In New Zealand, sheep outnumber people. Stanford boasts more bikes than students and employees. In Delaware, it’s the number of corporations that tops the population – Delaware has over 1 million business entities but only 917,002 inhabitants.
Some 60% of American businesses are incorporated in Delaware - a number that includes Silicon Valley companies like Google (and Priceonomics), financial firms like JP Morgan, Visa, and Bank of America, and 64% of Fortune 500 companies.
Most of these companies have no physical presence in Delaware. Several middlemen maintain their tenuous link to their home state by providing a mailing address and passing on legal notices. This has led to the bizarre situation of over 285,000 businesses (including Coca-Cola, General Electric, and Berkshire Hathaway) all sharing the same Delaware address.
Incorporating the country’s - and the world’s - businesses is a steady source of revenue for Delaware. Incorporation revenue accounts for almost a quarter of Delaware’s budget and total revenue from these businesses as high as 40% of its budget. In other states, incorporation revenue is such a minor revenue source that it does not merit its own category.
Why do so many businesses incorporate in Delaware? The answer depends on who you ask. For much of the business world, and the state of Delaware, the answer is the state’s commitment to maintaining a clear, modern body of corporate law, enforced by speedy courts and knowledgeable judges. To critics, Delaware is a tax haven: the Cayman Islands without the palm trees - a state whose business is helping corporations lower their tax bill.
A Great Place to Do Business
Delaware’s supporters argue that so many businesses incorporate in Delaware because it has outhustled its larger neighbors to become the best place to do business - something that law professor Jan C. Ting describes as a “bipartisan political consensus” in state politics.
Delaware maintains a unique court called the Court of Chancery to rule on legal issues for corporations. In most states, corporate cases get mired in the backlog of America’s civil courts. They are also delayed and potentially unpredictable due to the need to educate judges and lawyers on corporate law in each trial. In contrast, judges well versed in corporate law rule on cases before the Court of Chancery, without the need for juries. The average American civil trial takes around 2-3 years to resolve. But in the words of the Court of Chancery’s former head judge, “The court also works fast in real speed. If you need an answer in four days, you’ll get an answer in four days. [Delaware’s] Supreme Court will turn heaven and earth itself to give you an appellate answer.”
The bipartisan commitment to drawing America’s businesses also includes maintaining a clear body of corporate law that will be clear and predictable for corporations. Ting writes,
[Delaware’s politicians] keep the Delaware corporation statute modern and up-to-date, and rely on Delaware's corporate law specialists for advice in how to do this. As a result, law students at every law school in the United States study the Delaware corporation statute and the decisions of Delaware courts interpreting that law.
Thanks to the snowball effect of the increasing number of incorporated businesses in Delaware leading to a large number of corporate trials, Delaware also has a disproportionately large body of precedent on which to draw. This makes Delaware corporate law more predictable and easier to administer.
The spirit of good service described by the Court of Chancery’s head judge applies to administrative matters. Delaware has the quickest turnaround in the nation for incorporation and offices stay open late to accommodate businesses in different time zones. Delaware is the customer service standout among American states in the business of incorporation.
The Muckraker’s Account
Delaware has been called out as a corporate tax haven in the pages of the New York Times, topped a list of tax havens published by National Geographic, and been a target of Brazilian legislation targeting tax havens. Even The Economist has some choice words for Delaware.
Delaware’s corporate tax rate is actually above average and being incorporated in Delaware does not mean that a business pays all its taxes to Delaware. But other aspects of Delaware’s corporate law help businesses reduce their tax liability.
For example, Delaware does not tax “intangible assets” such as royalty payments. As a result, incorporating as a Delaware corporation, or transferring ownership of royalties to a Delaware subsidiary under what is known as the “Delaware loophole,” can avoid taxes on royalty incomes. A New York Times article estimated that corporations saved $9.5 billion in taxes over the last decade - a loss felt by other state budgets.
