A Corporate Governance Give-Away to Tax Inverters?

In July 1997, Tyco International (with then Wall St darling Dennis Kozlowski at the helm) was “acquired” by a relatively small provider of home security services, known as ADT Inc. The deal arguably exploited some strategic synergies between the two companies, but far and away the biggest benefit to Tyco lay elsewhere: It was a tax dodge. Although traded on US exchanges, ADT was incorporated in Bermuda, which has zero corporate income taxes – a far cry from the large headline tax rates in the US of near 40 per cent. The deal would allow Tyco – now a subsidiary of the surviving company – to claim that same tax residency as well.

Notwithstanding some (then-modest) regulatory obstacles, the resulting tax savings alone made the deal appear eminently worth pursuing. Tyco’s Bermudan exile produced a near-immediate pop in its after-tax earnings, and it marked the start of a five-year acquisitions smorgasbord that saw the company’s equity value skyrocket 500 per cent. Shareholders were ecstatic – at least at the time.

Tyco’s exile, however, also carried a hidden cost: it removed the company from US-style corporate governance standards, replacing them with poorly understood (and rarely utilized) Bermudan directives. And although the combined company remained publicly traded in the US, federal securities law requirements at the time mandated few corporate governance restrictions (traditionally the province of state law). Tyco was soon to become a poster child for poor governance run amuck: by late 2002, Tyco’s senior executives had been terminated, several were facing criminal indictments, the company’s credit rating had plummeted, and its stock price had conceded all of its half-decade-long crescendo.

Tyco’s strategic manoeuvring – and the unanticipated consequences it set into motion – have recently been re-incarnated, but in a reconstituted form. Although the regulatory landscape has changed dramatically since the 1990s, dozens of US public companies have recently executed similar ‘tax inversions’ – acquisitions that move a corporation’s residency abroad while maintaining its listing in domestic securities markets. When appropriately structured, inversions replace American with foreign tax treatment of extraterritorial earnings, often at far lower effective rates. Regulators and politicians have decried this ‘inversionitis’ pandemic, and many have begun to champion radical tax reforms to staunch the outflow.
In a forthcoming study, I question the prudence of radical tax-reform responses on a number of grounds. The first is practical: For a variety of reasons tax inversions are simply not a viable strategy for many firms, and thus the ongoing wave is likely to abate naturally (or with comparatively modest tax reforms).
The second, however, is more fundamental: I assess the inversion trend through the lens of regulatory competition theory, in which jurisdictions compete not only in setting tax policy, but also along other dimensions, such as the quality of their company law. I argue that just as US 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. This affinity has historically given the US sufficient market power to impose higher corporate taxes with little fear of chasing off incorporations, because US law has traditionally bundled tax residency and state corporate law into a conjoined regulatory package. To the extent this market power remains durable, most radical tax overhauls currently being championed would be unhelpful (and even counterproductive).
That said, whatever market power in corporate governance that the US enjoys has been unwittingly compromised by inconspicuous source: Securities Law. In the years since Tyco’s implosion, federal law has progressively suffused national securities regulations with mandates relating to internal corporate governance matters. Those federal mandates, in turn, have displaced and/or pre-empted state law as a primary source of governance regulation for US-traded issuers. And, because US securities law applies to all listed issuers (regardless of tax residence), this displacement has gradually ‘unbundled’ domestic tax law from corporate governance, eroding the US’s market power in regulatory competition. Although Tyco’s corporate governance sinkhole in Bermuda might have served as a cautionary tale to others in the early 2000s, aspiring inverters no longer need fear this same cost in a post-Sarbanes Oxley, post-Dodd Frank, unbundled world. Their corporate governance regime is effectively provided free of charge by US securities law to all domestically traded companies.
An effective elixir for this governance ‘give-away’, then, may also lie as much in securities regulation as in tax reform. I propose two alternative reform paths: either (a) domestic exchanges should charge listed foreign issuers for their consumption of federal corporate governance policies; or (b) federal law should cede corporate governance back to the states by rolling back many of the governance mandates promulgated over the last 15 years.

