USA: Tax inversions must be stopped now
22 July 2014
Posted by: Author: Edward D Kleindard
Author: Edward D Kleindard (WallStreetJournal)
The $54 billion AbbVie-Shire deal is the latest sign that the system needs fixing.
On Friday the U.S. drug maker AbbVie announced a plan to buy the U.K.-based Shire in a $54 billion deal, from which AbbVie will emerge as a subsidiary of the U.K. firm. It is but the latest example in a flurry of acquisitions known as inversions.
In an inversion, a large U.S. firm acquires a much smaller target company domiciled in a tax-friendly jurisdiction such as Ireland or the U.K., but the deal is structured so that the foreign minnow swallows the domestic whale. U.S. shareholders of the U.S. firm must pay immediate capital gains tax for the privilege of inversion, and the U.S. company ends up as the nominal subsidiary of a publicly held foreign corporation.
The deals are driven by planning to avoid paying the U.S. tax that applies when firms repatriate their low-taxed foreign earnings to the U.S. This has triggered demands—most recently, from Treasury Secretary Jack Lew —to close down inversions through the tax code, or to deprive inverted firms of government contracts or other benefits.
Firms that invert argue that the deals are "legal," harmless to U.S. tax-revenue collection, and a necessary response to our anticompetitive world-wide corporate tax system. The first point is a red herring and the second demonstrably false, but there is a kernel of truth in the third.Inversions are "legal" in the sense that they do not violate relevant tax rules.
But the real question is whether the rules should be changed.
Yes. If allowed to continue, inversions will eviscerate the U.S. domestic corporate tax base, because making a foreign company the parent of a U.S. firm opens up new tax-avoidance possibilities. The first thing an inverted firm will do is "lever up" the U.S. subsidiary by replacing its equity with intercompany loans from the foreign parent. The newly created intercompany interest expense will reduce tax paid on domestic earnings to nominal levels. (There are U.S. laws to limit this strategy, but they are too weak to have much effect.)
Then the inverted company will use the U.S. firm's stockpile of offshore cash. There's a lot of money in the treasure chest: U.S. firms hold nearly $1 trillion abroad, accrued over time by booking earnings in tax havens. The same tax-haven subsidiary of the U.S. firm owns the cash after an inversion transaction as did before the inversion, and therefore the cash cannot directly fund a dividend to the immediate U.S. parent without U.S. tax. But good lawyering gets you close.
As an example, a tax-haven subsidiary can lend its cash to the new foreign parent at very low interest rates. The foreign parent can then use the cash to fund higher-yielding projects in the U.S., to repay loans used to finance the inversion transaction, or to pay dividends or buy back stock from U.S. investors. Through these "hopscotch" transactions, cash skips over the immediate U.S. parent, and U.S. taxes are avoided. Also, cash is fungible. A U.S. firm's offshore cash can fund foreign operations, while the new foreign merger partner's operations can fund U.S. domestic operations.
Inversions thus enable inverted firms to shed their domestic U.S. corporate tax liability. They also allow companies to use existing offshore cash to fund U.S. investments, which typically cannot be done without paying U.S. tax. And once a company has inverted, it is gone. Corporate tax reform will not be able to undo the damage done to the U.S. tax base.
Companies argue that inversions are a reasonable response to an anticompetitive U.S. corporate tax system. But the hoary complaints about competitiveness are simply not true, as a quick glance at the financial statements of many U.S. firms pursuing inversions reveals.
Take AbbVie: The drug maker reported a global effective tax rate for 2013 of 22.6%, a roughly one-third discount off the U.S. statutory rate of 35%, largely as a result of its low-taxed foreign earnings. What's at stake for U.S. firms is their ability to goose their stock prices through dividends and buybacks funded by low-taxed foreign cash, not international "competitiveness."
Yet inversions are symptomatic of a corporate tax system that is highly distortionary, unstable and riddled with loopholes. The headline rate of 35% is well above world averages, effective rates imposed on investments vary wildly, and the international rules in particular are an incoherent mess. Inverting firms try to justify corporate self-help as the right response, but inversions both gut the domestic tax base and allow key players (those with international operations) to excuse themselves from the debate, while domestic firms are left holding the bag.
Thus fundamental corporate tax reform is urgently needed, but the path forward has two prongs. First, Congress should enact a temporary law to preserve the status quo, and thereby the corporate tax base, by treating inversions according to their economic substance, and by foreclosing the "hopscotch" strategies described above. Without this, there will be no corporate tax base left to reform.
Then both parties need to get serious about substantive reform, lowering the rate to say, 25%, and imposing a stable international regime that works well with territorial systems in other countries. The work Congress's tax-writing committees did last year shows that reform is possible. Now congressional leadership needs to make it a priority.
Mr. Kleinbard is a professor of law at the University of Southern California. His book, "We Are Better Than This: How Government Should Spend Our Money," will be published in October by Oxford University Press.
This article first appeared on online.wsj.com.