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News Analysis: The Basic Physics of Integration to Combat Inversions

Posted on March 21, 2016 by Andrew VelardeKaustuv Basu

Republican presidential candidate Donald Trump has his own definition of basic physics.

Speaking in Palm Beach, Florida, on March 15 after a resounding win in that state's GOP presidential primary that day, the real estate investor invoked his definition in criticizing pundits who would fault him for failing to capture a majority of primary voters: "I have to explain to these people, they don't understand basic physics, basic mathematics, basic whatever you want to call it when we don't get over 50 [percent of the vote]. We have four people [in the race]. . . . Do you understand that?"

After once more promoting his numerical strength against his rivals at the polls, Trump also used the moment to not so diplomatically criticize congressional inaction on inversions.

"Someday in the not-too-distant future, if I win . . . we're not going to be losing our companies. Our companies are leaving our country rapidly," Trump said, specifically calling out previous inverter to Ireland Eaton Corp. and planned inverter Pfizer Inc. "Frankly, I'm disgusted with it, and I'm tired of seeing it. There's no reason for it. It's just gross incompetence at the highest level. We should not allow it to happen." 

Trump faulted lawmakers for failing to reach a deal on inversions and fix the lockout effect, which has led to an estimated $2.5 trillion in corporate profits remaining offshore for fear of U.S. tax consequences. "Everybody agrees the money should be here, and the politicians, for three years, haven't been able to make a deal," he said.

In addition to a corporate rate reduction, Trump has called for an end to deferral of taxes on foreign earnings and the imposition of a deemed repatriation tax at 10 percent, designed to spur repatriation of trapped offshore earnings. The plan would "make corporate inversions unnecessary and will make America one of the most competitive markets in the world," Trump said in a Wall Street Journal op-ed in September 2015. With the Urban-Brookings Tax Policy Center concluding that Trump's corporate tax reform plan alone would cost nearly $2 trillion in revenue over 10 years, he may be forced to concede a lot in any deal if Congress is to be persuaded to fix inversions through any larger reform packages. 

But Trump is hardly alone in his attack on inversions. In what would likely amount to a substantial change to the tax code, Senate Finance Committee Chair Orrin G. Hatch, R-Utah, has been working on a corporate integration draft that he says would take "a fresh approach to how we tackle inversions." There have, however, been few details up until now on how such a problem would be solved through the implementation of a single tax on corporate earnings. 

DPD Proposal From 1984

While corporate integration can take several forms, sources told Tax Analysts that the most likely type of integration to come from Hatch's plan will be a dividends paid deduction (DPD). Such a deduction could be taken at the corporate level when a domestic corporation pays out of its earnings a dividend to its shareholders.

In 1984 Treasury made a similar proposal under which the double taxation of corporate earnings distributed as dividends would have been partially relieved by allowing domestic corporations not otherwise subject to special tax regimes a deduction of 50 percent of dividends paid to their shareholders. The deduction in the proposal fell short of a full 100 percent deduction because of revenue concerns. Corporations would have been required to maintain a "qualified dividend account," consisting of earnings taxed at the full corporate rate, against which the deduction could be claimed. Excess dividends could not be carried forward, and the proposal would not have allowed relief from double taxation of corporate earnings until those earnings were distributed outside the corporate sector.

The 1984 proposal recognized the treaty problem under a DPD system in potentially treating foreign shareholders differently by denying them relief, a denial that was common under an imputation system of integration. In an imputation system, shareholders include distributed earnings in income and are entitled to claim a credit for corporate taxes paid, and under that system, such a benefit could simply be allowed only to domestic shareholders. Treasury recognized that what allowed imputation to deny benefits to foreign shareholders in contrast to DPD was a "purely formalistic matter," but it was unwilling to impose withholding nonetheless.

"Virtually all United States bilateral tax treaties, however, establish a maximum rate at which withholding taxes may be assessed on dividends. Those treaty provisions would be directly violated if the benefits of the dividends paid deduction were denied to foreign shareholders by imposing a compensator withholding tax on dividends paid to residents of treaty countries," the proposal states.

John D. McDonald of Baker & McKenzie sees challenges presented by treaties as perhaps the most significant problem preventing implementation of a DPD. "We have already relinquished most -- or in some cases, all -- of the right to tax U.S. source dividends in our treaties," McDonald told Tax Analysts, noting that such action was taken on the assumption that at least one level of U.S. corporate tax had been paid.

If a DPD were introduced without changes to treaties, it is possible that no U.S. tax would be paid on business profits generated in the United States and paid to foreign shareholders, McDonald said. "Treaties can be renegotiated, of course, but that takes time. We have to address the concerns of our treaty partners," he said, adding that the OECD's base erosion and profit-shifting project and the recent modifications to the U.S. model income tax convention "make now a good time to have those discussions."

At first glance, it is difficult to see how allowing both domestic and foreign shareholders to benefit from a DPD that is limited to a 50 percent deduction would substantially impede inversions. There could be, however, some important distinctions between the 1984 proposal and the current proposal under consideration. Further, perhaps the goal of the new proposal could be better framed as not just providing more benefits to U.S. corporations but rather as trying to equalize treatment between domestic and foreign entities and across types of financing as well.

Tackling the Inversion Benefits

There are several benefits to inverting: It allows access to lower tax rates for future earnings; it provides relief from the lockout effect whereby foreign earnings would otherwise be subject to U.S. taxation if brought back by a U.S. corporation; and it provides the ability to strip U.S. earnings, through methods that include use of intercompany debt and deductible interest payments to foreign entities.

Earnings stripping is not a vehicle unique to inverters and could conceivably be done by any foreign-owned entity. A 2007 Treasury study, whose data a Treasury official has admitted are getting stale, showed that there was enough evidence to demonstrate only that inverted companies engaged in earnings stripping, rather than reaching conclusions about foreign-controlled entities more broadly.

To address earnings stripping, the DPD could seek to address the inequality of how debt and equity are treated in the code. With interest payments on debt being tax deductible, subject to some rather high threshold limitations under section 163(j), debt financing can often become the more attractive avenue when compared with equity. A tax lobbyist previously said that Hatch's plan could require withholding on interest to correspond with withholding on dividends. Some method of equalization seems to have been in the Finance Committee's sights for some time. In its December 2014 tax reform report, the committee's Republican staff argued that integration would eliminate economic distortions, including the "perverse incentive" to finance with debt instead of equity. Sources have confirmed that Hatch is exploring how to equalize the treatment of debt and equity. Any sort of interest equalization could presumably serve as a significant pay-for for the DPD. 

By itself, however, a DPD would not be sufficient in addressing earnings stripping in its entirety; other base erosion protections, including rules regarding royalty payments, would likely be necessary.

McDonald argued that reducing the top U.S. marginal corporate rate so that it is closer to other countries' rates, coupled with the modifications to the U.S. model treaty (once included in renegotiated treaties), would substantially reduce the benefit of interest deductions claimed by inverted companies and other foreign-parented companies. "If the value of the deduction is reduced by lowering U.S. marginal rates and withholding is only avoided if the related recipient pays the full foreign corporate tax on the interest income, which is what the treaty modifications seek to ensure, then the benefit mostly or completely disappears," McDonald said.

Sources said that unlike the 1984 proposal, Hatch is considering implementation of a 100 percent DPD as well as eligibility for dividends out to shareholders that are paid up to the parent entity by both foreign and domestic subsidiaries. The senator is also considering a mechanism, such as a withholding tax on dividends out to foreign shareholders, that was dismissed in 1984, on the theory that the treaty issue is better framed as one that is denying the creation of a distortion, because, under an integration system, dividends out to foreign shareholders would not be subject to the double taxation that is the foremost concern of treaties.

