Exploring the Role Delaware Plays as a Domestic Tax Haven

The following post comes to us from Scott Dyreng of the Accounting Department at Duke University, Bradley Lindsey of the Accounting Department at the College William and Mary, and Jacob Thornock of the Accounting Department at the University of Washington. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In the paper, Exploring the Role Delaware Plays as a Domestic Tax Haven, which was recently made publicly available on SSRN, we examine whether the market for incorporation extends beyond decisions related to the parent company down to decisions related to the subsidiaries of the firm. We extend the finance and legal literatures that examine why parent firms incorporate in the state of Delaware by showing that the decision to incorporate subsidiaries in Delaware is partially driven by corporate income tax considerations. This stands in contrast to the findings in prior research that legal and governance reasons dominate the market for parent incorporation location.

After establishing that taxes are a factor in determining where firms locate their subsidiary operations, we quantify the effect of operating subsidiaries in Delaware on state effective tax rates. We show that for a firm with the median number of subsidiaries in separate filing states, moving across the interquartile range for number of subsidiaries in Delaware reduces the state effective tax rate by about two percentage points.

Our results suggest that the state of Delaware is indeed a domestic tax haven in the sense that its corporate laws appear to enable firms to reduce state tax burdens. This reduction comes at the expense of other states and benefits Delaware via nominal franchise taxes and fees. Our analysis also suggests that states other than Delaware may potentially reduce the effect of Delaware-based tax avoidance strategies by requiring combined reporting. Consistent with this idea, several states have indeed made changes to their corporate tax reporting rules to require combined reporting. Our analysis suggests those states may see fewer tax dollars disappear into the domestic tax haven of Delaware, while running the risk of being perceived as less business friendly.

The results in the study are subject to a limitation. The decision of where to incorporate a subsidiary is likely endogenous. It is possible that firms that are skilled at tax planning are the same firms that incorporate subsidiaries in the state of Delaware. We make efforts to address this issue. We show that the effect of Delaware on state taxes is only salient for firms that also operate in states with separate filing rules. To the extent that the location of a firm‘s physical operations is limited by economic reasons other than taxes, the state tax rules a firm is subject to are exogenous. We also examine firms that enter or exit the state of Delaware at different times during our sample period. While this decision is also endogenous, examining changes (as opposed to levels) helps us rule out potential correlated omitted variables that are constant across time.

The full paper is available for download here.

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