Phony Expense Plan Fails To Convince Judges
North Carolina's textiles industry has been economically undone by Wal-Mart's China First procurement policy. As if those employment losses weren't bad enough, the state has also been engaged in a multi-year legal battle to get the giant retailer to pay its fair share of state income taxes.
Two years ago, the Wall Street Journal ran a story revealing that Wal-Mart pays billions of dollars a year in rent for its stores, but in 25 states -- most of them east of the Mississippi -- it has been paying most of that rent to itself, and deducting that amount from its state taxes. This scheme has allowed Wal-Mart to avoid paying several hundred million dollars in state taxes.
Based on a dodge developed by its accounting firm, Ernst & Young, as a "local tax reduction strategy," Wal-Mart's financial self-dealing has allowed it to pay rent to itself through a maze of eight corporate subsidiaries created in 1996, including Real Estate Investment Trusts (REITs).
Under the agreement with itself, Wal-Mart pays 2.5% of gross sales monthly as rent to its own REIT, which then wires the money quarterly to Wal-Mart Property Company in the form of a dividend, which is then paid to Wal-Mart Stores as a tax-exempt "dividends received." All of these transactions are handled through a "cash management agreement" between all the parties. Neither the REIT nor the Property Company has any employees.
The REITs don't pay taxes, as long as they pay 90% of their income out in dividends to shareholders. In Wal-Mart's case, the REITs are owned by Wal-Mart subsidiaries registered in Delaware, a state that has no corporate income tax. Wal-Mart gets the benefit of the rent expense, but also gets the benefit of the non-taxed dividend, on the same monies. The dividends escape taxation, and the original rent that created the dividends is deducted from taxable income in the states where the "expense" is incurred. The rent, in essence, goes from one Wal-Mart pocket into another.
The state of North Carolina challenged this tax work-around several years ago, and disallowed the rental deduction from Wal-Mart's taxable income for the period 1999 to 2002. North Carolina insisted that Wal-Mart submit "combined returns" for Wal-Mart Stores East, Wal-Mart REIT, and Wal-Mart Property Company. The state argued that Wal-Mart was "distorting its true net income." It charged that Wal-Mart Stores East owned all the stock of Wal-Mart Property Company, which owned a majority of the shares of Wal-Mart REIT. Wal-Mart paid their tax bill -- but then sued the state's Secretary of Revenue in 2006, charging that the retailer did not owe the higher taxes.
On December 31, 2007 an Emergency Special Judge in Wade County, North Carolina Superior Court, ruled in favor of the state of North Carolina, and against Wal-Mart's lawsuit. The Judge ruled that North Carolina had the statutory right to force a corporation to state its "true net income" through a consolidated statement, "so as to properly reflect the extent of the corporation's activities in the state." The judge ruled that Wal-Mart's treatment of rent had no "real economic substance," and was only a mechanism for reducing the taxes it pays to the state of North Carolina. "Plaintiffs do not deny the facts demonstrating the circular journey taken by the 'rents' paid by these plaintiffs," the judge wrote, "but contend that on each leg of the journey plaintiffs were only taking advantage of a lawful deduction afforded them by then-existing tax law. Such a piecemeal approach exalts form over substance, however...There is no evidence that the rent transaction, taken as a whole, has any real economic substance apart from its beneficial effect on plaintiffs' North Carolina tax liability. It is particularly difficult for the court to conclude that rents were actually 'paid,' when they are subsequently returned to the payor corporation."
Wal-Mart appealed the Wade County Superior Court ruling, and on May 19, 2009 the North Carolina Court of Appeals denied Wal-Mart's appeal. The three-judge panel voted unanimously that the state has the authority to combine the finances of subsidiaries for the purpose of calculating a company's state tax bill. "The language of the statute is broad," the court ruled, "allowing the secretary (of revenue) to require combined reporting if he finds as a fact that a report by a corporation does not disclose the true earnings of the corporation on its business carried on in this state."
Other states, most recently Massachusetts, have passed laws to require combined reporting of corporate income, and end the "circular journey" of money through companies like Wal-Mart. The retailer now has the option of appealing this week's decision to the North Carolina Supreme Court, and thereby keeping this "tax deadbeat" story alive for another news cycle. Just as Wal-Mart tries to compel its vendors to continually lower prices, so Wal-Mart has tried to continually lower its costs by avoiding its fair share of state taxes.
What Wal-Mart tries to shirk ends up being shifted to its customers -- who are also state taxpayers, and must make up what Wal-Mart sues to avoid. Wal-Mart shoppers may not feel the light touch of Wal-Mart, but the company's tax avoidance policy is akin to picking its customer's pockets even as they browse the store for everyday low prices.
This phony money-shuffling is part of Wal-Mart's "hidden tax" on the rest of us who pay our taxes without the counsel of corporate tax accountants. And we thank them by continuing to shop at their superstores.
Al Norman is the founder of Sprawl-Busters. He is the author of The Case Against Wal-Mart. His website is http://www.sprawl-busters.com