WILMINGTON—U.S. law, as is well known and well reported, allows companies to incorporate in Delaware (or any other state) and be governed by that state’s laws and tax code. Delaware doesn’t tax “intangible assets,” and this encourages companies to move parts of their business to Delaware to avoid taxes in other states. This has led to Delaware being labeled a “tax haven.”
But what is less understood is the role that other states play in allowing this. Those states, which collectively lose billions of dollars in tax revenues when companies put parts of their business in Delaware, could stop that from happening if they wanted to. But, for various political reasons, they don’t, depriving themselves of revenues that could fund education, infrastructure, and other basics. If Delaware is a “tax haven” for public companies who want to avoid paying state income tax, it’s because other states allow it to be so.
To understand how and why states are losing out on this money, it’s important to understand how the “Delaware loophole” works: A company sets up a subsidiary in Delaware, and transfers an intangible part of its business there—say, its trademark or naming rights. Then its other locations outside of Delaware pay money to the subsidiary in order to use that trademark. Since intangible assets are not taxed in Delaware, the company doesn’t have to pay taxes on the money that was transferred to the subsidiary. The company can deduct the cost of the royalties on its state returns in other states where it operates, and thus avoid a large share of the state income taxes it would have otherwise owed. It is the laws of states other than Delaware that allow this system to work.