Corporate Inversions
Although inversions are no doubt a current flashpoint of attention, it warrants observing that US multinational corporations (MNCs) utilise many tools to slash their tax liability. The most widespread such practice is the practice of non-repatriation. That is, they simply leave most of their offshore earnings offshore, held within their Controlled Foreign Companies (CFCs). Many MNCs, moreover, can utilise creative inter-company borrowing schemes to make use of that cash (albeit at some cost). However, as the aggregate size of retained off-shore earnings has grown (now estimated at over two trillion US dollars), the resurgence of tax inversion transactions among American MNCs was perhaps inevitable.
The intent behind an inversion transaction is to relocate the tax residence of an American MNC parent outside of US jurisdiction, transplanting it into a jurisdiction offering a more favourable tax environment. There are a host of foreign jurisdictions offering lower tax rates, territorial (rather than global) tax treatment, more flexible tax residency rules, and more liberal recognition rules than does the United States. The most creative forms of inversion transactions, therefore, attempt to capitalise on these differences, in a way that is maximally beneficial – all else (hopefully) held constant – for the inverting corporation.
Given the tremendous upsurge of late in inversion activity, it is also important to keep in mind that similar types of tax-avoidance-motivated merger transactions are nothing new. Indeed, four years before Tyco, an early border skirmish in the public battle over inversions took place when Helen of Troy, a publicly traded Delaware corporation in the personal care and cosmetics industry, formed a shell subsidiary in Bermuda, causing the subsidiary to acquire the parent in a stock-for-stock transaction. Under the then-prevailing tax rules, this transaction – like any other stock deal – was deemed non-taxable to US shareholders. Once the transaction closed, moreover, the surviving parent continued to be traded in the US public markets under Helen of Troy’s name, but with incorporation and tax residency in Bermuda.
The Bermudan tax abduction of Helen of Troy raised considerable alarm about the use of shell transactions to execute escape US tax treatment — sometimes known as a ‘naked’ or ‘shell’ inversion. The IRS soon thereafter dispatched a response, in the form of a set of anti-inversion regulations promulgated in 1996. The ultimate reforms made inverting decidedly more expensive, by deeming it a taxable event to US shareholders of the inverted company unless the US target’s equity was diluted by new ownership by no less than 50 per cent. The 1996 regulations also imposed a 15-percent ‘excise tax’ on stock remuneration of officers, directors, and large block shareholders of the inverting company – a levy that was (and is) difficult to sidestep.
Although this first generation of reforms possibly deterred a fair number of inversion transactions, it proved little more than an annoyance to others. Even after the 1996 reforms a steady stream of inverters continued to pursue the strategy. (These included the Tyco-ADT deal, described above.)
Eight years later, Congress and the IRS added a second significant set of inversion restrictions through IRC § 7874, which has become a centrepiece for structuring most of today’s inversions. Most focally, the section specifies that an inversion transaction can achieve most of the important tax benefits of moving offshore (and avoid US tax residence of the surviving entity) if it can demonstrate that the transaction dilutes the ownership of the US issuer’s shareholders in the surviving entity by at least 20 per cent. (Modestly larger benefits are available when the dilution exceeds 40 per cent)
Much like the 1996 reforms, the 2004 amendments put a momentary pause to inversion deals, but they once again came roaring back in late 2013, as corporate lawyers adapted, foreign jurisdictions began to reduce their own headline tax rates, and US federal law continued its decade-long displacement of state law in prescribing corporate governance rules for public companies.
In September 2014, the US Treasury took yet another shot, issuing new guidance intended to place more significant constraints on the attractiveness of tax inversions. The new Guidance did not alter the key attributes of § 7874 writ large. However, the new rules do make it harder for parties to engage in now-familiar parlour tricks that render a transaction compliant with targeted dilution thresholds. For example, the guidelines now heavily constrain skinny-down dividends, disregarding ‘extraordinary’ dividends made during the three-year period that precedes the transaction.
Additionally, the value of the foreign acquirer must be computed independent of passive asset holdings (such as cash or passive investments) when at least 50 per cent of the entity’s assets are passive. The new rules also place new hurdles in the way of ‘spin version’ transactions treating the spun off assets (even if incorporated abroad) as a US corporation for tax purposes. Another area where the 2014 Guidance tightened up scrutiny was in post-inversion intercompany loans. The guidelines specifically deem as taxable ‘hop-scotching’ loans in which the CFCs owned by the US target lone capital directly to the foreign acquirer. That is, these ‘hopscotch’ loans are deemed to have passed through the US target – subjecting it to dividend tax – for a period of 10 years after the inversion.
Although it is too early to tell what effect the new guidelines will have, many experts posit that at least for some aspiring inverters, they will (once again) look more like a speed bump than a crash wall. On the one hand, it is clear that the new Guidance has imposed a considerable constraint on some pending deals, particularly those that were signed (but not yet closed) prior to the rule change. On the other hand, the more stringent rule changes may simply invite more inversion activity, since the act of clarifying the applicable ground rules for inversions may end up catalysing more of them. Moreover, at least in some industries (such as pharma), the companies emerging from previous offshore inversions are now sufficiently large to qualify as ‘true’ acquirers (allowing them to overcome many anti-inversion hurdles).

Inversions through the Lens of Regulatory-Competition Theory

Stepping back somewhat, it may be helpful to appraise the conceptual and analytic role that inversions play within a larger international policy stage: regulatory competition. In tax policy circles, it is widely accepted that jurisdictions often ‘compete’ with one another to attract economic activity, including corporations’ locational choices. Although tax certainly represents one dimension of this competition, others are important as well. The primary focus of my forthcoming study – unsurprisingly – highlights the interaction between tax policy and corporate governance regulations. Specifically, I analyse the conditions under which jurisdictions offering packages of tax and governance regulations are likely to differentiate themselves from one another, and what implications such differentiation has for responding (if at all) when firms enjoy some mobility.

Several central intuitions emerge from this analysis.

1. First, when jurisdictions are able to bundle tax and governance regulations, they will tend to differentiate themselves in their offerings, with some jurisdictions serving as market ‘leaders’ in governance while others serve as market ‘laggards’. To most observers, the corporate governance regime that has evolved through the last century in the US (and particularly in Delaware) is thought pioneering in the field.

2. Second, jurisdictions that enjoy a position as market leaders will rationally attempt to capture the value they have created through their tax policies, and will therefore appear less competitive in their tax treatment of domestic firms. This fact may help explain why the US has been able to retain relatively high tax rates for so long without chasing off significant numbers of incorporations.

3. Third, because of their market power in governance, leaders can afford to moderate their responses to tax competition from other jurisdictions, and thus a market leader need not be drawn into “ruinous” forms of tax competition. Rather, a leader’s optimal response to another jurisdiction’s aggressive tax policies may be muted, possibly substantially. This observation is what leads me to be sceptical of the value of radical tax reform, at least to the extent that the US retains its market power in corporate governance leadership.

