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Global: Tax topical focus – corporate inversions FAQ

21 August 2014   (0 Comments)
Posted by: Author: Tax-News.com Editorial
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Author: Tax-News.com Editorial

To some, US companies switching their tax residency to gain a tax advantage are economic "traitors.” To others, they are victims of a United States tax code that effectively punishes them for investing at home and encourages them to look for opportunities overseas. In this Tax-News Topical Focus, we try to make sense of the corporate inversion debate in a "frequently-asked questions” style.

What are corporate inversions?

In summary, corporate inversions have been used by US companies when bidding for (generally smaller) foreign companies, as a means of moving away from the high American 35 percent corporate tax rate. A company that merges with an offshore counterpart can move its headquarters abroad (even though management and operations may remain in the US), and take advantage of the lower corporate tax rates in foreign jurisdictions as long as at least 20 percent of its shares are held by the foreign company's shareholders after the merger. 

Why have corporate inversions become such an issue in the United States?

According to data relayed to Congress by senior Treasury official Robert B. Stack in July 2014, 47 corporate inversions had taken place in the previous 10 years. So this is hardly a new issue. Indeed, it was a major talking point in the run-up to the 2002 congressional elections. However, there does seem to have been a flurry of deal making activity this summer, mainly involving the pharmaceutical sector.

Tax isn’t the only reason why US multinationals choose to acquire foreign rivals. One obvious advantage of doing so is access to potentially lucrative foreign markets. And much greater economies of scale can be achieved when two companies are combined. But it is the belief that companies are "gaming the system,” as President Obama puts it, by inverting that has come to the fore. And given that 2014 is also an election year, it should come as little surprise that this issue has taken on extra significance.

In an address to a college in Los Angeles, the President painted corporate inversions as a "threat" to the US tax base. These companies want to have "all the advantages of operating in the US,” he said, but "just don't want to pay for it." He added that, by technically renouncing their US citizenship, the companies are "cherry-picking the rules."

"I don't care if it's legal – it's wrong," he fumed.

According to a Congressional Budget Office calculation, the US Treasury stands to forgo some USD20bn in corporate tax revenue if the inversion "loophole” is not fixed. The extent of the revenue loss to the US as a result of companies continuing to shift their tax bases offshore is open to much debate, however. Indeed, there is a school of thought that the Treasury could actually benefit in the short-term, because individual shareholders resident for tax purposes in the US will have to pay capital gains tax if they make gains on stock bought by the foreign company.

Because US capital gains tax rates vary depending on how long shares have been held and the income level of the shareholder, and because nobody has any real idea at the moment how many affected shareholders are US tax residents, it is impossible to say how much capital gains tax revenue will be raised. There are ways for shareholders to avoid capital gains tax perfectly legally, but it is thought that new capital gains tax revenue could at best offset corporate tax revenue losses, and at worst cushion the blow to the Treasury.

What is Congress planning on doing about corporate inversions?

Two brothers, Ranking Member of the House of Representatives Ways and Means Committee Sandy Levin and Chairman of the Senate Permanent Subcommittee on Investigations Carl Levin, both Michigan Democrats, have introduced similar bills that would restrict the use of corporate inversions by US multinationals.

The two new bills would include a proposal made by President Obama in his 2015 budget proposals – to restrict corporate inversions by putting the minimum foreign shareholding at 50 percent. However, the bill in the Senate would contain a two-year sunset clause, while in the House the restriction would be permanent. The restrictions would apply retroactively to inversions after May 8, 2014.

Another piece of proposed legislation, the Bring Jobs Home bill, takes a different approach by providing a 20% tax credit against "eligible insourcing expenses" associated with relocation to the US on the condition that the company increase its workforce of full-time US employees. Allowable expenses would include costs incurred by the taxpayer in connection with the elimination of any of its business units (or of any of its affiliates) located outside the US, as well as those incurred by the taxpayer in connection with the establishment of a new business unit to be located in the US.

The bill also has a sting in the tail for would-be inverters, denying businesses any tax deduction for moving expenses if those costs are associated with an elimination of a business unit in the US and the establishment of a new business unit abroad. 

The bill failed to attract the 60 votes needed to move it to a full vote in the 100-member State however, with Republicans deriding the proposals as an election year gimmick. Orrin Hatch, the Senate Finance Committee’s senior Republican, also pointed out that the math doesn’t add up, because while the tax credit would cost USD357m over 10 years, denying the deduction on businesses expenses associated with "outsourcing” would only bring in USD143m over the same period.

In a display of how seriously Democrats and the Obama Administration are treating this issue however, measures are now being explored that would not require new legislation, therefore taking a deadlocked Congress out of the equation.

Answering questions at a press conference after the US-Africa Leaders Summit on August 6, 2014, Obama confirmed that he is looking to take whatever measures he can, including utilizing his administrative regulatory powers, while awaiting congressional action, to reduce tax benefits for inversions.

The flow of corporate inversions has also come about because America’s tax code has become increasingly uncompetitive and inefficient; at 35%, the US has the highest statutory rate of corporate tax in the OECD – that’s before state corporate tax rates are added on – and it is said that around USD1 trillion in tax revenue is lost each year through hundreds of special interest tax expenditures. Both Democrats and Republicans are in agreement that the US tax code needs an overhaul and that the corporate tax rate needs cutting, although they differ fundamentally on what tax reform should achieve: Democrats want tax reform to raise additional revenue to contribute to deficit reduction, while Republicans want revenue-neutral tax reform.

Republicans however are in favour of more radical corporate tax reform. Congressman Dave Camp’s (R – Michigan) tax reform blue print published in February 2014 calls for a switch to a quasi-territorial tax system from America’s current worldwide tax basis – thought to be a major reason why US multinationals have parked hundreds of billions of dollars in profits offshore.

Camp believes that his proposal would end the "lock-out effect" that discourages companies from bringing foreign earnings back to the US, putting American companies on a more level playing field with foreign competitors.

Democrats on the other hand, while in favour of cutting corporate tax, want to take America further towards a full worldwide basis of income tax.

However, some tax experts, like Edward Kleinbard, disagree that US multinationals are suffering as a result of the US tax code, because they are already paying effective tax rates in the low teens.

A former Joint Committee on Taxation chief of staff and currently University of Southern California Gould School of Law professor, Kleinbard asserted in a recent paper on the subject that the recent surge in interest in inversion transactions is explained primarily by US-based multinational firms' "increasingly desperate efforts to find a use for their stockpiles of offshore cash,” and a desire to 'strip' income from their US domestic tax base through intragroup interest payments to a new parent company located in a lower-taxed foreign jurisdiction.

"These motives," he adds, "play out against a backdrop of corporate existential despair over the political prospects for tax reform, or for a second 'repatriation tax holiday' of the sort offered by Congress in 2004," not international tax rate competitiveness.

In any case, the chances of comprehensive tax reform taking place this side of the midterm elections are next to zero.

How is the corporate world responding to the threat?

At least one US company intending to flip its tax residence appears to have got cold feet as the corporate inversion debate has snowballed. In exercising its option to purchase its remaining 55 percent stake in Alliance Boots, Walgreens, America’s largest drugstore chain, has decided against moving its tax residence from the United States to Switzerland. It is thought that the move could have saved Walgreens around USD4bn a year in tax, but the company wasn’t confident that the transaction would withstand scrutiny by the Internal Revenue Service. Walgreens said it was also "mindful of the ongoing public reaction to a potential inversion” with a major portion of its revenues derived from government-funded reimbursement programs.

However, most of the business world remains defiant in the face of increasingly fierce criticism from Democrats and their sympathisers. During remarks made in conjunction with release of the company's interim financial results to June 30, 2014, Mylan Inc's CEO Heather Bresch confirmed that it is to proceed with its plan to acquire some of Abbott Laboratories' non-United States businesseand move its tax residence to the Netherlands. Mylan's tax rate is expected to be lowered to around 20-21 percent in the first full year, and to the high teens thereafter, as a result of this transaction.

Bresch felt that "it would be challenging to change the US tax code to stop inversion without punishing other foreign companies. Being punitive and not allowing us to be competitive, I do not believe, is in our country's best interest.” She also condemned the "uneducated” nature of the corporate inversion debate.

The Organization for International Investment (OFII), a lobby group for the US operations of some of the world’s leading companies, warns that any inversion "quick fix” could backfire on the US economically by inadvertently affecting its members, making the US a less attractive place for FDI.

The OFII is specifically concerned by the calls to tighten rules governing the deduction of interest expense, which it fears may not be limited to US companies that re-incorporate abroad through inversions, but instead impact all US subsidiaries with foreign ownership. Another proposal of concern is that management and control provisions may be tightened to such an extent that foreign companies could be treated as resident in the US for tax purposes even if they have a relatively small presence in the country.

President Obama’s barb that the accounting industry is just as culpable for the increasing number of corporate inversions by helping companies find "loopholes” brought a predictably prickly response from the New York State Society of Certified Public Accountants. The Society’s Scott Adair responded that the President "should be aware that US corporations hire accountants for their distinct ability and expertise in seeing that clients fulfil their tax obligations as required by the laws adopted by Congress. In fact, it is a CPA's unique ability to legally navigate an extraordinarily complex tax code that makes a CPA's services so valuable to his or her individual and corporate clients." Comprehensive tax reform is the answer to the corporate inversion issue, Adair said.

Windstream, the advanced communications provider, has however, decided to take another route towards escaping America’s high corporate tax by planning to spin off its telecommunications network assets into an independent, publicly-traded real estate investment trust (REIT). REITS do not pay US corporate tax as long as they distribute at least 90 percent of their taxable income to shareholders annually in the form of dividends. As "pass through" entities, their owners and shareholders pay individual income tax on the dividends they receive.

The IRS’s recent acceptance that non-traditional real estate assets (such as office buildings, warehouses, shopping centers, and health care facilities) may be held in a REIT appears to have encouraged more American corporations to consider converting, or at least spinning-off assets, into REITS. However, it won’t be very surprising if these types of transaction also come under the microscope, given the politicised nature of the corporate tax avoidance debate.

So is there any realistic possibility of change?

While some Republicans sympathise with President Obama’s call for more "economic patriotism” from corporate America, in reality, Democrats and Republicans are probably too far apart on this issue for legislation to be passed restricting the benefits of inversions.

With Congress not set to return from its summer recess until September, there is precious little legislative time left before the election hiatus. Some commentators suggest that it is more likely that the Treasury will act unilaterally to plug the inversion loophole, but others think that the tough rhetoric on this matter coming out of the administration is merely sabre-rattling designed to deter further corporate inversions.

In an op-ed written for the Washington Post, Senator Hatch confirmed that there may be steps that Congress can take in the short-term to address the problem, but, although concerned by the recent spate of inversions, he continued to urge a cautious approach from lawmakers.

He continued to insist that any fix should not be punitive or retroactive, but suggested that there may be a way to address this issue in a "bipartisan manner.” However, if these two Republican conditions are set in stone – and recent experience suggests they probably are – it would seemingly rule out the possibility of a bipartisan solution.

This article first appeared on tax-news.com.



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