Broken levy: How U.S. tax law encourages inversions

An innocuously named species of transaction has inspired a political furor this summer. After a number of U.S. companies announced plans to move overseas in so-called inversion deals, Sen. Carl Levin proposed banning them outright. President Barack Obama called the companies unpatriotic. Because of the controversy, Walgreen Co. backed away from structuring its $18 billion purchase of Alliance Boots GmbH as an inversion, while the possibility that inversions will be barred may be pushing other U.S. corporations to consider doing them.

American companies have for decades been able to reincorporate overseas and thereby cut their tax bills, but such transactions were rare until the late 1990s. Between 1999 and 2002, about 20 U.S. corporations moved overseas, in many cases employing “self-inversions” that did not involve a combination with another operating company. Congress put an end to those deals in 2004 by changing the law to allow a U.S. company to move overseas only if it combined with a foreign company whose shareholders ended up with at least 20.1% of the combined entity.

That legislation and a slow M&A market after the financial crisis combined to reduce the number of inversions, but there have been about 15 announced so far in 2014, far more than in any year since the first notable corporate inversion was done in 1982. Among the 15 are AbbVie Inc.’s $54 billion agreement to buy Shire plc and Medtronic Inc.’s proposed $43 billion tie-up with Covidien plc, which like Shire is based in the tax haven of Ireland. Inversions have been especially appealing to pharmaceutical and biotechnology companies, which sell products all over the world and often locate their intellectual property in tax-favored jurisdictions.

While Democrats have seized upon the wave of inversions as a political issue that could help them in the midterm elections, tax academics see them as a symptom of a dysfunctional, outmoded tax system that’s out of step with the rest of the world. Analyses of that system are complex, and proposals for improving it are often at odds, but the global mobility of capital and the steps other countries have taken to attract it and allow their own companies to deploy it as effectively as possible give the academic debate a unusual topicality and show the policy choices embedded in any system of taxation.

“Inversions are symptomatic of a much broader problem with the U.S. system of corporate taxation,” said Mihir Desai, a professor at Harvard Business School. “In a way, it’s remarkable that firms are willing to make such substantive transactions to achieve these savings.” Broad corporate tax reform has been a quixotic endeavor for the few lawmakers who have been willing to take on the issue, but the recent prevalence of inversions has forced a reconsideration of the options U.S. policymakers have options for addressing them.

INVERSIONS REPRESENT a response both to U.S. tax rates, which are among the highest in the industrialized world, and to a basic feature of the way the U.S. taxes multinational corporations. Most nations tax only income earned in their own country, but the U.S. taxes its companies on income they earn around the world even though that income is also taxed in the jurisdiction where it’s earned.

The U.S. credits its companies for taxes paid overseas on repatriated earnings, but its 35% marginal rate on corporate income encourages U.S. companies with operations abroad to defer taxation on foreign profits by retaining them in foreign subsidiaries rather than paying them up to the U.S. parent and incurring additional tax. The incentive to retain money in foreign subsidiaries — or, put another way, the disincentive to repatriate it — has increased as other countries have reduced their marginal rates. Accounting rules add to the problem, since U.S. companies must provide for a tax reserve on foreign profits that they expect to repatriate later even if the companies keep the profits overseas and don’t immediately owe tax on them. Thus U.S. companies have strong motivation to retain foreign earnings in foreign subsidiaries, creating the problem of “trapped cash.”

The U.S. approach to taxation of its multinationals dates to the early decades of the 20th century, when other industrialized countries had similar systems. The U.S. reaffirmed its structure in 1962, the last time Congress revised subpart F of the Internal Revenue Code, which governs taxation of foreign-controlled subsidiaries.

That tax law was the product of a deliberate policy choice, said Bret Wells, a professor at the University of Houston Law Center. “When we were the largest capital exporter of the world, we wanted interest, rents and royalties to not be subject to source country taxation because we thought that was better for the U.S. It was purposeful earnings stripping,” he said, using a key term of art in tax law. “The victors of World War I did this thereafter. That world created the dynamic that is now being taken advantage of.”

In referring to earnings stripping, Wells was using the tax shorthand for the way companies structure the relationships between their foreign subsidiary corporations and domestic parent entities. The parent generally conducts business in foreign countries through subsidiaries incorporated in those jurisdictions. Revenue generated by the subsidiaries can be characterized in a variety of ways for tax purposes. If it’s characterized as income, it’s subject to taxation in the foreign country and then to taxation when it’s repatriated in the form of a dividend to a domestic parent. But if that revenue is structured as interest on a loan that the foreign sub pays to the domestic parent, or as rent on a building that the parent owns and the unit occupies, or as royalties on intellectual property that the parent owns and the subsidiary licenses, the revenue is often not subject to any withholding taxes and creates a tax deduction for the onshore business, thus eliminating source country taxation on these streams of income.

When countries around the world started to adopt corporate income taxes in the 1910s, a tax system that allowed for earnings stripping reflected an imperialist view of the world. The American or European headquarters and operations of a multinational company created almost all of its value; that value should therefore be taxed in the company’s home country. And when the U.S. revised subpart F in 1962, said James Hines, a professor the University of Michigan Law School, “The U.S. had almost half of the world’s GDP, and the view was we didn’t really have to think about competition from foreign countries.”

THAT’S CHANGED significantly in the last generation, as the so-called territorial approach to taxation of multinationals has gained ground. In such a system, the company’s home country taxes only income earned in the country and exempts from taxation foreign earnings that are paid as dividends back to the parent. Hence the term “dividend exemption” tax system, another way of referring to a territorial system.

That system eliminates the problem of trapped cash, since multinational companies can easily and cheaply repatriate earnings to their home country. In 1962, six of the 34 Organisation for Economic Co-operation and Development countries had a territorial regime; now, the only six that don’t are the U.S., Chile, Ireland, Israel, Mexico and Korea. Most of the shift has come in the last generation, a period in which many countries have also reduced their corporate tax rates. Differential tax regimes and rates lead multinational companies to engage in significant planning — inversions are but one example — and spur many countries to enact tax laws that they hope will attract incorporations and thereby revenue.

In 2009, both Japan and the U.K. overhauled their tax regimes, though for different reasons. Japan amended its law to virtually eliminate the Japanese tax cost of bringing foreign earned profits back to Japan, according to Eric Roose, a tax partner at Morrison & Foerster LLP in Singapore and Tokyo. At the time, Japan had the highest corporate tax rate in the world at around 42%, which made its multinationals reluctant to repatriate foreign income. With the Japanese population shrinking, its companies needed to expand overseas to generate growth, and they wanted to be able to redeploy their overseas cash to do so. In response, Japan changed its tax law to exempt from Japanese taxation 95% of dividends paid to a Japanese parent by a foreign subsidiary. That’s helped Japanese companies invest more at home as well as make acquisitions overseas. Japan also subsequently lowered its corporate tax rate to 38%, and Prime Minister Shinzo Abe recently announced a goal of further reducing the corporation tax rate to 20%, something that could can happen in the next few years. But that would leave Japan with a significant revenue gap, which is a critical limitation on many countries’ ability to reform their tax codes in corporation-friendly ways.

JAPANESE COMPANIES weren’t migrating overseas, but some U.K. companies were. In 2008, advertising giant WPP plc redomiciled in Ireland, and GlaxoSmithKline plc threatened to do so. The U.K.’s government “took a very interesting perspective,” said Harvard’s Desai. “They wanted to be a place where multinational firms wanted to be domiciled. They did not take the point of view that firms that were leaving were unpatriotic.” In 2009, Parliament reformed the country’s corporate tax system in three ways. It opted to tax only income earned in the U.K.; reduced the marginal rate to 23% from 28%, falling to 20% in 2016; and established a lower tax rate on profits attributable to U.K. or EU patents. That’s helped keep U.K. companies from moving offshore and made the U.K. a more appealing corporate domicile.

In contrast, Hines said, “[n]obody thinks the U.S. is an attractive tax environment.” The response should be obvious, he believes: “Congress tomorrow could pass legislation that would largely solve this problem. If we took our tax system and replaced it with the U.K. system, we would be one of the most attractive places in the world to do business. Why don’t we do that? If Congress can’t or won’t do anything to improve the U.S. tax system then we will just have to live with the consequences of continued economic decline relative to our potential.”

But such an overhaul may be unlikely given the gridlock in Washington and nation’s significant budget deficit. And while calls to outlaw inversions may help rally the Democratic base, such a ban is highly unlikely because it would invite copycat legislation from other countries that would limit the ability of U.S. companies to expand abroad.

Edward Kleinbard, from 2007 to 2009 the chief of staff for the U.S. Congress Joint Committee on Taxation and now a professor at the University of Southern California’s Gould School of Law, argued that, in practice, the U.S. already has “an ersatz variant on territorial systems” because of the ease of keeping earnings overseas. Shifting to a territorial regime, he said, would create at least as many problems as it solves.

Instead, Kleinbard argued for a three-pronged response to the current wave of inversions. First, he said, Congress should amend Section 7874 of the U.S. Tax Code — the provision passed in 2004 to bar self-inversions — to allow U.S. companies to reincorporate abroad via merger only if the foreign company’s shareholders own more than half of the combined company, up from 20.1% currently. He said that would harmonize 7874 with the domestic tax treatment of mergers between U.S. companies. Second, Congress should revise the rules governing earnings stripping to reduce the amount of revenue that both foreign and U.S. companies can shield from U.S. taxation. Lastly, he advocated the adoption of what he called an anti-hopscotch rule, which would further reduce the tax advantages of an inversion by limiting the ability of firms to access offshore cash after an inversion in ways they could not do before it.

Wells said that foreign companies with U.S. subsidiaries are more easily able to shield U.S. income from taxation here than domestic companies are. He said he believes the U.S. should change its tax laws to put foreign and domestic companies on equal footing in that regard. And he suggested that the U.S. adopt a regime that allocates profits to taxing jurisdictions based on their substantive contribution, which current law refers to as a profit-split methodology, and require it to be used in all cases. Doing so would reduce companies’ ability to strip earnings by recharacterizing them as interest, rents and royalties. Alternatively, he said, the U.S. could also consider reimposing withholding taxes on interest, rents and royalties paid from a U.S. subsidiary to a foreign parent.

Even if Congress can’t or won’t change the tax laws to disfavor inversions, the Treasury Department has broad leeway to adopt regulations that have the same effect, Harvard Law School professor Stephen Shay wrote last month in Tax Notes, the leading trade publication in the field. Regulators can act more quickly than legislators, he noted, and they need to do so here.

“When a material portion of the U.S. corporate tax base is at risk,” he wrote, “doing nothing borders on the irresponsible.”