Please enter your email address to receive a password reminder.
Log into Tax-News+
If you are an American taxpayer, it's quite likely that you've heard about corporate inversions, and that they make you very angry – even if, like most people (and politicians?) you know nothing about the finer points of international corporate finance. However, following the decision by Pfizer and Allergan to terminate what would probably have been the largest and most controversial inversion of modern times, has the United States Treasury finally put-paid to this much-despised corporate tax avoidance technique?
In this feature, we give the low-down on corporate inversion, and the efforts of the Government and Congress to stop them from happening.
So What Is a Corporate Inversion?
Simply put, 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.
Counting The Costs of Inversions
Most people assume that the US Treasury will forgo billions of dollars in future revenue as a result of inversions – a loss that will have to be recouped elsewhere in the tax system. However, it is actually very difficult to put a precise figure on the impact of these transactions because there are so many variables – and because the issue is so highly politicized.
Some point out however, that corporate tax rate avoidance is just the half of it. The ability to practice "earnings stripping" is a much more powerful incentive for a US company to invert, it has been argued. This occurs when US subsidiaries borrow from their new foreign parent company (or another foreign affiliate) to increase their interest payments, reduce their taxable income, and lower their US taxes. The foreign lender then typically pays a reduced or zero tax rate on the interest income under an existing tax treaty.
On the other hand, some tax experts contend that the actual impact on the US tax base is negligible because forgone revenue is likely to represent just a fraction of the overall federal tax take. Others have even suggested that the Treasury is likely to receive a short-term revenue boost from the recent wave of inversion activity, because US investors owning shares in the target company will pay capital gains tax. Just how many US shareholders will pay tax, and how much they will pay, remains something of a mystery, however.
One of the hardest estimates we do have comes from the Joint Committee on Taxation, a nonpartisan committee of the United States Congress, which says that the US Treasury is set to forgo USD33.5bn in corporate tax revenue over ten years as a result of inversions – a figure it recently revised upwards from a previous estimate of USD20bn. Ultimately however, it seems that it is almost impossible to say with any degree of certainty what the revenue impact of the recent inversion wave will be. This is a fact that even the Treasury acknowledged in a 2007 report on inversions, in which it states that "it is not possible to quantify with precision the extent of earnings stripping by foreign-controlled domestic corporations generally."
Plugging The Inversion "Loophole"
Irrespective of the revenue figures associated with inversions, there is a consensus across the political divide that these transactions, while legal, are wrong. As President Barack Obama has remarked, these corporations are effectively renouncing their citizenship by inverting, yet they still benefit from the American system, including its taxpayer-funded infrastructure. By "cherry-picking the rules," these companies want to have "all the advantages of operating in the US," but "just don't want to pay for it," the President has said.
So why has the Government and Congress been so slow to act? The short answer is that the Government itself, as the executive not the legislative arm, is limited to what it can do. But Congress, as has been the case on many important issues during President Obama's tenure, is divided.
Nevertheless, over the past couple of years, the US Treasury, using its executive authority, has, rather contentiously, issued several batches of temporary tax regulations designed to discourage corporations from inverting.
The latest proposed regulations were announced by the Treasury on April 4, 2016 and attempt to limit earnings. The regulations will target transactions that generate large interest deductions by simply increasing related-party debt without financing new investment in the United States.
The Treasury has emphasized that the proposed regulations generally do not apply to related-party debt that is incurred to fund actual business investment, such as building or equipping a factory; and that they only apply to debt issued between related corporations, subject to a general anti-abuse rule for structured transactions involving unrelated persons.
Separately, in a new temporary regulation, Treasury will limit inversions by disregarding foreign parent stock attributable to recent inversions or acquisitions of US companies. This measure is intended to prevent a foreign company (including a recent inverter) that acquires multiple American companies in stock-based transactions from using the resulting increase in size to avoid the current inversion thresholds for a subsequent US acquisition.
For the purposes of computing the ownership percentage when determining if an acquisition can be treated as an inversion under the current US tax code, the action therefore excludes stock of the foreign company attributable to assets acquired from an American company within three years prior to the signing date of the latest acquisition.
Will The Regulations Work?
It's the 64,000-dollar question. The Administration has claimed the credit for knocking the Pfizer/Allergan merger on the head as a result of the new regulations. However, previous regulatory action announced in 2014 and 2015 seems to have had little in the way of deterrent effect on large US corporations seeking inversion partners, and it is too early to say how the corporate world will react to the new ones. It may be that the latest regulations are a mere sticking-plaster which become steadily less effective as time goes on as taxpayers find new ways to legally cut their tax bills.
Nevertheless, even the Government itself acknowledges that regulations aren't the long-term solution. As Treasury Secretary Jacob Lew observed at the time the new regulations were announced: "This will have an important effect, but we cannot stop these transactions without new legislation. Ultimately, the best way to address inversions is to reform our business tax system."
Or, as Orrin Hatch (R – Utah), the Republican Chairman of the Senate Committee on Finance put it: "The Administration continues to tinker along the regulatory edges with unilateral proposals to address the symptoms of inversions. … A better approach would be for the administration to work with Congress in good faith to address the disease causing our companies to move offshore: our outdated tax code that burdens our job creators with the highest corporate tax rate in the developed world."
However, as mentioned earlier, the majority of Republican lawmakers disagree fundamentally with their Democrat counterparts on the details and intended outcomes of tax reform.
