You asked whether Connecticut can prevent Wal-Mart and other corporations from evading Connecticut corporation taxes by using so-called “captive” real estate investment trusts (REITs) as described in Wall Street Journal articles published in 2007 (copies attached).

SUMMARY

Because many states, including Connecticut, tax only corporate operations and profits that occur within, or have a “nexus” to, the taxing state, companies operating in many states may establish strategies to exploit tax “loopholes” created by differing state corporation tax laws to reduce their taxes in particular states or overall. The Wall Street Journal has published several articles this year describing various strategies companies use to avoid state taxes. The paper has focused on one particular strategy, described in detail in a February 1, 2007 article, used by big multi-state retailers (especially Wal-Mart) and banks called the “captive REIT” strategy.

The captive REIT strategy requires a company to set up a REIT that it owns or controls (i. e. , a “captive”) to own its land and stores and rent them back to the parent. This allows the parent to deduct the rent it pays the REIT as a business expense on its state corporation tax returns. Depending on the state, the parent may also be able to deduct the dividends it receives from the captive REIT, enhancing its tax savings, all without any money leaving the company.

A company paying corporation taxes in Connecticut could take a deduction for the rental payments but a 1997 state law disallows any deduction for dividends received directly from a captive REIT. If confronted with a transaction like the ones described in the Journal, in which the REIT dividends are paid to the parent through a second, non-REIT subsidiary, the Department of Revenue Services (DRS) says it would nevertheless try to use the 1997 law to disallow deductions for any such “indirect” dividends on the basis that the transaction was a sham whose purpose was to evade Connecticut taxes. It would also invoke another state law that allows the DRS commissioner to adjust a company's taxes if she finds its activity, business, income, or capital in Connecticut is improperly or inaccurately reflected on its corporation tax return.

A taxpayer could challenge such an adjustment in court and the outcome of any such litigation is unknown. DRS is not currently involved in any litigation nor has it issued any rulings concerning captive REITs.

WALL STREET JOURNAL ARTICLES

The Wall Street Journal has published three articles so far in 2007 about methods Wal-Mart and other companies have used to avoid corporation taxes in several states. The articles are based on documents filed in tax lawsuits involving Wal-Mart and states such as California, Illinois, and North Carolina, seeking to disallow the company's strategies for reducing state corporation taxes. The articles, all by Jesse Drucker, are:

• “Friendly Landlord: Wal-Mart Cuts Taxes by Paying Rent to Itself,” February 1, 2007.

• “Inside Wal-Mart's Bid to Slash State Taxes,” October 23, 2007.

• “Why Wal-Mart Set Up Shop in Italy,” November 14, 2007.

The Journal articles describe several tax strategies Wal-Mart has used in particular states to reduce its state tax liability. The most detailed and specific description was a so-called “captive REIT” strategy described in detail in the February 1 article and referred to again in follow-up articles.

CAPTIVE REITS

In two articles, the Journal describes a tax mitigation strategy that allows Wal-Mart to reduce its taxable income by deducting rent it pays on its stores, using so-called “captive REITs. ” The Journal also noted that this strategy has been used by other retailers and financial services companies including Regional Financial Corp's AmSouth Bancorp Unit, AutoZone, and two units of Bank of America Corp. , one of which is Fleet Funding, Inc. of Massachusetts.

The strategy has several variations. In its simplest form, it involves a company with many stores or branches, such as a big retailer or bank, transferring ownership of its real estate assets to a REIT it controls. In the case of the Wal-Mart REIT, according to the Journal, Wal-Mart owns 99% of the REIT's total shares and 100% of its voting shares. A REIT that is controlled by a single company or investor in this way is known as a “captive REIT. ” The controlling company pays rent to its captive REIT for the use of individual stores or branches and deducts the rental payments as a business expense, allowing it to reduce its taxable income in a particular state for corporation tax purposes.

To achieve the tax savings, the entity to which the property assets are transferred must be a REIT because REITs receive special tax treatment under federal law. As long as they have at least 100 shareholders and pay out at least 90% of their profits as dividends to investors, they are not subject to federal corporation taxes and most states follow the federal rule. If the real estate were owned by a subsidiary corporation that is not a REIT, that corporation could be taxed by the state where it was located, thus reducing or nullifying the parent's tax savings.

The benefit of deducting rental payments is one part of the parent company's tax savings. Depending on the law in each state, the parent might reap additional tax savings through deductions for dividends it receives from its captive REIT. Many states allow companies to deduct some or all dividends they receive from their subsidiaries when calculating corporation tax liability.

