Tax Analysts Blog

Can Congress Pass Tax Reform That Would Stop Inversions?

Posted on Sep 29, 2014

Conservatives correctly point out that proposals to stop inversions from the Obama administration and Democrats in the House and Senate are only stopgap measures—a mere Band-Aid. If Congress were to tighten the anti-inversion rules first enacted in 2004 and further increase the foreign ownership requirements for mergers that move American businesses’ corporate legal residence outside of the United States, it would stop the type of deals that are now getting all the attention. But we still will not have solved the fundamental problem of tax motivated foreign ownership of U.S. businesses.

Right now the U.S. tax system favors foreign owned corporations over U.S. owned corporations. Although you often hear about the U.S. having a higher corporate tax rate than other major economies, this really has little to do with the disparity between U.S. and foreign ownership. The two big factors that make foreign ownership attractive for tax purposes are 1) that foreign owned firms can pay a lot less tax on their non-U.S. activities (because as non-U.S. firms they are under territorial regimes) and 2) that they can pay a lot less on their U.S. activities (because U.S. rules make it much easier for foreign owned firms to strip earnings out of the United States).

If not through inversions, shifting foreign ownership can occur through a variety of channels: more start-ups incorporate abroad, large U.S. businesses spin off and sell divisions to foreign multinationals, and foreign-owned multinationals with the tax advantages simply grow faster than U.S. owned businesses. To truly prevent this migration of ownership, we need residence-neutral tax reform.

Now here’s the rub: A more competitive tax system and a residence-neutral system are not always the same thing. On the one hand, moving from a worldwide system to a territorial system—a system in which foreign profits of U.S. corporations are largely untaxed and the lockout effect is eliminated—makes U.S. multinationals more competitive and also makes the tax system more residence neutral. So, OK, no conflict there for tax reformers. On the other hand, reducing the ability of foreign owned firms to strip income out of the United States—which is necessary to prevent the migration of ownership--makes investing in the United States less attractive to foreign owned businesses, like Nestlé. This is a big political problem.

It is useful to divide foreign owned firms doing business in the United States into two categories: 1) those that became foreign by inverting and 2) foreign firms that began abroad and continue to be managed from abroad (a.k.a. “traditional” or “historical” multinationals). The public is stirred up because of the highly visible first group -- and tax barriers can be set up just for inverters. That is what Congress did in 2004. And since then, both the Bush and Obama administrations have proposed earnings stripping limitations that apply only to inverted firms.

But a principled tax reform will have features that include both categories. Otherwise, as conservatives complain, we have only a Band-Aid solution. You don't hear much from legislators about this because it is a minefield for them. Rightly or wrongly, the public’s wrath is focused on inverted firms, and doing something about them is probably inevitable.

Established non-inverted foreign companies that build factories in the United States are a whole different story. If one of these job-creating factories is in your district, your representative in Congress will pay a steep price to vote to raise its taxes.

Proposals to reduce earnings stripping by all foreign owned firms have been seen from Ways and Means Committee Chair Dave Camp, former Senate Finance Committee Chair Max Baucus, and President Obama. (In its latest budget the administration replaced its old proposal that applied only to inverted firms to one that applies to all foreign firms.) But it is a sure bet that foreign owned multinationals will put up a spirited and effective battle to prevent themselves from getting caught up in the anti-inversion net. And if they are successful, as they were in 2004, tax reform will slow down but not stop the outmigration.

Read Comments (5)

reuben richardSep 29, 2014

Whether congress pass the tax reforms or not but we should be always ready for
the worst case. Taxes can be managed by the Tax experts.

emsig beobachterSep 29, 2014

If territorial taxes are so wonderful, why is the OECD getting dysBEPStic about
profit shifting?

Actually, it's great theater to watch OECD officials, U.S. Treasury Department
and members of Congress rail against the perfidious multinational companies who
are stripping the tax bases of the nations in which they earn huge profits;
but, at the end of the day, will do nothing but apply another band aid. There
should be a category of EMMYs for best performance for a member of Congress
feigning outrage at earnings stripping.

Brian Dooley, CPA, MBTSep 30, 2014

I am seeing EU and UK firms planning on the worst case.

They are picking Canada (with them using NAFTA) over the U.S.

Canada has a better tax rate and a better research tax credit.

Also for private companies, there is no estate taxes.

Michael KarlinSep 30, 2014

One interesting problem that is not getting any attention during all the hubbub about large multinationals inverting is how the current U.S. tax system make it so very unattractive for closely held business to do business abroad, especially in countries with which we do not have an income tax treaty. The problem is that individuals are generally not permitted indirect credits. To get credit for foreign tax paid by the companies they set up abroad, they have to check the box. So, compared to how a U.S. corporation is treated, an S corporation, an LLC or a partnership, the vehicle of choice for the vast majority of closely held businesses, must choose between deferral with no foreign tax credits (except for foreign dividend withholding tax, a dying
breed) or no deferral in order to make use of foreign tax credits.

Below the radar screen are thousands of closely held businesses that are expanding abroad and facing effective tax rates of well in excess of 50% on
fully distributed income, after taking into account state taxes and the Affordable Care Act tax that is paid by individuals but not corporations.

Another problem for smaller businesses is that the fully panoply of U.S. rules apply to them from dollar one - section 367, transfer pricing, Subpart F, PFIC taxation of their joint ventures if they don't watch out, foreign currency adjustments, and on and on. Compare that to the U.K., where full transfer
rules don't kick in until enterprises have a turnover of 43m Euro and 250 staff.

We keep hearing about how small businesses are the engine of growth, but we ought to think a moment or two about how are international tax rules impose crushing substantive and compliance burdens on such businesses.

edmund dantesSep 30, 2014

Thank you, Michael Karlin, I did not know that.

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