Reform of the U.S. tax code still needed for the nation’s economy

As the 2016 Presidential campaign heats up with debates and public appearances replete with the candidate’s opinions on the economy, ISIS, and education, among others, few candidates have mentioned the issue of corporate tax reform, especially as it relates to a level playing field between the U.S. and foreign markets, with the possible exception of Republican Senator Marco Rubio, of Florida, who along with Utah Senator Mike Lee, wrote a recent proposal on reformation of the tax code that seems to have been lost in the televised debates.

With the highest corporate tax code of any developed country – 35 percent – the United States has been criticized, both within, and without for it; especially when it comes to the sustained onslaught of criticisms of tax inversions, which is when American companies buy foreign entities, then transfer their headquarters abroad to save on the much lowered rates abroad, a move that has garnered much criticism in the the press, and also, in turn, when American companies are bought by foreign investors, who then protect much of their earned income from U.S. taxes by stacking debt on the U.S. entities then deduct interest payments, further deferring tax payments.

These companies, on the American side, have quickly earned a negative press, and labels of “unpatriotic”, “bad,” or even “greedy” were applied by everyone from President Barack Obama to Treasury Secretary Jacob Lew, especially in the aftermath of the acquisition by Burger King of the Canadian coffee company, Tim Horton.

The value of these takeovers has increased from $71 billion in 2013 to $379 billion this year, claims FactSet; and the acquisition of Salix Pharmaceuticals by a Canadian rival, cut their taxes by more than $560 million, according to the Wall Street Journal.

The issue has become a media magnet and has garnered much attention. In an interview Douglas Stransky, a U.S. based international tax partner for the law firm of Sullivan & Worcester in their Boston office, shared his thoughts on them, but also,and significantly, the larger picture: the reform of the U.S. tax code, a behemoth that has not seen revision since 1986.

Stransky notes that while inversions have received their share of the media spotlight, they have been with us since 1986, but in the last decade they have increased in measure. While getting a bad rap, in the public eye, as tax dodgers, the reality is that corporate tax reform “has not been undertaken since the Kennedy administration,and the way that business was done has dramatically changed. Then, you had tangible goods sold, and transferred in containers on ships,” now.there are ideas, products and services, sold online,” transferrable anywhere, he said..

He also emphasized that inversions are really tax diversions, to be taxed when the profits are brought back to the United States. Also aiding in their proliferation, was a rule reversal that previously had American companies who left the country, ineligible to be listed on a stock market index, such as Standard and Poors, but the change has increased their number.

While Treasury Secretary Jacob Lew, and President Obama, have shown their displeasure, significant change before the 2016 presidential election, would be nigh to impossible, Stransky says, “since it would take a lot of legal action and from a political perspective [it would be easier] to let the next administration deal with it.”

In addition, he also notes that a large “part of it is even after the election is we don’t know what the House and Senate will look like.” One recent change, for hopeful action, is the soon-to-be new Speaker of the House, Paul Ryan, who is a strong advocate of corporate tax reform, but as Stransky noted, “with immigration reform, and other pressing issues leading, it would be difficult to see change before 2017.”

He also clarifies a common misperception, on the part of some observers: “The tax code does not tell one whether something is legal or illegal or whether one can do a certain thing. What the tax code does is tell us what the tax consequences are when we do something. For example, the tax code does not tell us whether we can form a company, but if we decide to do it, the tax code will tell us what happens from a tax perspective. In the early 90’s some U.S. companies decided that they wanted to move their headquarters to a foreign country, i.e., an inversion. Once they made that business decision, then the tax code provisions that were in effect with the Tax Reform Act of 1986 told those US companies what the tax consequences were that resulted from that inversion.”

Some lawmakers, most notably Sen. Rob Portman (R-Ohio) called recent efforts by the Treasury, “a Band-Aid.” and feels that the current tax code is noncompetitive, especially considering its short-lived changes. U.S. Treasury officials have also mulled over, how, and if, they can change the interest deductions that make foreign ownership so attractive.

Stransky however notes that “In 2004 Congress decided that the various provisions in the tax code that taxed inversions were not punitive enough so it added section 7874 to the Code (16 USC sec. 7874). That provision specifically deals with an inversion and tells people what the tax results are under various inversion scenarios. For example, if the US company inverts and has the same shareholders both before and after, the tax consequences are worse than if the majority of shareholders change. Recently, the US Treasury decided that section 7874 and its regulations needed to be tighter still and provided a notice of proposed rulemaking.”

In 2012, governments noted that there was wholesale tax avoidance by large companies, using a series of laws from the 1920s. This October leaders of the Organization for Economic Cooperation and Development met to establish new rules and regulations to tamp down, what they term tax avoidance by multinationals. Recent estimates of loss have been calculated at 0.6 percent of GDP for developed countries, and 1.75 percent for developing countries.These rules are expected to be presented to heads of state at the Group of 20 meeting in November.

Stransky notes that this effort should be looked at cautiously, saying, “In sum, there is no law in the world that specifically says that a U.S. company can or cannot do an inversion. But, if one does it, the tax code describes various ways it could be done and tells you what the tax results are. Obviously, if the tax cost is higher than the business benefit ,and potential tax savings, the company will not do it, which was the intent of the recent rules.”

The Guardian reported that there are five major rules, with the most important stating that, “Multinationals will be required to disclose to tax offices around the world a detailed summary of their global activities, broken down country by country.”

Some American companies may feel a pinch with proposed rules designed to guard against “multinationals building cross-border structures to exploit differences in the tax codes of two countries,” for example, where production offices and warehouses, are split from research and development..Also significant, are proposals that those companies who are tax shopping for better benefits, a cap should limit how much “a multinational can derive from routing investments in a second jurisdiction through a third country.”

Google and Amazon, for example, two large multinationals may have to take a hard look, in anticipation of other recommendations, if implemented, that might impact on the way that they are doing business. These changes are designed to clarify what “will mean it is no longer possible to claim you are not active in a jurisdiction if you have a large local warehouse with many local employees storing and delivering goods which are sold on a website based and operated overseas.”

There is some objection that these rules from the OECD’s Base Erosion and Profit Sharing division are not what is needed, and some like Nancy McLernon, President and CEO of the Organization for International Investment, see unintended consequences, and in an earlier press release she said, “The BEPS action plan is not a substitute for good tax policy.”

Later, she noted that “inversions are not a bad thing for the economy, but one that can help it grow.” And, that there would be a significant drop in the GDP — $11.1 billion annually, as well as a decrease in the investment by foreign economies in the U.S. and a further depression of wages of $7.9 trillion.” Stransky fully concurs and also says, “BEPS does not create an open establishment,” with foreign sales, and distribution.”

Reform of the U.S. tax code may not be seen in the next two years, but it may be the elephant in the room, when it comes to discussions of the global economy, and what direction it takes, and its effect on the nation’s economy.