The last few days have seen a flurry of discussion about corporate inversions. Examples include this Washington Post op-ed by Treasury Secretary Jacob Lew, and today’s NYT op-ed by Paul Krugman.
Corporate inversions are transactions in which a U.S. multinational transmutes itself into a foreign multinational by arranging to convert the U.S. entity into a mere subsidiary, rather than the company at the top of the chain. Meanwhile, in such a deal, the internal corporate structure is rearranged so that any foreign affiliates that previously were subsidiaries of the U.S. company become instead its lateral siblings. They are owned by the new foreign parent, and hence are outside any U.S. chain of ownership.
At the end of the day in an inversion, there is still a U.S. company conducting U.S. operations. But there are two big changes on the ground. First, unrepatriated foreign earnings of the foreign affiliates no longer face the threat of U.S. tax upon repatriation to the U.S. parent (since there is no U.S. parent). In theory, the repatriation tax is merely being deferred while the money stays abroad. And deferral does nothing to reduce the present value of the expected repatriation tax if it is certain to be incurred eventually and if the U.S. repatriation tax rate will always be the same. But with an inversion, the company wages its magic wand and presto, the deferred tax completely disappears. This not only causes a seemingly fixed tax burden (in present value terms) to disappear, but makes it a lot easier for the company to play around with retained earnings however it deems best, instead of needing to jump through hoops to keep deferral going. (By the way, the fact that they are willing to jump through hoops to keep deferral going shows how unrealistic it is to base analysis of deferral on the assumption that repatriation is inevitable at some point at the currently applicable repatriation tax rate.)
Second, it becomes vastly easier to reduce taxes on one’s U.S operations once the U.S. company is merely a subsidiary rather than a corporate parent. For example, the use of both intra-company and third-party debt to strip earnings out of the U.S. and make sure they will show up elsewhere instead can be a highly effective tax planning strategy post-inversion. Pre-inversion, the use of intra-company debt to do this generally doesn’t work well at all (since it triggers passive income, currently taxable in the U.S., from the foreign affiliate that lends to the U.S. company), and loading third-party debt into the U.S. company can also fail to pay off due to our interest allocation rules. For a fuller account, see Stephen Shay’s article in today’s Tax Notes.
An earlier flurry of inversions was shut down by the 2004 enactment of an anti-inversion statute in 2004 that basically prevents pure paper-shuffling transactions from working, as in the case where a U.S. company creates a Caymans affiliate that emerges at the end of the day as the parent on top even though nothing substantive has actually happened. But the rules are now being beaten by transactions that have just enough economic substance to work - e.g., where there is an actual acquisition or merger of some kind, with an actual company located in a country where the U.S. group had some prior activity, but the whole thing is still in fact highly tax-influenced. So the Obama Administration has been calling for legislation to address these transactions and prevent them from being tax-effective.
Yesterday I was on Arise TV, an Africa-based international news and entertainment station, to discuss inversions for a few minutes on a news show. The host wanted to address whether inversions are immoral. My response was, that’s not a very useful way to think about the problem. Companies are going to do what they do (although it’s true that I myself would feel bad about spending my time doing this sort of deal), and the important thing is that we have rules in place that lead to the results we want. More on what I mean by that in a moment.
But inevitably moralistic vocabulary is going to be a part of these discussions. In 2004 there was talk of “corporate Benedict Arnolds,” and President Obama has been speaking of “corporate deserters.” This is pretty much how discussion needs to proceed in general public debate if one accepts – as I do – the bottom line conclusion that allowing the transactions to be tax-effective is undesirable.
As summarized by Treasury Secretary Lew, the proposed legislation would cause inversions to be ineffective for tax purposes if the multinational company “is still managed and controlled in the United States, does a significant amount of its business here and does not do a significant amount of its business in the country it claims as its new home …. [In addition, t]o make sure the merged company is not merely masquerading as a non-U.S. company, shareholders of the foreign company [that ostensibly acquired the U.S. company] would have to own at least 50 percent of the newly merged company – the current legal standard requires only 20 percent.”
I support this legislation because I see no reason why we should let it so be easy for U.S. companies to avoid the repatriation tax that ostensibly has merely been deferred, and because I also see no reason to make it easier for them to strip away U.S. earnings. But the fact that these are the two problems has three broader implications worth noting here.
First, Congress should consider enacting an “exit tax” when U.S. companies with unrepatriated foreign earnings cease to be U.S. companies – even in deals that would pass muster under the new proposed legislation. The exit tax could be based on the amount of U.S. tax that the company would have paid had it repatriated all of its earnings just before the change in legal status occurred. Then deferral for foreign earnings would truly be just deferral, at least so far as this particular escape hatch was concerned. Under the simplest version, the tax due would be the amount of unrepatriated foreign earnings times the U.S. corporate tax, minus the amount of tax reduction that would have resulted from claiming foreign tax credits. But one could also consider other approaches, such as providing “rough justice” in the form of a lower tax rate in lieu of counting up all the credits.
Second, so far as stripping income out of the U.S. tax base is concerned, it would be desirable to move towards having “residence-neutral” rules that applied similarly to U.S. and foreign multinationals. In particular, there ought to be ongoing multilateral discussion (such as through the OECD) of causing information from the entire global corporate group to be available to countries that merely host subsidiaries, rather than the parents. This, for example, would permit the U.S. to apply interest allocation rules neutrally as between U.S. and foreign multinationals, for purposes of measuring U.S. source income.
Third, in the tax policy literature, we ought to be operating from realistic, rather than unrealistic, assumptions. I noted above that deferral does nothing to reduce the present value of the expected repatriation tax if it is certain to be incurred eventually and if the U.S. repatriation tax rate will always be the same. The reason is that, with further standard assumptions, the amount of tax ultimately due grows at the discount rate, so its present value stays the same.
It’s important for people who are working in the field to understand this point, which often is called the “new view” of dividend repatriations but is in fact a provable theorem (aka a tautology) under the requisite assumptions. But what they should NOT do is assume that the assumptions are true. Inversions raise the issue of the deferred tax simply disappearing. But consider as well the fact that the U.S. could change the repatriation tax rate – for example, by lowering it to zero through the adoption of a territorial system without enactment of a transition tax, or through the enactment of further tax holidays. (I say “further” because a dividend tax holiday was enacted in 2004, and there has been lots of discussion of doing it again.)