Legislative Proposals To Curb Inversions
Essentially, the reason for the stark partisan divide over the issue of tax reform boils down to the following:
Republicans want "revenue-neutral" reform with lower and simpler taxes and a more "territorial" (as opposed to worldwide) basis of taxation that incentivizes US corporations to remain in America, and foreign companies to establish there.
Democrats also want lower and simpler taxes, but not for the wealthy and large corporations. They envisage a continuation, even an expansion of the worldwide tax system, and, crucially, want tax reform to raise revenue to pay down the federal budget deficit.
In other words, the Republican carrot versus the Democrat stick.
These differences are reflected vividly in the various proposals put forward to curtail corporate inversions, with Democrats having introduced numerous proposals into Congress to deal specifically with this problem, but Republicans favoring a more holistic approach which removes incentives to invert as part of wider corporate tax reform.
Recent Democrat bills include the Stop Corporate Inversions Act, which would increase the minimum foreign shareholding cap to 50 percent; the Putting America First Corporate Tax Act, which would cancel the provision in the current US tax code that allows corporations to defer paying corporate tax on foreign profits until that money is repatriated back to the US and require corporations to pay US taxes on all future domestic and foreign active income; the Stop Corporate Earnings Stripping Act, which would limit the use of earnings stripping techniques; and the Pay What You Owe Before You Go Act, which would impose a 35 percent "exit tax" with credits for foreign taxes paid against the overseas profits of corporations seeking to invert.
Commenting on the initial announcement that Pfizer and Ireland-based Allergan had agreed to merge, Democratic Senate Minority Leader, Harry Reid (D – Nevada) said it is "time for Congress to get serious, close the loopholes, and prevent these kind of inversions from happening in the future." Democratic Party presidential candidate Hillary Clinton also looked for the closing of the "loopholes that allow [corporations] to hide earnings abroad to lower their taxes. … We cannot delay in cracking down on inversions that erode our tax base."
However, in an illustration of the partisan divide, the Republican Chairman of the House Ways and Means Committee, which has jurisdiction over tax legislation, said that standalone anti-inversion legislation would be ultimately self-defeating. He argued that "the only real solution to inversions is tax reform that makes American companies more competitive. Mandating new rules to raise taxes on American businesses simply make them more attractive takeover targets for foreign corporations."
In like manner, Orrin Hatch responded that "the best way to resolve these [inversion] issues would be through a comprehensive tax overhaul that lowers the corporate tax rate and shifts the US to a territorial tax system." He later added that the Pfizer-Allergan transaction "only further underscores the arcane, anticompetitive nature of the US tax code."
What Do Businesses Think?
Unsurprisingly, America's business lobby has been more inclined to align itself with the Republican carrot rather than the Democrat stick. And they see any other solution other than comprehensive pro-business tax reform as flawed.
In an article on the US Chamber of Commerce website, its Senior Tax Policy Counsel, Anne Warhola, warned that recent legislation introduced into Congress with the aim of discouraging US multinational companies from undertaking corporate tax inversions "misses the point."
Recent Democrat proposals fail to address the "fundamental flaws in the US international tax system that are causing the rise in inversions," she wrote, adding: "Until Congress enacts comprehensive tax reform with a lower rate and a more competitive international tax system, corporations will continue to seek a level playing field."
In a 2014 study by BDO USA, 79 percent of company board directors believe the increased use of corporate tax inversions is an expected outcome given the United States' high corporate tax rate, and, of those, a majority looked to tax reform legislation as the means by which Congress could properly address the issue. A majority (56 percent) of directors were in favor of Congress addressing the issue directly through legislation, and, of those in favor of legislative action, 85 percent saw that any remedy must be part of broad-based reform of both the corporate and personal income tax codes.
But Has The Government Delivered The Corporate Inversion A Fatal Blow?
The Government may have claimed to delivered a terminal blow to the Pfizer/Allergan merger, but as suggested above, it is too early to judge whether the new tax regulations, in combination with those announced since 2014, will stall the current wave of inversions.
While the United States maintains the OECD's highest statutory rate of corporate tax, however, US corporations will have an incentive to cut their tax bills by every legal means possible, and will doubtless continue to explore the inversion trail, even if they risk a public relations drubbing in so doing.
It seems clear that this trail won't be blocked off by regulatory action alone. Legislation is needed to do that. But legislation can only come from Congress, and until both sides are prepared to compromise, or until one party gains a decisive majority allowing them to push bills through the House and Senate more easily, nothing will change on the legislative front.
The 2016 elections do present an opportunity for the recent congressional stalemate to be swept away, which means that things could start to get very interesting on the tax front in 2017. However, until then, and probably for some time after as well, corporate inversions will probably remain one of America's hottest topics.
Tags: tax | regulation | tax reform | legislation | business | United States | Tax | interest | law | investment | offshore | mining | tax rates | Ireland | exit tax | budget | Finance | business investment | Work | Other | Regulations
IMPORTANT NOTICE: Wolters Kluwer TAA Limited has taken reasonable care in sourcing and presenting the information contained on this site, but accepts no responsibility for any financial or other loss or damage that may result from its use. In particular, users of the site are advised to take appropriate professional advice before committing themselves to involvement in offshore jurisdictions, offshore trusts or offshore investments.
All rights reserved. © 2017 Wolters Kluwer