4. Fourth, and most critically, the advantageous strategic position that a jurisdictional leader in governance enjoys persist only insofar as the tax and governance attributes offered by the leader remain ‘bundled’ – ie, firms must be forced to accept the leader’s tax policy as they embrace its governance rules, and they cannot selectively build a medley of the best pieces of different jurisdictions’ regulatory frameworks. Unbundling tax from governance (as I argue has happened unwittingly through US securities law reforms) not only negates the leader’s market power, but it negates the incentives of jurisdictions to sink resources into providing high quality governance regimes to begin with.
In the long run, I contend, unbundling will lead to a material contraction in quality and heterogeneity of competing governance regimes – a clear negative when firms have heterogeneous needs and capabilities. And, most radical reform proposals currently on the table – such as the complete elimination of corporate taxes or the migration to a territorial system of taxes – explicitly or implicitly embrace unbundling as a core design feature. This is, in my view, a significant mistake. Worse yet, it is an avoidable one.

Tentative Reform Proposals
Assuming the US is still able to offer a different (and higher quality) governance product than its competitors, then it can likely afford to impose a distinct tax product as well. Domestic policymakers may therefore have the flexibility to approach responsive tax reform in a more incremental fashion, without re-imagining the entire corporate tax philosophy of the US.

This of course does not imply that utter passivity is the optimal US response to recent out-migrations either. Clearly, something has caused a wave of pent-up outbound M&A activity to take hold. To be sure, the large (and growing) differences in nominal tax rates imposed on US resident corporations are part of this problem, and the US may well wish to consider reducing nominal rates by some margin to narrow (though not eliminate) the gap, as the Obama administration’s 2016 budget proposes.

However, an analogously significant concern is the extent to which the US has unwittingly undermined its ability to raise corporate tax revenues by unbundling corporate governance from tax residence. Over the last 15 years, US securities law has gradually supplanted state corporate governance laws as the lingua franca (and lex franca) of US-traded companies, independent of incorporation jurisdiction. By unbundling governance from tax, the federal government has arguably compromised its ability to extract tax revenues in exchange for offering value-enhancing governance. To the extent that this unbundling trend continues, moreover, the inversion wave could actually grow worse.

My analysis therefore suggests at least two alternative measures as promising responses to this trend: Either (1) the US should devise a new mechanism for ‘pricing out’ the governance services that it increasingly gives away to public companies; or (2) the federal government should reverse course in its longstanding program to suffuse securities law with heightened corporate governance requirements. I address each (very briefly) below.

Pricing Federal Governance

One potential response for re-bundling tax and governance would be for the US government to charge foreign corporations for their access to US securities laws, markets, courts, regulators and jurisprudence. Perhaps the most effective way to do this would be to assess an extra-ordinary surcharge to issuers who wish to list (or cross-list) on US exchanges, subject to a credit for those issuers who, by virtue of US incorporation, are subject to US tax treatment at the parent level.

At present, the fees charged to foreign issuers by US exchanges are not subject to any extraordinary US tax, and they are trivial (in the tens of thousands of US dollars on average per firm) by comparison to tax liabilities. Imposing an extraordinary levy on foreign issuers could reduce the difference tax burden between domestic and foreign incorporations, effectively re-bundling the benefits of US listings with tax revenues.

One potentially significant drawback to a special tax levy on foreign issuers comes from pre-existing constraints the US faces under international law. Although levying a listing surcharge on listed foreign corporations may not carry the same Constitutional implications as when US states discriminate against out-of-state corporations, it could face significant challenges elsewhere. In particular, international tax treaties typically prohibit (or heavily constrain) tax discrimination against foreign incorporated entities. To the extent that such taxes abrogate these treaty provisions, they might be unenforceable. This particular problem might be addressed, however, by double-barrel reforms: simultaneously implementing a reduction in corporate tax for listed US incorporated issuers, combined with a uniform listing surcharge for all listed companies, foreign and domestic. Nevertheless, such fixes involve time, effort, creativity and may themselves run various types of risks to enforcement.

A second (and perhaps more imposing) challenge, however, might remain. As noted above, my central thesis in this article turns on federal securities law displacing state corporate law, but not on whether the displacing elements of federal law securities law are desirable or not. Either way, both foreign and domestic listing entities are subject to the same governance restrictions, and consequently the cost of leaving US corporate law jurisprudence goes down. However, if one is convinced that the governance reforms in Sarbanes Oxley and Dodd-Frank were an affirmatively bad idea (and the jury is still out on this one – and haggling with one another), then imposing a listing surcharge comes with an attendant risk: flight from US securities markets as well as state corporate law. Indeed, of the governance changes during the last 15 years both have been pre-emptive and value eroding, they have eroded the value of US-style governance writ large. Accordingly, an overly aggressive attempt to extract rents from US listing companies might bring about just the opposite – flight to foreign exchanges. Thus, while a listings surcharge may be one way to approach the unbundling dilemma, it is a high-risk proposition.

