NEW YORK (Thomson Reuters Regulatory Intelligence) - The Republican-led government under a Donald Trump presidency will now have a chance to do what previous administrations could not – stop U.S. multinationals from using corporate inversions to flee the U.S. tax net.
In an inversion, a U.S. company relocates its legal domicile to a tax-friendly country by merging with and becoming the subsidiary of a smaller foreign company. U.S. policymakers for years have sought with mixed results to rein in the practice. In the latest salvo, regulators went after serial inverters, companies that have undertaken multiple inversions. The government also recently finalized regulations to stop earnings stripping transactions employed by multinational companies to lower their overall taxes. In the maneuver, the U.S. subsidiary pays interest on a post-inversion loan from its new foreign parent company. The subsidiary deducts its interest payments, thus lowering its income in the high-tax United States, and the foreign parent company (in the low tax country) pays less tax on its interest income.
An anticipated push for comprehensive tax reform could make inversions obsolete, and some policymakers say that tax reform could help reduce the U.S. trade deficit.
But it is far from settled what tax reform ultimately will look like. There is disagreement among Republicans about major issues, such as a provision in a House Republican tax blueprint for a “border-adjusted consumption tax” that favors exports over imports. Republicans also will face stiff opposition from Democrats who have made corporate tax avoidance a populist issue.
Here is a look at some of the issues.
Reducing the statutory U.S. corporate tax rate, currently 35 percent, is a centerpiece of the Republican platform. Trump has called for a 15-percent rate, while the House blueprint calls for 20 percent. The United States, however, faces intense tax competition from many countries. U.K. companies, for example, already are taxed at a 20-percent rate and there are rumblings that Britain might cut it in half as it pulls away from the EU. Such talk may serve as a bargaining chip to help the U.K. to preserve at least some of the “passporting rights” that would continue to allow U.K. financial institutions to roam the continent after Brexit. Ireland, which stands to lose business, threatens to cut its 12.5 percent corporate tax rate even further, or leave the EU altogether.
The analysis is more complicated than just comparing statutory tax rates. Global tax laws diverge on many issues that affect a corporation’s effective tax rate, including what’s deductible and when. For example, the House Republican plan contains two game-changers – interest costs would no longer be deductible, and companies could immediately deduct rather than depreciate the cost of capital investments.
The point is that tax competition is everywhere. U.K. and Irish “patent boxes” promise even lower corporate income tax rates (10 percent in the U.K., and 6.5 percent in Ireland) on profits generated from intellectual property developed by workers in those jurisdictions. Without doing more, lower U.S. tax rates might not prevent companies from leaving for even greener tax pastures, whether or not the U.S. maintains its mostly worldwide system of taxation.
All of the large U.S. trading partners maintain territorial systems, which tax only income generated at home. The United States maintains a worldwide system, which taxes a U.S. company’s worldwide income, no matter where generated. The only concession the United States makes to a territorial system is that a U.S. company can defer paying U.S. tax on foreign non-passive income until it brings that money home. The deferral has been targeted by both the left and the right because U.S. companies have stockpiled over $2 trillion overseas, money that both parties hope can be repatriated to help create jobs or increase wages.
Republicans want a one-time tax of the money currently stashed overseas at a “tax holiday” rate of 8.75 percent, according to the House blueprint, while Trump has called for 10 percent. This money would be taxed even if it is not repatriated. After this one-time taxable “deemed repatriation,” the Republicans want to convert the United States to a pure territorial system of taxation, which would allow U.S. companies to repatriate foreign income tax-free, without the need for an inversion or a tax holiday.
Converting may very well encourage U.S. companies to repatriate their foreign profits. It is unclear, however, whether the money would be used to help workers. Instead, companies could use the cash to pay dividends or executives. Or they could use the money to buy back stock, which tends to increase the stock price and make companies less vulnerable to shareholder activism and hostile takeovers. Companies that actually reinvest the money might invest in technology meant to replace humans without also investing in education and training to help workers adapt.
Furthermore, converting to a territorial system, in the absence of other steps, would not stop multinationals from shifting portable profit-generating assets like intellectual property to affiliates in even lower tax rate jurisdictions. This is because U.S. income taxes have always been pegged to profits and not sales.