Under the Hatch proposal, sources said, a DPD would allow a corporation's management to control its own effective tax rate through its dividend payments, regardless of where the earnings came from. That proposal could reduce the rate arbitrage currently available between domestic and foreign corporations. For example, according to Morningstar Inc., Pfizer's dividend payout ratio in 2015 was a whopping 82.7 percent, an amount that obviously would have offered a substantial cut to its statutory rate, if maintained anywhere near those levels. In all likelihood, many companies would increase dividend payments in the presence of DPDs in order to reduce their effective tax rates into the low double digits or single digits. This aspect of a DPD may make it the more attractive alternative to executives in the corporate boardroom when compared with the shareholder credit.

"Tax is a cost, just like labor cost or raw material cost," McDonald said. "Corporate officers are incentivized to reduce all corporate costs, including, but not limited to, corporate-level taxes. A shareholder imputation credit, by itself, would not reduce that cost; an imputation credit just reduces a shareholder's tax liability. The corporate manager wouldn't even know the precise impact that the credit has on each of the company's public shareholders."

McDonald said that the long history of numerous integration efforts, particularly the integration debate held immediately after World War II and the George W. Bush administration's attempt at reform in the 2000s, is proof that corporate managers are "not going to get too excited" about a shareholder imputation system that does not lower the corporate tax line item on the income statement. Moreover, a shareholder credit by itself would not reduce the incentive to invert, he added.

McDonald argued that the lower tax cost arising from a DPD could also lower the cost of producing in the United States and cause some production that would otherwise be done outside the U.S. to be performed domestically. "An unlimited dividends paid deduction, i.e., $1 dividends equals $1 deduction, could substantially reduce the importance of [the corporate tax expense] item for many companies and, hopefully, have a positive impact on their behavior," he said.

Regarding lockout, a DPD could dampen that effect by providing a deduction equal to the total amount of cash repatriated, provided that it was passed on as a dividend to shareholders. A company could face a 35 percent tax on the billions it repatriates, but as long as those billions are dividended out, there would be no tax increase for the company given the subsequent deduction. Further, the United States would still benefit from collecting taxes on the taxable shareholder end of the equation.

With the 2004 repatriation tax holiday serving as a testament to the likelihood of a dividend following a tax break on offshore earnings brought back, it is a good bet that companies would make full use of a DPD with those repatriated funds. The 2004 tax break under section 965 offered a special 5.25 percent rate on repatriated funds and saw $362 billion return to the U.S. It should be noted that unlike section 965, the DPD structure, according to sources, is generally designed to be revenue neutral, with the shift of the tax burden on corporate earnings from the corporation to the shareholders. The potential political pushback in the wake of another mass cash repatriation that would not be used for corporations to invest, but rather shareholders to invest, is another matter. 

McDonald believes that a DPD could reduce, though not eliminate, the incentive to invert, citing specifically its potential effect on the cost of repatriating cash.

"That cost has increased dramatically over the last 30 years as the U.S. rate remained the same and foreign rates steadily decreased. The cost is now so high that repatriation is prohibitive," McDonald said. "The dividends paid deduction is not a panacea, however," he added, arguing that companies that don't currently pay dividends and want to bring back offshore earnings to repay outstanding indebtedness or acquire a U.S. company would not benefit.

"Moreover, it is important to consider what the second and third order effects of a dividends paid deduction would be. It may not be all upside," McDonald said. "If the deduction is apportioned like interest expense, it may have a significant negative impact on the ability of many U.S.-based multinationals to claim foreign tax credits."

Still, McDonald argued that the DPD is probably the most administrable approach to achieving integration and that any challenges are surmountable, with every other integration approach possessing equal or greater challenges.

Concerns in the Bond Markets and Among Pensions

Estimates for when Hatch's draft bill might be ready have varied from March to May, as uncertainty remains on how it would affect bond markets and how they would react to a DPD. Sources said that staff members are looking at the behavioral issue there and continue to look at market data and other information.