Rolling back Federal Corporate Governance

A second possible policy option to re-bundle tax and governance would entail ‘rolling back’ (either retrenching or repealing) many of the governance reforms introduced by Sarbanes Oxley, Dodd Frank, and their progeny, which have squeezed out state law in several domains where states were traditionally dominant. Most of the federal governance mandates introduced since Tyco’s implosion, for example, could be candidates for the chopping block under this approach.
Although rollbacks are, in some ways, less legally fraught than new tax levies, they carry significant risks and obstacles of their own. A significant impediment of rolling back federal corporate law stems from coordinating state and federal legal actors. When the federal government is the chief authority for both taxation and provision of governance, it is easier to develop a coherent strategy for bundling the two policy instruments. In contrast, when states (such as Delaware) are the primary arbiters of corporate law, while the federal government retains primary tax authority, it becomes unclear whether the relevant actors have appropriate incentives to coordinate with one another in such that their regulatory strategies internalize relevant domestic costs and benefits. Granted, states likely internalize some revenue benefits from offering strong governance regimes (such as nurturing a strong regional legal services market); but many states raise somewhat little capital from corporate taxes on domestic corporations, particularly when such businesses do their business elsewhere. All else constant, the coordination problems that would ensue from ceding governance back to the states represent a distinct drawback to using federal roll-backs to re-bundle tax with company law.
Yet another impediment to using federal rollbacks to re-bundle tax and corporate law – and an artefact of federal-state coordination problems noted above – potentially comes from firms themselves. Increasingly, incorporated entities are going to extraordinary lengths to ‘contractualise’ their corporate governance regime, which can have the effect of instituting a form of private unbundling. For example, US companies have increasingly inserted choice of forum clauses in their governing bylaws, usually to steer internal affairs litigation back to their own state of incorporation. However, it is plausible that inverting companies may employ similar tactics to affect the opposite result, steering corporate litigation away from their unfamiliar new foreign home, and back into US (and Delaware) courts. It is unclear how receptive the Delaware Chancery Court would be to adjudicating, say, corporate litigation involving the internal affairs of an Irish or British corporation. However, it seems plausible that at least some Delaware judges – who do not personally benefit from federal tax revenues and who enjoy being at the helm of high-profile business litigation – might be willing to entertain such cases. (It bears noting, for example, that a recent Delaware Chancery Court opinion recognised the validity an unconventional forum-selection bylaw for a Delaware corporation that had opted out of Delaware and into North Carolina as the sole venue for litigating internal affairs disputes.) To the extent such self-help strategies become routine and accepted, a roll-back of federal corporate governance mandates would face long odds in reclaiming US market power in the regulatory competition market. It seems plausible, then, that a federal governance roll-back would have to be coupled with a stronger mandate (from Congress, the Supreme Court, or some other actor) on the sanctity of the internal affairs doctrine in the face of such “inverted” choice of law/forum provisions.
Finally, a strategy of rolling-back of federal corporate governance mandates poses challenges in prioritising which particular mandates should be subject to repeal. It seems plausible that at least some recent federal mandates have enhanced average company value, while others have been value-eroding. (The relative mixture of good and bad mandates remains a subject to considerable debate.) One might have an intuitive inclination to target those federal mandates that are generally agreed to have been least successful in enhancing issuer value. However, the calculus of unbundling calls even this intuitive logic into question. Recall that both good and bad governance mandates can effectively displace state law, and in that sense both types incrementally unbundle tax from governance. Somewhat counter-intuitively, in fact, one could argue that it is paramount to pull the plug on the most valuable federal governance mandates, since those rules represent the most significant areas where federal law provides the maximal benefit to foreign issuers without attempting to extract tax revenues.

Conclusion

Tax inversions have been at the centre of a heated legal policy debate that has sporadically flared up for decades. Such transactions have proven extraordinarily difficult for policy makers to address because they represent a complex intersection of tax law, capital mobility, public finance, corporate law & governance, securities law, and perfervid political jockeying about the appropriate role (if any) of corporate taxes.

This paper and underlying study argues that our current bout of ‘inversionitis’ is an artifact – at least in part – of a fundamental (and largely self-inflicted) distortion to the competitive landscape, where the US has traditionally enjoyed market power by ‘bundling’ its tax residency rules with a strong system of state corporate law and governance, utilising the latter to extract rents with the former.

Since the turn of the 21st century, US market power in the regulatory competition sphere has dwindled – perhaps unwittingly – as securities law has progressively unbundled these two policy levers through a steady colonisation of corporate governance. A more appropriate elixir for our current malaise, then, may lie in securities market reforms that address the unbundling phenomenon (rather than a radical reimagining of US Corporate Tax policy).
The precise shape of prescriptive reform, however, turns crucially on one’s assessment of whether the 15 year federal corporate governance experiment has been innovatively creative, or irresponsibly destructive. This latter question is still open to some speculation and debate; but the dilemmas it poses may be far more tractable (and politically manageable) than those presented by radical tax reform proposals.

Postscript

In the years since its 1997 exile to Bermuda, Tyco’s corporate governance identity crisis has morphed it into a veritable pinball of international corporate itinerancy. After determining in 2009 that Bermuda incorporation was not all it’s cracked up to be, Tyco split into multiple companies, each of which migrated abroad yet again. Most of the surviving pieces moved to Switzerland, another notoriously low-tax jurisdiction, where corporate governance remained an afterthought. In 2013, however, Swiss executive compensation standards changed dramatically and onerously, causing the company to decamp once again to Ireland, where it now – at least for the moment – calls home. Perhaps reflecting the current unbundled state of play, current Tyco CEO George Oliver made the following reassurances in its proxy statement to any shareholders who might be apprehensive about its new incorporation home:
“Upon completion of the Merger, Tyco Ireland will remain subject to US Securities and Exchange Commission reporting requirements, the mandates of the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform…and the applicable corporate governance rules of the NYSE…”
In July 1997, Tyco International (with then Wall St darling Dennis Kozlowski at the helm) was “acquired” by a relatively small provider of home security services, known as ADT Inc. The deal arguably exploited some strategic synergies between the two companies, but far and away the biggest benefit to Tyco lay elsewhere: It was a tax dodge. Although traded on US exchanges, ADT was incorporated in Bermuda, which has zero corporate income taxes – a far cry from the large headline tax rates in the US of near 40 per cent. The deal would allow Tyco – now a subsidiary of the surviving company – to claim that same tax residency as well.
Notwithstanding some (then-modest) regulatory obstacles, the resulting tax savings alone made the deal appear eminently worth pursuing. Tyco’s Bermudan exile produced a near-immediate pop in its after-tax earnings, and it marked the start of a five-year acquisitions smorgasbord that saw the company’s equity value skyrocket 500 per cent. Shareholders were ecstatic – at least at the time.
Tyco’s exile, however, also carried a hidden cost: it removed the company from US-style corporate governance standards, replacing them with poorly understood (and rarely utilized) Bermudan directives. And although the combined company remained publicly traded in the US, federal securities law requirements at the time mandated few corporate governance restrictions (traditionally the province of state law). Tyco was soon to become a poster child for poor governance run amuck: by late 2002, Tyco’s senior executives had been terminated, several were facing criminal indictments, the company’s credit rating had plummeted, and its stock price had conceded all of its half-decade-long crescendo.
Tyco’s strategic manoeuvring – and the unanticipated consequences it set into motion – have recently been re-incarnated, but in a reconstituted form. Although the regulatory landscape has changed dramatically since the 1990s, dozens of US public companies have recently executed similar ‘tax inversions’ – acquisitions that move a corporation’s residency abroad while maintaining its listing in domestic securities markets. When appropriately structured, inversions replace American with foreign tax treatment of extraterritorial earnings, often at far lower effective rates. Regulators and politicians have decried this ‘inversionitis’ pandemic, and many have begun to champion radical tax reforms to staunch the outflow.

In a forthcoming study, I question the prudence of radical tax-reform responses on a number of grounds. The first is practical: For a variety of reasons tax inversions are simply not a viable strategy for many firms, and thus the ongoing wave is likely to abate naturally (or with comparatively modest tax reforms).

The second, however, is more fundamental: I assess the inversion trend through the lens of regulatory competition theory, in which jurisdictions compete not only in setting tax policy, but also along other dimensions, such as the quality of their company law. I argue that just as US 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. This affinity has historically given the US sufficient market power to impose higher corporate taxes with little fear of chasing off incorporations, because US law has traditionally bundled tax residency and state corporate law into a conjoined regulatory package. To the extent this market power remains durable, most radical tax overhauls currently being championed would be unhelpful (and even counterproductive).

That said, whatever market power in corporate governance that the US enjoys has been unwittingly compromised by inconspicuous source: Securities Law. In the years since Tyco’s implosion, federal law has progressively suffused national securities regulations with mandates relating to internal corporate governance matters. Those federal mandates, in turn, have displaced and/or pre-empted state law as a primary source of governance regulation for US-traded issuers. And, because US securities law applies to all listed issuers (regardless of tax residence), this displacement has gradually ‘unbundled’ domestic tax law from corporate governance, eroding the US’s market power in regulatory competition. Although Tyco’s corporate governance sinkhole in Bermuda might have served as a cautionary tale to others in the early 2000s, aspiring inverters no longer need fear this same cost in a post-Sarbanes Oxley, post-Dodd Frank, unbundled world. Their corporate governance regime is effectively provided free of charge by US securities law to all domestically traded companies.

An effective elixir for this governance ‘give-away’, then, may also lie as much in securities regulation as in tax reform. I propose two alternative reform paths: either (a) domestic exchanges should charge listed foreign issuers for their consumption of federal corporate governance policies; or (b) federal law should cede corporate governance back to the states by rolling back many of the governance mandates promulgated over the last 15 years.

Corporate Inversions

Although inversions are no doubt a current flashpoint of attention, it warrants observing that US multinational corporations (MNCs) utilise many tools to slash their tax liability. The most widespread such practice is the practice of non-repatriation. That is, they simply leave most of their offshore earnings offshore, held within their Controlled Foreign Companies (CFCs). Many MNCs, moreover, can utilise creative inter-company borrowing schemes to make use of that cash (albeit at some cost). However, as the aggregate size of retained off-shore earnings has grown (now estimated at over two trillion US dollars), the resurgence of tax inversion transactions among American MNCs was perhaps inevitable.

The intent behind an inversion transaction is to relocate the tax residence of an American MNC parent outside of US jurisdiction, transplanting it into a jurisdiction offering a more favourable tax environment. There are a host of foreign jurisdictions offering lower tax rates, territorial (rather than global) tax treatment, more flexible tax residency rules, and more liberal recognition rules than does the United States. The most creative forms of inversion transactions, therefore, attempt to capitalise on these differences, in a way that is maximally beneficial – all else (hopefully) held constant – for the inverting corporation.

Given the tremendous upsurge of late in inversion activity, it is also important to keep in mind that similar types of tax-avoidance-motivated merger transactions are nothing new. Indeed, four years before Tyco, an early border skirmish in the public battle over inversions took place when Helen of Troy, a publicly traded Delaware corporation in the personal care and cosmetics industry, formed a shell subsidiary in Bermuda, causing the subsidiary to acquire the parent in a stock-for-stock transaction. Under the then-prevailing tax rules, this transaction – like any other stock deal – was deemed non-taxable to US shareholders. Once the transaction closed, moreover, the surviving parent continued to be traded in the US public markets under Helen of Troy’s name, but with incorporation and tax residency in Bermuda.

