My remarks at this afternoon's Fordham session on corporate inversions

The panel today, which I mentioned in my previous blog post, was off the record, so I can't address any of the particulars of the session.  But here is the written version of my remarks there:

One of the hazards of being asked regularly to comment on things is that you start wanting to be known as a sage who has made great predictions in advance.  So you get football prognosticators who keep picking the upset special, on the view that no one will remember when they’re wrong, but that they’ll be able to crow about it when they’re finally right.

Insofar as I predicted something in this area, it definitely wasn’t the upset special.  If anything, it was more like predicting that the Mets wouldn’t make the playoffs this year.

And anyway, I didn’t specifically say that we’d be back in the inversion soup so soon after Congress addressed the issue in 2004 (if ten years later is indeed soon).  What I said, with a kind of confirmation from the current inversion controversy, is that a really crucial attribute, in assessing what sort of international tax regime the U.S. should have, is what I call the effective degree of our system’s corporate residence electivity.  If we attach potentially adverse tax consequences to being a U.S. company, then it is important to know how avoidable that status is, or isn’t.

There are multiple margins at which you need to think about corporate residence electivity.  One involves new incorporations, and the extent to which tax considerations affect their occurring in the U.S. rather than abroad.  A second margin involves existing companies, both U.S. & foreign, and the question of which of them are the ones to issue new equity and/or make overseas investments.  And inversions involve a third margin: changing the corporate residence of the company at the top of an existing multinational group, as when a U.S. multinational becomes a foreign one.

When I was doing research for an NYU Tillinghast Lecture discussing corporate residence electivity that I delivered in 2010, I was surprised to hear from leading New York practitioners that, even just for new incorporations, effective electivity appeared to be lower than I had expected.  That is, while they typically told their clients to incorporate abroad for tax reasons, they often didn’t win these arguments.  Data about new incorporations actually seem to bear this out (there’s a paper, for example, by Eric Allen and Susan Morse).  But I thought that corporate residence electivity was likely to rise over time, with adverse long-term implications for the extent to which we can benefit from following policies that seek to impose distinctive tax burdens on U.S., as compared to foreign, multinationals.

At the time of my Tillinghast lecture, the pre-2004 inversion fever had abated, because those deals were generally self-inversions with zero economic substance, making them easy to address legislatively.  What we have now are deals with some economic substance, although often very strong tax planning considerations as well, making the design of rules that will block at least some of them, if that’s what you want to do, more challenging than it had been in 2004.

There are several ways we could address inversions like the ones that we are seeing today, involving actual mergers between foreign and U.S. companies that are not pure cases of a minnow swallowing a whale.  One is just to let them happen.  Another is to change the rules by requiring somewhat more economic substance than we do under current law.  A third, emphasized by the Treasury in recently issued regulations, is to reduce the expected tax advantages of these deals.  And a fourth is more generally to address the differences in U.S. tax treatment of U.S.-headed, as compared to non-U.S.-headed, multinationals.

Before saying more about that, I want to address two half-truths that purport to explain why U.S. companies may engage in these deals.

According to the first half-truth: “U.S. companies want to invert because the U.S. tax rate is just too high.” 

Now, it’s true that the U.S. corporate tax has a 35 percent statutory rate, even disregarding state-level corporate income taxes, and that peer countries have lower statutory rates.  But first, the average or effective tax rate matters more for many taxpayer decisions than the statutory rate applying at the margin, and U.S. companies’ overall effective rates do not appear to be out-of-line with those that foreign companies pay.

Second, the U.S. source income of foreign as well as U.S. companies is, at least on its face, generally taxable by us at 35 percent.  If that rate is too high, this goes more to the domestic corporate tax rate question than to inversion issues.

So why isn’t it wholly false to say “U.S. companies want to invert because the rate is too high,” instead of the clearly true statement: “Companies will be more interested in shifting their investments and claimed profits abroad if our rate is high, than if it is low”?  The reason the first statement isn’t wholly false is that there actually is a practical link between inversion and the effective domestic tax rate.

A major reason why U.S. companies want to invert is the hope that this will make it easier for them to reduce reported U.S. source taxable income, even if their true economic activities around the world remain the same.  This reflects what I’d call existing anti-base erosion features of the U.S. international tax rules – involving, for example, interest allocation and subpart F.  These rules, at least when they’re working effectively, can make it harder for U.S. companies than foreign ones to lower their U.S. tax bills through such planning steps as assigning lots of debt, including intercompany debt, to the U.S. affiliates in a global group. 

The second half-truth about inversions goes as follows: “U.S. companies want to invert because we, unlike most other countries, tax our resident companies’ foreign source income.”  Well, perhaps this is even a two-thirds truth.  But it does require amplification and correction, potentially changing its apparent implications a bit, if we actually want to understand it.

Now it’s formally true that we have a “worldwide” system, in which U.S. companies’ foreign source income, even if earned through foreign subsidiaries, is eventually supposed to be taxable here.  Most of our peer countries have territorial systems, in which at least active business income that’s earned abroad is domestically exempt, albeit potentially subject to the reach of anti-tax haven rules.

For three particular reasons, however, the statement can misleading if one doesn’t say a bit more about it.

First, we don’t do a great job of taxing U.S. companies’ officially reported foreign source income.  More than $2 trillion of that income is currently reported for accounting purposes as “permanently reinvested abroad” – which means that the companies have successfully argued to their auditors that they will NEVER have to pay the U.S. repatriation tax.  The reason those companies may be interested in inverting is to make it easier for themselves to access the funds that they have stashed abroad, without as much concern about triggering a taxable U.S. repatriation.  This can reduce their tax planning costs even if they would never have paid the U.S. tax anyway.  Now, this is potentially a pro-taxpayer point, since no one wins except for the lawyers when the companies incur extra tax planning costs, but it does show that we’re not overtaxing as such.  The conclusion might be, not that we are taxing U.S. companies’ foreign source income too much, but that we are doing it the wrong way.

Second, a lot of the foreign source income on which U.S. companies want to avoid paying U.S. tax may actually, as an economic matter, have been earned here.  Again, this goes to the U.S. base erosion and profit-shifting opportunities that are greater here for foreign than U.S. multinationals.  Now, this does mean that the U.S. companies can truthfully say that they are trying to put themselves on more of a par with their foreign rivals, although the issue here is actually U.S. rather than foreign investment.  But we may not be entirely happy about it in either case.

Third, some of the motivation for inversions relates to the past, not the future.  Suppose you are a company with $10 billion of foreign earnings.  If you repatriated the funds today, you would pay $3.5 billion of U.S. tax on this income, minus the amount of any foreign tax credits (which may be trivial if you have stashed most of the profits in tax havens).  The only reason the U.S. doesn’t make you pay that tax is that we have deferral, permitting you to postpone the payment until you actually repatriate the funds.  Deferral is a realization rule.

In theory, deferral – unlike realization in some other cases – doesn’t reduce the present value of your U.S. tax liability.  After all, the amount that’s waiting to be repatriated presumably is growing annually at your after-foreign tax rate of return.  Thus, in terms of my earlier example, in theory you’ll eventually pay $3.5 billion plus interest on earnings of $10 billion plus interest, eliminating the present value benefit of deferral.  So, again in theory, allowing deferral to U.S. companies is like granting them a loan – and not an interest-free loan, but a true loan with a floating market rate that automatically depends on actual rates of return.

As soon as you invert, however, this may change.  Even if the U.S. company’s prior foreign subsidiaries remain below it on the ownership chain, with the new foreign parent standing above both, it may now become much easier in practice to avoid ever paying the U.S. repatriation tax.  You may have more ways than you had pre-inversion to actually access the funds while you sit and wait for the next corporate tax rate cut, or foreign dividend tax holiday, or the enactment by Congress of a territorial system, all of which might potentially reduce or even eliminate the deferred tax bill.

So allowing U.S. companies to invert without triggering realization of the deferred gain is a bit like allowing them to increase the likelihood of default on a loan.  This is why there has been some talk of an exit tax – a deemed taxable repatriation – when U.S. companies invert, even if the U.S. company’s foreign subsidiaries still stand below it in the ownership chain.

“Exit tax” is an ugly-sounding term.  It brings to mind Soviet-era harassment of dissidents.  So let me propose a term that sounds better and yet is metaphorically accurate: loan repayment acceleration.  When you own your home subject to a mortgage, and you sell the house and buy a new one, they generally make you repay the loan.  I think we should consider applying such an approach to deferral, via deemed repatriations when U.S. companies expatriate, on the view that the loan’s “credit risk” – i.e., the chance that it will never be repaid, has likely increased.  This doesn’t mean that the special tax rate here should be as high as 35 percent, even in the absence of foreign tax credits – but perhaps a zero tax rate on deemed repatriations when you invert, by reason of not deeming them at all, is too low.

Now, companies that invert are typically looking forward as well as back.  They want to ease profit-shifting and their access to foreign earnings for the future, not just retroactively for the earnings that already are stashed abroad.  So the tax motivations for a given deal are likely to go beyond easing the company’s full access to permanently reinvested earnings.

Given that issue, I would like to see us move in the direction of adopting what I call more residence-neutral rules for determining the source of income – and in substance, not just formally, although this is tricky when the methods used to address base erosion include treating resident companies’ claimed foreign source income as currently taxable, rather than re-defining it as actually U.S. source.

I also agree that we have to accept that we are living in a world in which corporate residence electivity, genuine capital mobility, and inevitable source tax reporting flexibility mean that it’s going to be growing ever harder to hold the line.  Indeed, some retreat from relying on entity-level corporate income taxes, and income taxes more generally, is surely in order – perhaps even a large retreat, depending on what else is on the tax reform table.  But that requires a much bigger conversation, and in the interim I believe that we should take some steps to hold the line a bit longer, both on the corporate inversions front and with regard to base erosion and profit-shifting generally.

Even if we are in retreat with regard to taxing corporate income at the entity level, there is a difference between an orderly withdrawal and a rout.  Making it too easy to escape the U.S. tax net, especially when that means that you can get a kind of retroactive windfall gain from reducing the expected tax burden on foreign earnings that you accumulated in the past, would in my view make the retreat too much of a rout.