By Hunter Blair, Economic Policy Institute
Yesterday, the Treasury Department took laudable regulatory action to discourage corporate inversions, a tax evasion maneuver where U.S. multinational corporations merge with much smaller foreign corporations in order to move the corporation, on paper, to a lower-tax country. As Treasury Secretary Jack Lew notes, “After an inversion, many of these companies continue to take advantage of the benefits of being based in the United States—including our rule of law, skilled workforce, infrastructure, and research and development capabilities—all while shifting a greater tax burden to other businesses and American families.”
The new Treasury rules make it harder for companies to access some of the tax benefits of corporate inversions. If the shareholders of the old U.S. parent company end up owning more than 60 percent of the new merged foreign company, then many tax benefits obtained by inverting will be clawed back by Treasury. Today’s rule changes strengthen this provision by excluding the stock of the foreign company attributable to assets acquired from an American company in the three previous years. The upshot is that the ability of foreign companies to engage in serial inverting is reduced.
To see how this works, consider the recent example of Pfizer’s proposed inversion with Allergen. In 2014, Treasury issued a Notice to limit the tax breaks associated with an inversion to companies whose original shareholders owned less than 60 percent of the new merged foreign firm. Pfizer therefore structured its inversion so that its current shareholders would own 56 percent of the newly merged foreign company. However, Allergen is a serial inverter, being the result of numerous mergers with American companies over the past 3 years. With the new regulatory guidance, it looks likely that the Pfizer-Allergen inversion will no longer meet the appropriate threshold. The new regulatory action means that foreign firms cannot simply use a string of acquisitions to increase their size and avoid inversion thresholds.
Treasury is also trying to impede the practice known as “earnings stripping.” This is where the U.S. subsidiary of the now-foreign firm is loaded up with debt, reducing the taxable income of the U.S. subsidiary, since these interest payments are now tax deductible. In turn, the profits of overseas subsidiaries increase, but face foreign (presumably lower) corporate taxes. As we’ve outlined previously, one way regulatory authority can limit this loophole is through reclassification of the U.S. subsidiary’s debt as equity. Given their limited toolbox, the Treasury was able to apply this reclassification to shareholder dividends and economically similar transactions. However, the proposed regulations do not apply to related-party debt incurred for business investment. Since money is fungible, multinational corporations and their tax engineers will likely find a way around this before too long—but it provides a useful stopgap in the short-run.
The Treasury’s regulatory actions continue to provide temporary fixes, which will help reduce the short-term erosion of the U.S. corporate tax base. They deserve credit for using the limited tools available to them in the most robust way to slow this erosion. But regulatory authority can only go so far, and legislative action is necessary to fully stop this type of corporate tax evasion. One possibility is allowing U.S. corporations to invert only if they truly become a foreign firm, meaning that current shareholders of the U.S. firm would have to own less than 50 percent of the new merged foreign firm.
Sadly, rather than pass more targeted fixes to corporate inversion, a Republican-led Congress has decided to sit on its hands as multinational corporations avoid more and more taxes, eroding the corporate tax base, and shifting the burden of taxation onto domestic companies and American workers.