In case you missed it, U.S.-based Terex Corp. has substantially altered its proposed merger with Finland’s Konecranes PLC. The original all-stock deal would have resulted in current Terex shareholders acquiring roughly 60 percent of the newly formed firm, which would have been based overseas. Instead, the two companies are now eyeing a much smaller cash and stock transaction that would be limited to an acquisition of two of Konecranes’ business units. Terex’s explanation for the change of plans is straightforward: The anticipated tax benefits are no longer available.
Blame is being directed at the government’s anti-inversion regulations released in April. Under these rules, the IRS will be able to crack down on abusive earning stripping. This will be accomplished by recasting related-party debt as though it were an equity holding, thereby eliminating the interest expense that would otherwise be deductible against the borrower’s taxable income.
Policy experts argue that related-party lending is inherently dubious. It’s not genuine indebtedness in the economic sense, but our tax code has generally respected these arrangements – until now. It’s well established that related-party debt is a leading factor in the erosion of the corporate tax base, which is proving to be a global phenomenon. Action 4 of the OECD’s base erosion and profit-shifting project was focused on the strategic manipulation of corporate interest expense. Earnings stripping is also widely used by firms in the immediate aftermath of an inversion. The cynical among us might note that earnings stripping is the whole point of an inversion. Terex’s SEC filings acknowledge that the new Treasury regulations have eliminated $35 million s in previously anticipated tax savings.
Let’s remind everybody what an inversion is. It’s a corporate merger between a U.S.-domiciled firm (the target) and a foreign firm (the acquirer). One critical point is that the newly formed, post-merger entity must be based overseas, meaning the U.S. affiliates become subsidiaries of a foreign parent company. Before the merger there was a U.S.-parented corporate group; after the transaction we’re left with a foreign-parented group.
Inversions resemble foreign takeovers, but they should not be confused with instances of a "runaway factory" in which American jobs disappear and move overseas. In fact, labor costs have nothing to do with these deals. Most inversions are purely paper transactions that result in no discernible domestic job loss, but they trigger a significant drop in tax revenue. Because of the peculiar design elements of our tax code, a U.S. company can save tens of millions of dollars each year simply by being part of a foreign-parented group.
Suffice it to say that the Treasury Department hates inversions. In each of the last three years, Treasury has released a major regulatory package aimed at deterring these transactions. Taken together, these efforts have been fairly successful. In addition to the Terex deal, we’ve seen companies like Pfizer and CF Industries each cancel planned inversions. The transactions didn’t make sound business sense absent the tax benefits.
I understand why Treasury is trying to shut down earnings stripping. Its job is to protect the public fisc. But I also understand why the firms wanted to invert. Management owes a duty to shareholders to maximize value. That means cutting all avoidable costs, including tax costs. If the tax code permits it, who can say no to trimming millions of dollars off your taxes? Arguably, a firm that doesn’t at least consider pursuing such tax savings is failing to serve its shareholders’ best interest.
For that reason I don't necessarily agree with the criticism that inverted firms (or those considering an inversion) lack patriotism or display questionable morality. Patriotism and morality are wonderful concepts, but they have nothing to do with corporate taxation.
This point is worth making because we increasingly hear talk about "corporate social responsibility." When I first heard that phrase, I thought it sounded benign enough. What could be the problem with expecting firms to avoid socially irresponsible behavior? We like it when our multinational enterprises abstain from things like dumping toxic waste in the local river. We applaud them when they adopt nondiscriminatory hiring practices, and so on. If that’s what corporate social responsibility means, then I’m all for it.
But taxes are different. As a taxpayer, your only obligation is to adhere to the tax law, full stop. Either you’re compliant or you’re not. Patriotism and morality have nothing to do with it. These should be obvious conclusions. But an increasing number of people want to believe that for every large corporation there exists a certain level of tax liability -- the so-called fair share -- below which a firm becomes a bad actor, irrespective of whether it is playing by the rules.
I get that income inequality is a genuine concern. I get that people are frustrated when they read about rampant profit-shifting in the corporate sector. I am no apologist for the current tax system, which is clearly flawed. But let’s recognize that there are two separate concepts at play: What the tax code ought to be in a perfect world, and what current law actually provides for. Those are two very different things. So please, no more talk about unpatriotic corporations. It's unconstructive, and it doesn’t help solve the legitimate problem of how best to tax capital income in a global economy.
In the case of the recent Treasury regulations, their justification should be that related-party debt doesn’t warrant an interest deduction on substantive grounds, not because we suspect that corporations lack sufficient patriotic fervor.