Here are some reasons why you should know about Tax Inversions
Tax inversions have been in the news recently due to a number of high profile corporate tax inversions, which have led the US Treasury Department to impose tough new rules to limit the number of inversions. Examples of recent tax inversions are Burger King relocating its domicile to Canada after acquiring Canadian corporation Tim Hortons and Medtronic moving its domicile to Ireland after acquiring Covidien, an Irish corporation. US pharmaceutical giant Pfizer Inc was pursuing the acquisition of Allergan PLC, an Irish company, in order relocate its domicile to Ireland. That move has now been put on hold due to the Treasury Department’s new rules.
A corporate tax inversion is the relocation of a company’s domicile from one country to another in order to reduce the tax burden on income earned abroad. It is important to point out here that relocating its domicile does not equate to relocating its operations- the corporation can continue to carry out its operations in much the same manner as it did before the inversion; the only difference being that it is now subject to the laws of the new country of domicile rather than the old one. Reducing it’s tax burden this way can be hugely beneficial for a corporation- Elizabeth Chorvat, a Visiting Assistant Professor at the University of Illinois, has shown that between 1993 and 2002 inversions generated statistically and economically significant excess returns of 224.7% in the years following the inversion transaction.[1]
The chief reason inversions are such an attractive proposition for US multinational corporations (MNCs) is that the US, which operates a worldwide tax regime, is increasingly out of step with other industrialised countries, which use a territorial tax system.[2] Under the US worldwide tax regime income originating outside the US is taxed when those earnings are repatriated. Under the territorial tax system employed in other industrialised countries such as Canada, Germany, Japan and the UK, the residence country taxes only active business income earned within its borders. Foreign-owned MNCs are therefore able to significantly reduce their US tax liability on US operations compared with their US MNC competitors.[3] US MNCs therefore face a competitive disadvantage in comparison with their foreign-owned peers.
The failure of Congress to enact comprehensive tax reform to address this has led many US MNCs to undertake inversions. Bret Wells, Associate Professor of Law at the University of Houston Law Centre, has argued that faced with this situation it is no surprise that company directors, who have a fiduciary duty to maximize returns to their shareholders, choose to opt for inversions.[4] He quotes the decisions in Gregory v Helvering (1935)[5] and Commissioner v Newman (1947),[6] two prominent court decisions that say there is nothing wrong with arranging one’s affairs so as to keep taxes as low as possible and that nobody owes any public duty to pay more taxes than the law demands.
The problem with inversions, however, is that they erode the US tax base and put other US corporations at a competitive disadvantage.[7] After inversion most MNCs engage in earnings stripping, a practice in which foreign-based corporations avoid paying US taxes by artificially shifting their profits out of the US. They do this by having a US subsidiary pay interest on a loan from a subsidiary in another country, typically a low-tax country. The US subsidiary lowers its taxes in the US by deducting the cost of its interest payments and the foreign subsidiary owes little or no tax on those interest payments- it’s a win-win for the inverted MNCs.[8] This win, however, comes at the expense of other US corporations. Treasury Secretary Jack Lew argues that many MNCs that opt for inversion continue to enjoy the benefits of being based in the US including access to US markets, the rule of law, patent and intellectual property enforcement, support for research and development, infrastructure and a skilled workforce even though these inverted MNCs shift a greater tax burden to other businesses and American families.[9] The Congress Joint Committee on Taxation has said that inversions will cost the US Treasury over $40 billion in the 10 years between 2015 and 2025.[10]
The problems associated with inversions led the Treasury Department to bring in new rules, in April 2016, that make it more difficult and less lucrative for corporations to exploit the inversions loophole. Although these new rules will reduce the number of inversions, only legislation passed by Congress can get rid of inversions completely. The time is long overdue for Congress, not just to get rid of inversions, but also to comprehensively reform the US tax system in order to make it more efficient and effective.
[1] Elizabeth Chorvat, Expatriations and Expatriations, A Long-Run Event Study (September 20, 2015). U of Chicago, Public Law Working Paper No. 445. Available at SSRN: http://ssrn.com/abstract=2309915 or http://dx.doi.org/10.2139/ssrn.2309915 [2] ibid [3] Bret Wells, What Corporate Inversions Teach About International Tax Reform, Tax Notes, June 21, 2010, p. 1345, Doc 2010-11447, 2010 TNT 119-5 [4] Bret Wells, Cant and the Inconvenient Truth About Corporate Inversions, Tax Notes, July 23, 2012, p.437 [5] Gregory v Helvering, 293 U.S. 465 (1935) [6] Commissioner v Newman, 159 F.2d 848, 850-851 (2d Cir. 1947) [7] Jeffrey Zients & Seth Hanlon, The Corporate Inversions Tax Loophole: What you Need to Know, The White House Blog, April 8, 2016, https://www.whitehouse.gov/blog/2016/04/08/corporate-inversions-tax-loophole-what-you-need-know [8] ibid [9] US Department of Treasury, “Treasury Announces Additional Action to Curb Inversion, Address Earnings Stripping”, April 4, 2016, https://www.treasury.gov/press-center/press-releases/Pages/jl0405.aspx [10] Congress Joint Committee on Taxation, Memorandum on Revenue Estimate Request for H.R 415, http://democrats.waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/JCT%20Score%20July%202015.pdf