Cayman Islands blamed for huge tax shortfall in Minnesota

Wednesday, July 14, 2004

Picture Minnesota businesses electronically sending hundreds of millions of dollars every year to tiny shell corporations in the Cayman Islands, where the money is instantaneously swept back home with only a few bookkeeping entries recording its Caribbean visit.

According to the Pioneer Press in St. Paul, that scenario is at the heart of a mystery that Minnesota Revenue Commissioner Dan Salomone and state economist Tom Stinson are trying to solve: Why, when corporate profits seem to be rising fast, are state corporate tax payments lagging?

Salomone’s best guess is that a sloppily drafted 1988 state law covering foreign operating corporations, or FOCs, is allowing companies to shelter income from state taxes by sending it offshore.

And Stinson’s best guess, based on advance income tax payments by businesses in December, March and June, is that the cost to the state is $100 million a year and probably rising.

“We could eventually lose a good part of the corporate income tax,” Salomone said.

The approximate $600-million-a-year corporate tax is less than 5 percent of total state tax collections, but any decline in overall receipts is important as the state struggles with recurring deficits.

A recent national study reported that corporate taxes in states across the country increased 15.2 percent in the first quarter of this year versus the same period a year earlier. But in Minnesota, the taxes declined 5 percent.

What Salomone and Stinson suspect is that businesses with few, if any, real foreign operations are taking advantage of a tax break that lawmakers originally intended for firms manufacturing or selling products overseas.

Debra Anderson, an accountant who has helped companies establish foreign operating corporations to avoid state taxes, said Salomone and James are correct that many companies are using FOCs to shelter domestic income in ways lawmakers never anticipated.

“I have a hard time with what the definition of loophole is, but if there is one, this would be it,” she said.

Anderson, a partner in the Wilkerson, Guthmann & Johnson accounting firm in the Twin Cities, said personal qualms about pitching foreign operating corporations to clients as tax shelters were a factor in her decision in 2002 to leave the Minneapolis branch of KPMG, a big national accounting firm.

Anderson said she personally sold three or four KPMG clients on establishing foreign operating corporations, and added that she knew of perhaps a dozen other companies that set them up on KPMG’s advice during the three years she was at the firm.

All, or most, of KPMG’s big national competitors were promoting the tax shelters, she said. Anderson refused to name the clients she or KPMG helped establish foreign operating corporations.

It was common, she said, for the accounting firms to pitch an FOC as a tax shelter that would give companies tax savings in Minnesota and Illinois. She gave the Pioneer Press a copy of material she used in a presentation to a business, which she refused to name.

In the material, Anderson said the company could save $875,000 a year on its Illinois and Minnesota taxes by setting up an FOC offshore and transferring assets to it. The company ultimately rejected the FOC, she said.

Accounting firms commonly charged up to 30 percent of a company’s first-year tax savings as their fee, according to Anderson. As the competition among accountants intensified, fees were driven down to the $50,000 to $100,000 range, she said.

Anderson said companies could use other tax-planning methods to cut Minnesota’s 9.8 percent corporate tax rate to an effective rate of half that. Then, with an FOC, a firm could reduce its state taxes to zero if it pushed enough assets and income into the shelter. She said she advised firms not to be greedy and to settle for an effective tax rate of about 2 percent.

That strategy of leaving some taxes on the table, she said, was based on an adage in the tax-planning industry: “Pigs get fat, and hogs get slaughtered.”

According to Anderson, the normal practice for a company setting up an FOC would be to work through its accounting firm to link up with a “service provider” in the Cayman Islands. For a few thousand dollars, the service provider would arrange for the parent company to sublease office space and hire a part-time employee to staff the FOC.

Then the parent company would route some money through the Caribbean shell, the money would circle back home and the part-timer would make some journal entries to record its transit.

“It’s real,” Anderson said of the arrangement. “I mean you’ve got real people and a little piece of property. But there’s no way you would do it if you weren’t trying to save on taxes.”

Who uses FOCs? Salomone said he and his staff are barred from identifying businesses whose FOCs were reported on their tax returns or discovered in audits. But he said financial holding companies stood out among firms whose advance income payments have declined recently.

Anderson said many Minnesota banks, including midsize institutions, have set up FOCs to cut their taxes. “Banks are paying, you know, nothing,” she said. “And those are often banks that don’t do business anywhere but Minnesota.”

She said it has been common for banks to bundle mortgages into a real estate investment trust and assign the trust to an offshore FOC.

Few public records exist to document the use of FOCs by banks or other companies.

But the Pioneer Press found documentation in the annual report of one firm, the Rochester-based HMN Financial Corp. HMN is a holding company that is the parent company of Home Federal Savings Bank, a chain of banks in Minnesota and Iowa.

The 2003 annual report for HMN lists a Delaware-chartered subsidiary operating in the Cayman Islands. The annual report says the Cayman subsidiary — HFH — was formed in 2002 and is the parent of still another subsidiary that “invests in real estate loans acquired from the bank.”

According to the annual report, expenses the parent company incurred from state taxes plunged from about $683,000 in 2001 to $34,600 in 2002. The report said an overall decline in state and federal taxes partly resulted from lower taxable income and partly from “state tax planning implemented during 2002.”

In an interview, Jon Eberle, HMN’s chief financial officer, said the Cayman Islands company is an FOC. He also noted that the bank chain’s state taxes rose substantially in 2003, although not to the level they were in 2001.

Eberle refused to answer other questions about the Cayman subsidiary or its impact on the bank chain’s state taxes.

So what happened to HMN’s state taxes? How much did the chain save because of its foreign operating corporation? And is the chain continuing to enjoy those savings?

Those are the kind of questions that Salomone, his auditors and researchers are trying to answer for hundreds of companies.

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