used the PIC to reduce its taxable income in several states, including South Carolina, by paying a royalty to the Delaware PIC for the right to use the Geoffrey trademark. In the highly influential Geoffrey, Inc. v. South Carolina [437 S.E.2d 13 (1993)], the South Carolina Department of Revenue argued that the requirement of physical presence to establish nexus from the Supreme Court’s decision in Quill Corporation v. North Dakota [504 U.S. 298 (1992)] only applied to sales and use tax, not to income tax. The South Carolina Supreme Court ruled in the state’s favor, finding that the Delaware PIC had established economic nexus in South Carolina through its licensing agreement with the Toys “R” Us operating entity in that state. Thus, the concept of economic nexus was legitimized by a court of law for the first time.

A vast and growing economic nexus litigation history has evolved since Geoffrey. Numerous state courts with varying levels of authority have heard similar cases, with some finding in favor of taxpayers and others in favor of states. Several taxpayers have petitioned the U.S. Supreme Court to hear economic nexus doctrine cases, but the Court has so far refused to hear them.

Another commonly implemented strategy, expense disallowance, disallows the tax deductibility of certain intracompany expenses attributable to income not reported in the state. Expense disallowance rules effectively impose combined reporting on the tax accounting for the Delaware PIC strategy without burdening corporate taxpayers with the increased compliance costs and burdens of combined reporting. The disadvantage is that it can be cumbersome to identify and legislatively target the myriad expenses that can be generated in a Delaware PIC strategy—inevitably leaving loopholes to be exploited by corporate tax planners. As a result, expense disallowance rules have been implemented differently by different states, and most of the states that have passed expense disallowance rules have subsequently adopted combined reporting or economic nexus doctrines, suggesting the expense disallowance rules were not as effective.

Results of States’ Efforts to Limit Lost Tax Revenues from PICs

Dyreng et al. also examined the effects of states’ efforts to limit lost revenues from PICs across two sample periods, 1995–2002 and 2003–2009. Exhibit 1 shows that although businesses still enjoyed a Delaware PIC benefit in the second subsample period, the benefit declined by about one-third, resulting in the average state effective tax rate increasing from 3.4% to approximately 3.8%. This result appears to correlate with states’ use of the three above-discussed methods of curtailing PIC tax deductions, as shown in Exhibit 2. States asserting an economic nexus doctrine were associated with a 13.3% increase in corporate tax revenue collection, and states requiring combined reporting were associated with a 12.3% increase. States imposing expense disallowance rules, however, showed no increase in state corporate tax revenue collections. In summary, there is evidence that requiring combined reporting and asserting an economic nexus doctrine have helped states to limit corporate tax revenues lost from the Delaware PIC strategy.


Average Effective State Tax Rate for Sample Companies


Percentage Increase in Corporate State Tax Revenue Collections

The state tax landscape affords U.S. companies numerous tax savings opportunities. While the Delaware PIC tax benefit has diminished over time, in part due to other states requiring combined reporting and asserting economic nexus, Delaware continues to play a significant role in state tax planning. CPAs who advise businesses considering the PIC strategy should be aware of the current status of state law and policy, as well as possible future developments.

Scott D. Dyreng, PhD is an associate professor of accounting at Duke University, Durham, N.C.
Bradley P. Lindsey, PhD, CPA is an associate professor of accounting at North Carolina State University, Raleigh, N.C.
Jacob R. Thornock, PhD is an associate professor of accounting at Brigham Young University, Provo, Utah.