Critics also assert that the ease of incorporating in Delaware helps nefarious actors as well as tax-allergic businesses. Delaware does not require corporations to be linked to a real name or identity. An agent who helps non-American residents set up shop in Delaware described the amount of information required to incorporate: “Basically, it requires none.” This makes Delaware popular for anyone seeking obscurity, from money launderers like arms dealer Viktor Bout to corporations setting up shell companies or businesses set up solely to donate money anonymously to a Super PAC. Delaware’s lack of reporting practices has led the Treasury Department to investigate and Congress to attempt to rein it in.
Beyond reporting practices, critics also contend that Delaware’s vaunted corporate legal system is pro-business at the expense of the public and other stakeholders. Delaware is popular among credit card companies because it does not limit the amount of interest they can charge - making it possible to extend high interest credit to risky borrowers across the country. According to the vice chancellor of the Court of Chancery, “Under its guiding business judgment rule, the court tends not to second-guess business decisions that company leaders determine to be in the best interest of the stockholders.”
Judging whether Delaware is a tax haven is difficult because its critics and defenders mostly speak past each other.
In its 3,000 word, feature-length article on Delaware, the New York Times did not devote a single paragraph to responses from Delaware officials or corporations. Advocates, in contrast, mostly highlight Delaware's benefits to their business audience. A retort to the Times article from Delaware corporate lawyers called it a “smear piece,” although it did trot out two pieces of evidence in their favor - examples of cases in which Delaware courts ruled against business interests and reports that the amount of revenue derived by Delaware from holding companies is decreasing.
One of the only sources rigorously investigating the question is a 2012 academic paper titled “Exploring the Role Delaware Plays as a Domestic Tax Haven." To focus on the Delaware loophole, the paper looked at the incorporation of subsidiaries (rather than parent companies) since they can be used to set up a shell company to avoid taxes on assets like royalties.
The researchers found that Delaware has absurdly more subsidiaries than other states (58% of all subsidiaries in their sample) and far more patents relative to its GDP than any other state - four times what you would expect and double the next closest state. Since the Delaware loophole works by transferring patents to Delaware to avoid royalties, this speaks against Delaware.
Selecting a representative sampling of corporations from SEC filings, the researchers then attempted to test whether corporations opened subsidiaries in Delaware for tax avoidance purposes. Their model found a positive, meaningful but not dramatic correlation between firms with subsidiaries in Delaware and factors that would suggest a preference for (or strategy of) tax avoidance. Companies with Delaware subsidiaries were more likely to face a high tax rate in their areas of operation, have subsidiaries in foreign tax havens, and be located in states that have not passed legislation that closes the Delaware loophole.
Based on their sample, the authors estimated the potential tax savings of all firms over the course of the 1995-2009 period they investigated:
Firms likely to be using Delaware-based state tax avoidance strategies have state effective tax rates (State ETRs) between 0.7 and 1.1 percentage points lower than other firms, on average. The reduction in State ETRs translates into a decrease in state income tax payments of 15% to 24%. In aggregate, we estimate a range of total state tax savings of $6.6 to $9.5 billion over the sample period.
The authors declare that their results “are consistent with Delaware serving as a domestic haven against state corporate taxation.” Full details are available here.
However, the paper notes that the tax savings decreased by 25-40% during the period they studied - likely due to the actions of other states to prevent companies from shifting liabilities to Delaware. (As noted by Delaware lawyers in response to the New York Times article.) They also argue that the real tax savings come from incorporating subsidiaries in Delaware, not the parent company, which suggests that the choice of incorporating in Delaware could often represent a legitimate preference for its corporate rules and laws.
Finally, a number of critiques (including The Economist's) of Delaware are less indictments of the state in particular than investigations of how countries like Britain and America are tax havens just as much as the usual suspects. Delaware is merely singled out as an example of the practices that cause America to be ranked near last for compliance with international anti-laundering standards and other transparency practices.
Regardless, it’s time to take note of Delaware. Because even if its reputation as a tax haven is undeserved, the state known for producing nothing but Joe Biden is actually actively setting corporate policy and law for much of the United States and the world.
April 17, 2014 · 19,092 views
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