The Bermudan tax abduction of Helen of Troy raised considerable alarm about the use of shell transactions to execute escape US tax treatment — sometimes known as a ‘naked’ or ‘shell’ inversion. The IRS soon thereafter dispatched a response, in the form of a set of anti-inversion regulations promulgated in 1996. The ultimate reforms made inverting decidedly more expensive, by deeming it a taxable event to US shareholders of the inverted company unless the US target’s equity was diluted by new ownership by no less than 50 per cent. The 1996 regulations also imposed a 15-percent ‘excise tax’ on stock remuneration of officers, directors, and large block shareholders of the inverting company – a levy that was (and is) difficult to sidestep.

Although this first generation of reforms possibly deterred a fair number of inversion transactions, it proved little more than an annoyance to others. Even after the 1996 reforms a steady stream of inverters continued to pursue the strategy. (These included the Tyco-ADT deal, described above.)

Eight years later, Congress and the IRS added a second significant set of inversion restrictions through IRC § 7874, which has become a centrepiece for structuring most of today’s inversions. Most focally, the section specifies that an inversion transaction can achieve most of the important tax benefits of moving offshore (and avoid US tax residence of the surviving entity) if it can demonstrate that the transaction dilutes the ownership of the US issuer’s shareholders in the surviving entity by at least 20 per cent. (Modestly larger benefits are available when the dilution exceeds 40 per cent)

Much like the 1996 reforms, the 2004 amendments put a momentary pause to inversion deals, but they once again came roaring back in late 2013, as corporate lawyers adapted, foreign jurisdictions began to reduce their own headline tax rates, and US federal law continued its decade-long displacement of state law in prescribing corporate governance rules for public companies.

In September 2014, the US Treasury took yet another shot, issuing new guidance intended to place more significant constraints on the attractiveness of tax inversions. The new Guidance did not alter the key attributes of § 7874 writ large. However, the new rules do make it harder for parties to engage in now-familiar parlour tricks that render a transaction compliant with targeted dilution thresholds. For example, the guidelines now heavily constrain skinny-down dividends, disregarding ‘extraordinary’ dividends made during the three-year period that precedes the transaction.

Additionally, the value of the foreign acquirer must be computed independent of passive asset holdings (such as cash or passive investments) when at least 50 per cent of the entity’s assets are passive. The new rules also place new hurdles in the way of ‘spin version’ transactions treating the spun off assets (even if incorporated abroad) as a US corporation for tax purposes. Another area where the 2014 Guidance tightened up scrutiny was in post-inversion intercompany loans. The guidelines specifically deem as taxable ‘hop-scotching’ loans in which the CFCs owned by the US target lone capital directly to the foreign acquirer. That is, these ‘hopscotch’ loans are deemed to have passed through the US target – subjecting it to dividend tax – for a period of 10 years after the inversion.

Although it is too early to tell what effect the new guidelines will have, many experts posit that at least for some aspiring inverters, they will (once again) look more like a speed bump than a crash wall. On the one hand, it is clear that the new Guidance has imposed a considerable constraint on some pending deals, particularly those that were signed (but not yet closed) prior to the rule change. On the other hand, the more stringent rule changes may simply invite more inversion activity, since the act of clarifying the applicable ground rules for inversions may end up catalysing more of them. Moreover, at least in some industries (such as pharma), the companies emerging from previous offshore inversions are now sufficiently large to qualify as ‘true’ acquirers (allowing them to overcome many anti-inversion hurdles).

Inversions through the Lens of Regulatory-Competition Theory
Stepping back somewhat, it may be helpful to appraise the conceptual and analytic role that inversions play within a larger international policy stage: regulatory competition. In tax policy circles, it is widely accepted that jurisdictions often ‘compete’ with one another to attract economic activity, including corporations’ locational choices. Although tax certainly represents one dimension of this competition, others are important as well. The primary focus of my forthcoming study – unsurprisingly – highlights the interaction between tax policy and corporate governance regulations. Specifically, I analyse the conditions under which jurisdictions offering packages of tax and governance regulations are likely to differentiate themselves from one another, and what implications such differentiation has for responding (if at all) when firms enjoy some mobility.
Several central intuitions emerge from this analysis.
1. First, when jurisdictions are able to bundle tax and governance regulations, they will tend to differentiate themselves in their offerings, with some jurisdictions serving as market ‘leaders’ in governance while others serve as market ‘laggards’. To most observers, the corporate governance regime that has evolved through the last century in the US (and particularly in Delaware) is thought pioneering in the field.
2. Second, jurisdictions that enjoy a position as market leaders will rationally attempt to capture the value they have created through their tax policies, and will therefore appear less competitive in their tax treatment of domestic firms. This fact may help explain why the US has been able to retain relatively high tax rates for so long without chasing off significant numbers of incorporations.
3. Third, because of their market power in governance, leaders can afford to moderate their responses to tax competition from other jurisdictions, and thus a market leader need not be drawn into “ruinous” forms of tax competition. Rather, a leader’s optimal response to another jurisdiction’s aggressive tax policies may be muted, possibly substantially. This observation is what leads me to be sceptical of the value of radical tax reform, at least to the extent that the US retains its market power in corporate governance leadership.
4. Fourth, and most critically, the advantageous strategic position that a jurisdictional leader in governance enjoys persist only insofar as the tax and governance attributes offered by the leader remain ‘bundled’ – ie, firms must be forced to accept the leader’s tax policy as they embrace its governance rules, and they cannot selectively build a medley of the best pieces of different jurisdictions’ regulatory frameworks. Unbundling tax from governance (as I argue has happened unwittingly through US securities law reforms) not only negates the leader’s market power, but it negates the incentives of jurisdictions to sink resources into providing high quality governance regimes to begin with.

