Interesting front-page story in today’s Wall Street Journal:  Inside Wal-Mart’s Bid to Slash State Taxes; Ernst & Young Devises Complex Strategies; California Pushes Back, by Jesse Drucker:

Wal-Mart decided to hire Ernst & Young to help devise complex tax strategies to use in at least four big states. The accounting firm, for example, helped Wal-Mart take tax deductions in California for dividends it never actually paid. And in Texas, Ernst & Young advised, the giant retailer could exploit a wrinkle in the tax law involving limited partners from out-of-state — a maneuver subsequently shut down by the state’s legislature. …

Wal-Mart’s 2001 letter to accounting firms got right to the point. It began: "Wal-Mart is requesting your proposal(s) for professional tax advice and related implementation services in connection with minimization of state income taxes in the following states: Arizona, California, Florida, Illinois, Indiana, Michigan, Minnesota, and Pennsylvania." …

David Bullington, Wal-Mart’s vice president for tax policy, said in a deposition that he began feeling pressure to lower the company’s effective tax rate after the current chief financial officer, Thomas Schoewe, was hired in 2000. Mr. Schoewe was familiar with "some very sophisticated and aggressive tax planning," Mr. Bullington said, according to a transcript of the deposition, taken by the North Carolina attorney general’s office in July. "And he ride herds [sic] on us all the time that we have the world’s highest tax rate of any major company." Compared with many other large multinational companies, Wal-Mart has a small presence in foreign countries with low tax rates, reducing opportunities to shift income overseas for tax purposes. …

California was a key state for Ernst & Young’s project. Its tax system is among the most stringent in the country. Many states only tax income from operations within their own borders — called the separate-reporting method — which makes it easier for companies to shift taxable income out of reach of tax authorities in those states. But "combined reporting" states such as California total up all profits of a company’s domestic or world-wide operations, regardless of what state they’re in, then allocate a portion of those profits to their states.

Ernst & Young dreamed up a novel way to sidestep combined-reporting requirements in California. It used an unusual type of dividend to transfer income from one subsidiary to another in such a way that the second unit wouldn’t be taxed.

Here’s how it worked: When REITs pay dividends to their shareholders, they can deduct those payments from their taxable income. The federal government permits REITs to take deductions for dividends before they’re actually paid — a provision intended to give them extra time to make payments. Such dividends are called "consent dividends" because the recipients must consent to record the unpaid dividends as taxable income.

Ernst & Young argued that California law permitted REITs to deduct such consent dividends, but that the state law didn’t also require recipients of the consent dividends to count them as taxable income, according to one person who worked on the transactions. The accounting firm proposed a strategy in which the Wal-Mart REIT would claim a tax deduction for paying consent dividends to its parent, but the unit receiving the dividends wouldn’t record them as income for tax purposes. The bottom line: Wal-Mart could reduce its taxable income in California by an amount equal to the total consent dividend payments it recorded, thereby cutting its tax bill.

Two years later, California’s Franchise Tax Board, the state’s income-tax agency, put the strategy on its list of "Abusive Tax Shelters." Wal-Mart’s Mr. Bullington said in his deposition that California tax authorities have protested various tax benefits taken by the retailer since 1998. …

In Texas, Ernst & Young helped Wal-Mart set up a somewhat more common tax-cutting vehicle. Under Texas law at the time, a limited partner from out of state was exempt from Texas’s corporate franchise tax. As a result, scores of companies, including Wal-Mart, reorganized their Texas operations into limited partnerships. The general partner, which was subject to state taxation, was typically a subsidiary based in Texas. But the limited partner, often owning as much as 99.9% of the entity, would be based in Delaware or another tax-friendly state. The result: up to 99.9% of the profits of the Texas operation would flow to that out-of-state limited partner, making that income tax-free. Texas’s state legislature eliminated that option when it revamped its tax laws earlier this year.