Territorial Tax Reform Won’t Curb Inversions: Study

Rather than installing a territorial tax system, the federal government should change U.S. securities rules, a law professor contends.

Changing to a “territorial” tax system in the United States won’t ultimately stem the exodus of U.S.-based multinationals to lower-tax countries and could come at a significant cost in terms of good corporate governance, a new study contends.

Under the “territorial” approach to taxing multinationals (MNCs), many countries tax only that part of a company’s net income spawned within those countries, largely exempting income earned abroad. In contrast, under the current U.S. system of worldwide taxation, U.S.-based MNCs are taxed in this country when they “repatriate” income they’ve earned abroad.

“Initially, territoriality is a bonanza [for U.S. MNCs] because you get something for free as a company,” Eric Talley, a University of California at Berkeley law and economics professor and an author of the study, “Corporate Inversions and the Unbundling of Regulatory Competition.” acknowledges. Still able to enjoy the benefits of listing on U.S. stock exchanges, companies wouldn’t be taxed in the United States on income earned abroad. That combination could be a key to keeping companies onshore, advocates of revamping the tax code argue.

In the meantime, to make hay out of foreign territorial tax systems and benefit from lower offshore tax rates, a number of U.S. public companies have recently transformed their corporate structures via “tax inversions.” Such M&A deals move a company’s residency abroad — and most often provide the benefits of a territorial system while enabling the company to hang on to its listing in domestic stock markets.

When they’re properly structured, “inversions replace American with foreign tax treatment of extraterritorial earnings, often at far lower effective rates,” according to the paper.

But politicians and regulators “have reacted with alarm to the ‘inversionitis’ pandemic, with many championing radical tax reforms,” Talley writes. The paper questions “the prudence of such extreme reactions,” like switching to a territorial system.

Further, under a territorial system, the United States, principally via Delaware, which has spent a lot of money on judges and courts in the effort to build up solid corporate governance, would lose tax revenues that could be used to keep governance standards high.

That’s because corporations would only be taxed by a given (foreign or domestic) jurisdiction on the revenue earned in that jurisdiction. Thus, the taxes on revenues earned by a foreign subsidiary of a U.S. MNC would go to the foreign country rather than Delaware, even though the subsidiary benefits from being governed by Delaware.

Rather than pursuing “radical” reform strategies like territoriality, which would involve the huge effort of revamping the U.S. tax system and would cost the federal government large amounts of tax revenue, Talley proposes a novel and what he considers a more moderate approach to stanching the flow of tax corporate revenue via inversions: changing securities regulation, rather than the U.S. tax code.

Say Again
What does changing the rules governing the sale of equity and debt have to do with keeping corporate tax revenue from drifting offshore? Talley’s central notion stems from the theory that U.S. global competitiveness depends on its “bundling” of high standards of governance for publicly listed companies along with its system of taxing those companies based on the state in which they’re domiciled.

“I argue that just as U.S. companies have a strong aversion to high tax rates, they have an affinity for robust corporate governance rules — a traditional strength of American corporate law,” the professor writes in the abstract to his paper. “This affinity has historically given the United States enough market power to keep taxes high without chasing off incorporations, because U.S. law specifically bundles tax residency and state corporate law into a conjoined regulatory package.”

Strengthening corporate law and governance rules to keep the link between tax and corporate governance solid would be likelier than territorial tax reform to help the United States “withstand even substantial international tax rate competition without being drawn into a ruinous tit-for-tat death spiral in tax revenues,” he writes.

Specifically, he proposes an “elixir” to the erosion of U.S. corporate tax dollars involving one of two “alternative reform paths.” Under one of the paths, the New York Stock Exchange, Nasdaq, and other U.S.-based exchanges would “charge listed foreign issuers for their consumption of federal corporate governance policies.”

Under current federal securities law, foreign-based companies get the “goodies” associated with their ability to list on U.S. exchanges without having to pay taxes here, he says. Thus making such companies pay for reputation-enhancing good governance might level the playing field for U.S.-based companies, according to Talley.

Under the second alternative reform, the federal government would “cede corporate governance back to the states by rolling back many of the governance mandates promulgated over the last fifteen years.”

During that time, “financial regulators have progressively suffused U.S. securities regulations with mandates relating to internal corporate governance matters — traditionally the domain of state law,” Talley writes, referring to such mandates as the internal controls provisions of the Sarbanes-Oxley Act 2002 and the executive compensation provisions of the Dodd-Frank Act of 2010.

Those strictures have gradually replaced state law as a primary source of governance regulation for U.S.-traded issuers, making the federal government, via the Securities and Exchange Commission, “the big gorilla in the room,” he says.

Previously, the United States had been able to offset the stigma of its relatively high tax rates with the quality of the corporate governance mandated by state regulation — particularly regulation in the state of Delaware.

For many years, shareholders have been enamored of corporations located in Delaware, because of such features as its chancery court and its independent-minded justices. Such rigorous corporate regulation results in a transparency and a stability that greatly appeals to investors, luring them to companies that list on U.S. exchanges, according to Talley’s reasoning.

That attraction has real value, many have argued, adding a “premium” to the worth of U.S.-listed stocks. Talley says that that premium, by drawing investment dollars, has more than outweighed the tax disadvantages for U.S. MNCs of listing here.

To stem the outbreak of inversionitis, U.S. politicians would do better to focus on changing securities laws than introducing a territorial system here, he concludes.