Bond issuers would not face changes immediately and would have a meaningful transition period to deal with changing scenarios, the sources said, pointing out that the bond markets adjust to external influences such as interest rates and currency all the time.

Concerns fester about how pension funds would be affected by such a change. "People were not expecting [that] this meant even dividends paid to tax-exempts. This alone will cause a lot of angst among endowments, pension funds, etc.," one lobbyist familiar with the situation said. "This will affect investment returns, grandma's pension, scholarships, other philanthropic activity, which I would assume would cause a ripple effect across the economy."

The lobbyist pointed out that transition rules are important and can be tricky. "You'd have to write the rules to limit the ability to renew or extend debt, if the withholding only applied to new debt," the lobbyist said.

Delays over the Joint Committee on Taxation's dynamic scoring model could be another reason why the draft has been delayed.

A second lobbyist pointed out that the JCT's dynamic scoring process can be lengthy because it requires modeling many more assumptions than traditional scoring. "Any changes to the proposal means running the entire thing through the model again," the lobbyist said. "Without question, dynamic scoring is more advanced than traditional scoring -- even as it continues to evolve -- but it's definitely more complex, and so it takes longer to do."

The second lobbyist argued that the corporate integration plan could be a bridge too far politically because it's easy to portray it as a corporate tax windfall borne by others such as charities and pensions. "It's instructive to recall that the 2003 dividend tax cut started out as a corporate integration plan, and, even with the backing of the Bush administration, Congress was only willing to go halfway with a reduced (but not eliminated) rate," the lobbyist said.

Long-Term Threats and Short-Term fixes

At a March 2 Joint Economic Committee hearing, Jason Furman, the chair of the Council of Economic Advisers, advocated an instant though temporary deterrent to inversions through a ban on the specific practice. In its fiscal 2017 budget proposal, the Obama administration promoted a strengthening of anti-inversion rules, including lowering the ownership interest threshold for former shareholders of the domestic entity under which an inverted entity will continue to be treated as domestic from 80 percent to 50 percent. Furman admitted at the hearing that comprehensive business tax reform will take much longer, and Treasury Secretary Jacob Lew has likewise emphasized tax reform that would lower rates as the only permanent solution to end inversions.

Democratic lawmakers have also put forth anti-inversion measures in recent days. Finance Committee member Charles E. Schumer, D-N.Y., released the Corporate Inverters Earnings Stripping Reform Act of 2016, a revival of a bill put forth in 2014, which would reduce allowable interest deductions available to inverters. The bill complements the Pay What You Owe Before You Go Act, introduced by Finance member Sherrod Brown, D-Ohio, which would require corporations to pay taxes on deferred overseas profits before inverting. And on March 18, Democratic presidential candidate and Sen. Bernie Sanders, I-Vt., sent a letter to Lew calling on Treasury to take action to block the corporate inversion of Pfizer and save $35 billion in revenue through a banning of hopscotch loans and earnings stripping for all foreign-parented corporations. 

Despite widespread agreement on the need for broader reform in the long run, there is substantial disagreement regarding the efficacy of targeted legislation aimed at being a stopgap against inverters. If Congress cannot act in quick order to address inversions with targeted legislation before implementing more comprehensive international reform, doubtless more U.S. companies will leave for greener tax pastures. And the window may not be a narrow one with the delays already seen in the expected timeline for an integration plan and a separate international reform plan from the House.

But more troubling than the near-term fallout from congressional delays and gridlock are the long-term consequences of inaction. While an inversion deal would certainly take longer to reach than Trump's outlandish press conference prediction of 10 minutes (which may or may not have been hyperbole, given the speaker), if Congress refuses to come together and either focuses its energy exclusively on the more narrow inversion symptoms or fails to rally behind comprehensive reform through collaboration and compromise, corporations will keep using methods to invert. And seeking lower tax burdens, the companies will continue to move their earnings away from the United States like water flowing downhill.

Let's call it basic physics.