In the long run, I contend, unbundling will lead to a material contraction in quality and heterogeneity of competing governance regimes – a clear negative when firms have heterogeneous needs and capabilities. And, most radical reform proposals currently on the table – such as the complete elimination of corporate taxes or the migration to a territorial system of taxes – explicitly or implicitly embrace unbundling as a core design feature. This is, in my view, a significant mistake. Worse yet, it is an avoidable one.

Tentative Reform Proposals
Assuming the US is still able to offer a different (and higher quality) governance product than its competitors, then it can likely afford to impose a distinct tax product as well. Domestic policymakers may therefore have the flexibility to approach responsive tax reform in a more incremental fashion, without re-imagining the entire corporate tax philosophy of the US.
This of course does not imply that utter passivity is the optimal US response to recent out-migrations either. Clearly, something has caused a wave of pent-up outbound M&A activity to take hold. To be sure, the large (and growing) differences in nominal tax rates imposed on US resident corporations are part of this problem, and the US may well wish to consider reducing nominal rates by some margin to narrow (though not eliminate) the gap, as the Obama administration’s 2016 budget proposes.
However, an analogously significant concern is the extent to which the US has unwittingly undermined its ability to raise corporate tax revenues by unbundling corporate governance from tax residence. Over the last 15 years, US securities law has gradually supplanted state corporate governance laws as the lingua franca (and lex franca) of US-traded companies, independent of incorporation jurisdiction. By unbundling governance from tax, the federal government has arguably compromised its ability to extract tax revenues in exchange for offering value-enhancing governance. To the extent that this unbundling trend continues, moreover, the inversion wave could actually grow worse.
My analysis therefore suggests at least two alternative measures as promising responses to this trend: Either (1) the US should devise a new mechanism for ‘pricing out’ the governance services that it increasingly gives away to public companies; or (2) the federal government should reverse course in its longstanding program to suffuse securities law with heightened corporate governance requirements. I address each (very briefly) below.

Pricing Federal Governance
One potential response for re-bundling tax and governance would be for the US government to charge foreign corporations for their access to US securities laws, markets, courts, regulators and jurisprudence. Perhaps the most effective way to do this would be to assess an extra-ordinary surcharge to issuers who wish to list (or cross-list) on US exchanges, subject to a credit for those issuers who, by virtue of US incorporation, are subject to US tax treatment at the parent level.
At present, the fees charged to foreign issuers by US exchanges are not subject to any extraordinary US tax, and they are trivial (in the tens of thousands of US dollars on average per firm) by comparison to tax liabilities. Imposing an extraordinary levy on foreign issuers could reduce the difference tax burden between domestic and foreign incorporations, effectively re-bundling the benefits of US listings with tax revenues.
One potentially significant drawback to a special tax levy on foreign issuers comes from pre-existing constraints the US faces under international law. Although levying a listing surcharge on listed foreign corporations may not carry the same Constitutional implications as when US states discriminate against out-of-state corporations, it could face significant challenges elsewhere. In particular, international tax treaties typically prohibit (or heavily constrain) tax discrimination against foreign incorporated entities. To the extent that such taxes abrogate these treaty provisions, they might be unenforceable. This particular problem might be addressed, however, by double-barrel reforms: simultaneously implementing a reduction in corporate tax for listed US incorporated issuers, combined with a uniform listing surcharge for all listed companies, foreign and domestic. Nevertheless, such fixes involve time, effort, creativity and may themselves run various types of risks to enforcement.
A second (and perhaps more imposing) challenge, however, might remain. As noted above, my central thesis in this article turns on federal securities law displacing state corporate law, but not on whether the displacing elements of federal law securities law are desirable or not. Either way, both foreign and domestic listing entities are subject to the same governance restrictions, and consequently the cost of leaving US corporate law jurisprudence goes down. However, if one is convinced that the governance reforms in Sarbanes Oxley and Dodd-Frank were an affirmatively bad idea (and the jury is still out on this one – and haggling with one another), then imposing a listing surcharge comes with an attendant risk: flight from US securities markets as well as state corporate law. Indeed, of the governance changes during the last 15 years both have been pre-emptive and value eroding, they have eroded the value of US-style governance writ large. Accordingly, an overly aggressive attempt to extract rents from US listing companies might bring about just the opposite – flight to foreign exchanges. Thus, while a listings surcharge may be one way to approach the unbundling dilemma, it is a high-risk proposition.

Rolling back Federal Corporate Governance
A second possible policy option to re-bundle tax and governance would entail ‘rolling back’ (either retrenching or repealing) many of the governance reforms introduced by Sarbanes Oxley, Dodd Frank, and their progeny, which have squeezed out state law in several domains where states were traditionally dominant. Most of the federal governance mandates introduced since Tyco’s implosion, for example, could be candidates for the chopping block under this approach.

