The ongoing income tax dispute PepsiCo Inc. v. Illinois Dept. of Revenue is shedding light on a state tax provision that encourages profit shifting by multi-jurisdictional taxpayers. This provision involves the exclusion of 80/20 companies from the combined filing requirements of nearly 15 states. An 80/20 company is a domestic corporation, subject to federal tax, with at least 80% of its property and payroll located overseas. While the definitions vary slightly, the practical effects are essentially the same.
This exclusion provision can be traced back to the 1984 Worldwide Unitary Taxation Working Group. Following the US Supreme Court’s decision to uphold California’s worldwide combined reporting system, the group was assembled to address fears of federal preemption of these requirements. Despite state representatives recognizing the potential for abuse, the 80/20 exclusion came into play in many state water’s edge reporting systems during the 1980s.
Two aspects of state corporate taxation warrant explanation to better understand how 80/20 companies can exploit the system. Most states define 80/20 companies using the narrow definitions of “property” and “payroll” borrowed from the Uniform Division of Income for Tax Purposes Act. The Act’s definitions allow for a minimum amount of physical property to be located overseas, while transferring the payroll responsibilities for a few employees already abroad to the new entity.
Secondly, the impact of states’ conformity to the federal tax code is crucial. Section 351 and Section 367(d) of the tax code play critical roles. The former allows domestic corporations to transfer tangible and intangible property to a new domestic subsidiary without tax recognition. A similar transfer to a foreign subsidiary, however, would subject the parent corporation to tax liability, under Section 367(d), to prevent loss of revenue attributable to the transferred property.
Understanding these points makes it clearer how 80/20 exclusion allows companies to reduce state tax revenue. While the strategies and structures facilitating income shifting differ among states, the Multistate Tax Commission recommends implementing a comprehensive combined filing statute, including all unitary corporations in the combined group. They have developed two models for states’ consideration.
Whether the PepsiCo case will result in positive legislative change remains to be seen. In 2013, Minnesota eliminated its 80/20 provision following a state supreme court decision and Vermont did the same in 2022. However, after a court in Colorado detailed how Target Corp. shielded $18 billion in income, the state legislature did not act.