Democrats believe tax reform won’t come fast enough to stop the new wave of inversions. And Republicans don’t like the proposals by the Obama administration or by congressional Democrats to expand the foreign ownership requirements necessary to allow a corporation to expatriate. But that doesn’t mean there is no common ground on which the two parties can come together to significantly slow the pace of inversions. One approach to deterring expatriations that has gotten little attention in the press is tightening current law rules to prevent firms that invert from stripping profits out of the United States.
Putting matters in the simplest terms, corporations that transfer their legal domicile out of the United States get two benefits. First, profits from their operations outside the United States are exempt from U.S.tax. Second, those corporations are much better able to shift profit from their U.S. operations to tax havens. It is this second advantage that is particularly objectionable. In the biz, this is known as earnings stripping. And it is remarkably easy to accomplish: A wholly owned subsidiary in a tax haven makes a loan to the U.S. business. The U.S. business then deducts the interest payments and reduces its U.S. tax. The tax haven subsidiary books the income but pays little or no tax on that income.
These loans are all legal fiction. They are entirely the creation of lawyers for the sole purpose of avoiding U.S. tax. They have no impact on the underlying business operations of the corporation, and in fact are not even reported to shareholders in company annual reports.
In its latest budget, the Obama administration has a proposal (p. 49) that would make it much more difficult for foreign corporations to strip profits out of the United States with related-party lending. Although they have not offered any proposals of their own just yet, Senate Democrats have made it clear that they too are interested in limiting abusive related-party lending. At the Senate Finance Committee’s July 22 hearing, committee Chair Ron Wyden, Sen. Sherrod Brown, and Sen. Charles E. Schumer all expressed strong interest in this approach to combating inversions.
But it isn’t just Democrats who object to earnings stripping. In his opening statement at the July 22 hearing, Republican Sen. Chuck Grassley said: “One area that should be studied further is the role tax rules that allow inverted companies to strip income out of the United States play in a company’s decision to invert. Reforms to curtail such abuses should be considered to protect the U.S. tax base and reduce the incentive to invert.”
And two days later, Sen. Orrin Hatch, the lead Republican on the Finance Committee, said: "We have to fight income stripping. And there's a way of doing that, and we're going to come up with that. . . . Companies flip the debt over here, where they can deduct the interest, and put the income over there.”
Grassley and Hatch are not breaking new ground. In 2002 Grassley sponsored legislation that included limits on earnings stripping. Also that year, Ways and Means Committee Chair Bill Thomas proposed limiting earnings stripping. At the other end of Pennsylvania Avenue, the Bush Treasury Department was also adamant about the need to prevent foreign companies from inappropriately shifting income out of the United States. Unfortunately, objections from the business community and foreign governments blocked inclusion of earnings stripping rules from the final anti-inversion legislation enacted in 2004.
Some press reports are stressing the partisan divide on the issue of inversions. But history and recent statements from the Republicans quoted above show us that there is a lot of room for agreement.