Although rollbacks are, in some ways, less legally fraught than new tax levies, they carry significant risks and obstacles of their own. A significant impediment of rolling back federal corporate law stems from coordinating state and federal legal actors. When the federal government is the chief authority for both taxation and provision of governance, it is easier to develop a coherent strategy for bundling the two policy instruments. In contrast, when states (such as Delaware) are the primary arbiters of corporate law, while the federal government retains primary tax authority, it becomes unclear whether the relevant actors have appropriate incentives to coordinate with one another in such that their regulatory strategies internalize relevant domestic costs and benefits. Granted, states likely internalize some revenue benefits from offering strong governance regimes (such as nurturing a strong regional legal services market); but many states raise somewhat little capital from corporate taxes on domestic corporations, particularly when such businesses do their business elsewhere. All else constant, the coordination problems that would ensue from ceding governance back to the states represent a distinct drawback to using federal roll-backs to re-bundle tax with company law.

Yet another impediment to using federal rollbacks to re-bundle tax and corporate law – and an artefact of federal-state coordination problems noted above – potentially comes from firms themselves. Increasingly, incorporated entities are going to extraordinary lengths to ‘contractualise’ their corporate governance regime, which can have the effect of instituting a form of private unbundling. For example, US companies have increasingly inserted choice of forum clauses in their governing bylaws, usually to steer internal affairs litigation back to their own state of incorporation. However, it is plausible that inverting companies may employ similar tactics to affect the opposite result, steering corporate litigation away from their unfamiliar new foreign home, and back into US (and Delaware) courts. It is unclear how receptive the Delaware Chancery Court would be to adjudicating, say, corporate litigation involving the internal affairs of an Irish or British corporation. However, it seems plausible that at least some Delaware judges – who do not personally benefit from federal tax revenues and who enjoy being at the helm of high-profile business litigation – might be willing to entertain such cases. (It bears noting, for example, that a recent Delaware Chancery Court opinion recognised the validity an unconventional forum-selection bylaw for a Delaware corporation that had opted out of Delaware and into North Carolina as the sole venue for litigating internal affairs disputes.) To the extent such self-help strategies become routine and accepted, a roll-back of federal corporate governance mandates would face long odds in reclaiming US market power in the regulatory competition market. It seems plausible, then, that a federal governance roll-back would have to be coupled with a stronger mandate (from Congress, the Supreme Court, or some other actor) on the sanctity of the internal affairs doctrine in the face of such “inverted” choice of law/forum provisions.

Finally, a strategy of rolling-back of federal corporate governance mandates poses challenges in prioritising which particular mandates should be subject to repeal. It seems plausible that at least some recent federal mandates have enhanced average company value, while others have been value-eroding. (The relative mixture of good and bad mandates remains a subject to considerable debate.) One might have an intuitive inclination to target those federal mandates that are generally agreed to have been least successful in enhancing issuer value. However, the calculus of unbundling calls even this intuitive logic into question. Recall that both good and bad governance mandates can effectively displace state law, and in that sense both types incrementally unbundle tax from governance. Somewhat counter-intuitively, in fact, one could argue that it is paramount to pull the plug on the most valuable federal governance mandates, since those rules represent the most significant areas where federal law provides the maximal benefit to foreign issuers without attempting to extract tax revenues.

Conclusion
Tax inversions have been at the centre of a heated legal policy debate that has sporadically flared up for decades. Such transactions have proven extraordinarily difficult for policy makers to address because they represent a complex intersection of tax law, capital mobility, public finance, corporate law & governance, securities law, and perfervid political jockeying about the appropriate role (if any) of corporate taxes.

This paper and underlying study argues that our current bout of ‘inversionitis’ is an artifact – at least in part – of a fundamental (and largely self-inflicted) distortion to the competitive landscape, where the US has traditionally enjoyed market power by ‘bundling’ its tax residency rules with a strong system of state corporate law and governance, utilising the latter to extract rents with the former.

Since the turn of the 21st century, US market power in the regulatory competition sphere has dwindled – perhaps unwittingly – as securities law has progressively unbundled these two policy levers through a steady colonisation of corporate governance. A more appropriate elixir for our current malaise, then, may lie in securities market reforms that address the unbundling phenomenon (rather than a radical reimagining of US Corporate Tax policy).

The precise shape of prescriptive reform, however, turns crucially on one’s assessment of whether the 15 year federal corporate governance experiment has been innovatively creative, or irresponsibly destructive. This latter question is still open to some speculation and debate; but the dilemmas it poses may be far more tractable (and politically manageable) than those presented by radical tax reform proposals.

Postscript

In the years since its 1997 exile to Bermuda, Tyco’s corporate governance identity crisis has morphed it into a veritable pinball of international corporate itinerancy. After determining in 2009 that Bermuda incorporation was not all it’s cracked up to be, Tyco split into multiple companies, each of which migrated abroad yet again. Most of the surviving pieces moved to Switzerland, another notoriously low-tax jurisdiction, where corporate governance remained an afterthought. In 2013, however, Swiss executive compensation standards changed dramatically and onerously, causing the company to decamp once again to Ireland, where it now – at least for the moment – calls home. Perhaps reflecting the current unbundled state of play, current Tyco CEO George Oliver made the following reassurances in its proxy statement to any shareholders who might be apprehensive about its new incorporation home:

“Upon completion of the Merger, Tyco Ireland will remain subject to US Securities and Exchange Commission reporting requirements, the mandates of the Sarbanes-Oxley Act and the Dodd-Frank Wall Street Reform…and the applicable corporate governance rules of the NYSE…”