DESTINATION-BASED CONSUMPTION TAXES
The House blueprint hopes to end profit-shifting once and for all by supplementing a territorial system with a "destination-based" tax framework. The framework is based on the work of Alan J. Auerbach (here), an economics professor at the University of California, Berkeley. It would tax revenue based on where goods are sold, rather than where they were made, which theoretically should make inversions and profit-shifting obsolete.
Practically speaking, “border adjustments” would tax imports, but not exports. The plan would eliminate an importer’s deduction for the cost of foreign-sourced goods or components. Export revenue would either be taxed and then the taxes rebated, or simply excluded from income. It sounds a lot like the kind of VAT (value-added tax) systems employed by most U.S. trading partners, with a key difference being that the plan would allow U.S. companies to deduct domestic wages.
By making inversions and profit-shifting obsolete, companies would have less incentive to relocate jobs for tax reasons. But a consumption-based system would not stop companies from hunting for tax advantages. Companies that arbitrage international tax law to allocate their profits to tax-friendly jurisdictions might now try to structure their transactions to maximize their U.S. tax deductions.
Global supply chains are complex. This makes it easy to manipulate where and when a sale is made. Furthermore, multinationals are adept at moving not only goods and services, but also money, between affiliates. They might eventually figure out how to make their imports look like exports. That could once again hurt U.S. manufacturing jobs.
A destination-based system might be good tax policy, but it has also been incorrectly touted by policymakers as a tool to stop imports, supercharge exports, and reduce the U.S. trade deficit. Big retailers, which rely on imports, have hit back hard, and say that the plan will increase consumer prices and decimate their financials. It doesn’t help that the individual parts of the plan look discriminatory and might not sit well with the World Trade Organization, even though the economics of the plan are similar to the VAT routinely implemented all over the world.
However, according to commentary (here) by Auerbach and Dr. Douglas Holtz-Eakin (President, American Action Forum), and others like Kyle Pomerleau and Stephen J. Entin of the Tax Foundation (here), the import and export components of the plan, when paired together and properly calibrated, will have little economic impact on trade or consumption. In theory, the plan will trigger increased demand for U.S. dollars, which will cancel out any perceived impact on the balance of trade. Thus the plan does not give importers a discriminatory trade disadvantage or exporters a discriminatory trade advantage.
The problem, however, is one of perception. Stock market valuations gyrate at the drop of a pin; companies won’t take the chance that their shareholders might not agree with standard economic theory that predicts that the plan will be a wash on trade. And there’s no way to know how the plan’s intended impact might be distorted by lobbying and all the other parts of tax reform and trade policy reform, not to mention tax competition. Other countries will surely seek to counter any perceived U.S. advantage. The plan will also impact U.S. bilateral tax treaties and the OECD’s BEPS (Base Erosion and Profit Shifting) initiative. Any changes will open up new opportunities for tax arbitrage.
For now, the U.S. government fights inversions through executive action (here) to make it too expensive to circumvent the Internal Revenue Code Section 7874 continuing ownership thresholds. Congress designed the thresholds in 2004 to curb inversions that result in a high degree of continuing ownership by the former shareholders of a U.S. company in the combined company after an international merger. The government presumes that a high degree of continuing ownership signals that the transaction was entered into for tax avoidance rather than non-tax business purposes. But this big stick simply hasn't solved the problem. Dealmakers have become adept at structuring their inversions to fall just outside of the thresholds.
Some Democrats want to double down and move to a purely worldwide system of taxation. Their rhetoric suggests that they would take any number of other steps to make U.S. companies pay an effective rate closer to the current statutory rate of 35 percent.
This could make the problem worse, by encouraging more companies to flee and leading to more government intervention. One idea, floated many years ago, would change the continuing ownership threshold to 50 percent, but this would stop nearly all international M&A activity except the acquisition of U.S. companies by larger foreign companies.
It will take a lot of work to move the needle on the Republican plan, but the government is running out of sticks to compel companies on taxes. Republicans have long argued that the best way to stop inversions is to give companies the tax incentive to stay. Maybe we should start having a real discussion about carrots instead of sticks.
(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters and author of the Corporate Transactions Handbook. The views expressed here are his own.)
This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Jan. 18. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters