Tax Analysts Blog

Don’t Count on Tax Reform to Stop Inversions

Posted on Aug 4, 2014
In the press and on Capitol Hill, the conventional wisdom is that inversions occur because Congress has failed to enact tax reform. The United States has a high corporate tax rate and a worldwide system. Foreign countries have lower corporate tax rates and territorial systems. If the United States lowers its rate and adopts a territorial system, the incentive to invert will be removed, right?

Well, no. Almost certainly not.

Inversions occur for the simple reason that U.S. tax rules are significantly more advantageous to foreign-incorporated businesses than to U.S.-incorporated businesses. But in fact, the tax reform proposals that have been fleshed out on Capitol Hill so far do not eliminate the differential treatment of domestic and foreign corporations. Consider the following:
    • Most tax reform proposals, including those offered by House Ways and Means Committee Chair Dave Camp, and former Senate Finance Committee Chair Max Baucus, would impose some type of new minimum tax on low-taxed foreign-source income.
    • Territorial systems as a rule do not eliminate U.S. tax on interest, dividends, rents, and royalties earned by foreign affiliates of U.S. multinationals. This taxation prevents U.S. multinationals from stripping profits out of the United States by allowing the U.S. parent to borrow from a related finance subsidiary in a low-tax country.
    • Many territorial proposals do not provide complete tax relief for foreign-source income. For example, under the Camp proposal, foreign-source income would still be subject to a 1.25 percent tax when repatriated.

It is likely that any real-world territorial system will include these and perhaps other anti-base-erosion features that retain advantages for foreign corporations over U.S. corporations. So strong incentives to invert will remain even after tax reform.

Don’t just take my word for it. More than a decade ago, professor Reuven Avi-Yonah of the University of Michigan Law School wrote: “Permitting inversions gives inverting U.S. multinationals a significant competitive advantage over foreign multinationals and noninverting U.S. multinationals. . . . Inversions would continue even if the U.S. adopted territoriality” (Tax Notes,June 17, 2002, p. 1793).

Also in 2002, a report by the New York State Bar Association Tax Section stated: "As many have pointed out, most so-called territorial systems do not provide a blanket exemption that is as favorable as the intended tax treatment of the inverted company.”

In 2013 professor John Steines of the New York University School of Law said: "Even if the United States adopted a dividend exemption system, companies might still expatriate" (Tax Notes,Oct. 28, 2013, p. 355). In a follow-up inquiry, Steines elaborated: “There is no obvious reason why the objective to reduce U.S. tax on U.S. income by a corporation that inverts would be muted by a territorial system.”

In a recent e-mail, Willard Taylor an adjunct professor at NYU Law wrote: “Treasury Department data on inverted companies strongly suggest that these corporations are shifting substantially all of their income out of the United States, primarily through interest payments. “A territorial system would not deal with this, nor would a reduction in the corporate tax rate, unless the reduction was to the 12.5 percent level in Ireland. And no one has proposed that.”

The situation is not hopeless. It may be possible to design tax reform that snuffs out inversions. But that brand of reform has only been sketched out on academic blackboards so far. Despite prodigious efforts by the staffs of the taxwriting committees in recent years, the kind of residence-neutral tax reform needed to deter inversions has not surfaced in any introduced bill or proposal on Capitol Hill.

Read Comments (2)

edmund dantesAug 4, 2014

No obvious reason that a territorial system won't reduce the tax benefit of
inversion? Are you kidding? Are you paying attention? It may not be a
panacea, but it's got to help, it's a step in the right direction.

Articles such as this post are ultimately just excuses to do nothing, letting
the perfect be the enemy of the good. Or is the Obama Administration secretly
cheering on the inversions as another way to "spread the wealth," letting other
countries become home to formerly American firms?

vivian darkbloomAug 4, 2014

"Inversions occur for the simple reason that U.S. tax rules are significantly
more advantageous to foreign-incorporated businesses than to U.S.-incorporated
businesses. "

Well, nothing here is "simple". To demonstrate that, let's see if that
sentence makes sense with a bit of inversion:

"Inversion occurs for the simple reason that foreign tax rules are
significantly more advantageous to foreign incorporated businesses than US tax
rules are to US incorporated businesses."

Sure, earnings stripping can (with limits under section 163(j)) erode the US
tax base. Foreign jurisdictions can be eroded, too, but they are generally not
as susceptible. Why? Despite the general absence of earnings stripping rules,
they are generally less susceptible given lower corporate tax rates non-US
corporations enjoy. Money will flow where the rates are lower, no question
about that. Competition seems to be a virtue, except when it comes to
corporate income taxation.

Also, I presume Mr. Sullivan may have intended to suggest that US tax rules are
less favorable *with respect to income derived by US corporations *and
effectively connected with the US* than such effectively connected income
derived by foreign corporations (due to earnings stripping possibilities for
the latter). But, without this added emphasis, Mr. Sullivan might be on to
something. The United States does not tax, at a 35 percent marginal rate,
earnings of foreign corporations that were effectively connected with non-US
jurisdictions. Indeed, those foreign corporations are at an advantage in that
respect.

There is, of course, a way to test Mr. Sullivan's hypothesis: Engage in real
corporate tax reform that adopts a territorial system (e.g., through a dividend
exemption regime for active income) and lower the corporate tax rate to
competitive levels. There is no reason to guess, as Mr. Sullivan does here, as
to what might happen. Simply do it. If one is still not happy with the rate
of inversion activity, he can always say he told us so and push for
implementation of "Plan B".

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