CONNECTICUT LAW DISALLOWS A TAX DEDUCTION FOR REIT DIVIDENDS

Although Connecticut's corporation tax has a relatively generous deduction for dividends corporations receive from companies in which they have ownership stakes, Connecticut, like the federal government, disallows deductions for dividends companies receive from REITs.

In general, Connecticut allows a corporate taxpayer to deduct 100% of any dividends it receives from another company if it owns 20% or more of that company. If the taxpayer owns less than 20% of the dividend-paying company, it can deduct 70% of the dividend income (CGS § 12-217(a)(1)(D)). But Connecticut's dividend deduction excludes dividends received from REITs. The exclusion applies to REITs whose dividends are not deductible under the federal tax code (IRC § 243(d)(3)) and to dividends received from REITs established on or after April 1, 1997. The law also excludes dividends from a pre-April 1, 1997 REIT that (a) did not have at least $ 500 million in assets contributed to it before April 1, 1997, (b) did not elect to be a REIT under federal tax law before April 1, 1998, and (c) did not have at least one investor not related to the dividend's payee contributing at least 5% of the fair market value of the REIT's capital assets as of the last day of the period for which the dividend is paid (CGS § 12-217(a)(3)).

CONNECTICUT RESPONSE TO TAX AVOIDANCE BY USE OF CAPTIVE REITS

Current Laws

A company can attempt to get around Connecticut's REIT dividend exclusion by structuring its transaction so the REIT pays dividends to the parent through a second subsidiary located in a state that either does not have a REIT dividend exclusion or has no corporation tax (such a Delaware or Nevada). The second subsidiary could also be located in a foreign country, as described in the Journal's November 14, 2007 article about Wal-Mart's dispute with Illinois tax authorities over dividend payments made through a subsidiary based in Italy.

The Journal's February 1, 2007 article describes Wal-Mart's multi-level strategy. It transferred ownership of land and buildings in 27 states to a Delaware-based REIT called Wal-Mart Real Estate Business Trust. Wal-Mart Property Company, also based in Delaware, owns 99% of the REIT's shares and 100% of its voting shares. The remaining 1% of the trust's nonvoting shares is owned by 114 Wal-Mart executives, allowing the REIT to achieve the 100-shareholder minimum required for the federal corporation tax exemption. Wal-Mart Property Company's parent is Wal-Mart Stores East, Inc. , which leases and pays rent for the stores to the REIT. Wal-Mart Real Estate Business Trust pays out at least 90% of the rental payments as dividends (also required to be a federally tax-exempt REIT) to Wal-Mart Property Company (not a REIT), which in turn pays dividends to Wal-Mart Stores East, Inc.

Michael Galliher of DRS told us in an e-mail that he could not discuss or disclose any information about Wal-Mart or any other individual taxpayer. However, if a hypothetical company structured a transaction so its captive REIT pays dividends to an intermediary not subject to tax in Connecticut, which then pays dividends to the Connecticut taxpayer which tries to deduct it, DRS would take the position that Connecticut's REIT dividend exclusion law applies, even in cases where the dividend is received “indirectly” from a REIT.

According to Galliher, a Connecticut tax examiner would seek to apply either the REIT exclusion (CGS §12-217(a)(3)) or invoke Connecticut's law that permits the DRS commissioner to exercise her discretion in disallowing a transaction where the taxpayer's income in Connecticut is “improperly or inaccurately reflected” (CGS § 12-226a). “In the case of a transaction like the one described in the Wall Street Journal, DRS would invoke § 12-226a to alternatively combine the REIT with the taxpayer or disallow the dividend deduction,” Galliher wrote.

Court Appeals

If DRS made such an adjustment, the taxpayer involved could appeal the adjustment to court and the outcome of such an appeal is uncertain. As it has in other states, if the taxpayer were Wal-Mart, it would likely argue that its use of the captive REIT has a legitimate business purpose and is not simply a means to avoid state taxes.

Other states that have challenged taxpayers' use of captive REITs have seen mixed results, according to the February 1 Journal article. Louisiana was successful against AutoZone, an auto parts chain, and Hawaii against Central Pacific Financial Corp. , a bank holding company. But Kentucky recently lost its case against AutoZone on appeal. Meanwhile litigation against Wal-Mart continues in Illinois and North Carolina, and Massachusetts is pursuing cases against Fleet Funding and Bank Boston Corp. , both recently acquired by Bank of America.

DRS is not currently involved in any court case on this issue nor has it issued any formal ruling on it.

JL: ts