Following a summer filled with foreign mergers, tax inversions have become the innovative and morally dubious business practice of 2014. As American firms shift their headquarters overseas, widespread claims that a continued corporate exodus will critically hurt both tax revenues and the United States economy have sent regulators, politicians, and the IRS into a frenzy. Blame has largely been assigned to corporations, but the trend has a thick silver lining. In addition to raising awareness of the horrible shortcomings of American corporate taxation, these inversions may prove to help the U.S. economy.
Tax inversions are a benign response to painfully hostile American corporate tax policy. Corporations purchase smaller foreign companies in countries with lower corporate tax rates, and then use the foreign company’s headquarters as that of the newly merged corporation, bringing the company within the tax jurisdiction of the more corporate-friendly foreign country. Inversions involve neither American job losses nor capital flight; effectively the entire change happens on paper. Kimberley Clausing of the Tax Policy Institute argues that firms embark on this otherwise trivial accounting trick because American corporate tax policy has “a high statutory tax rate, a worldwide system of taxation, and limits on income shifting.” Not only does the United States’ corporate tax rate peak at 39.1%, the highest in the OECD, an organization of wealthy nations whose average corporate tax rate is 25%, but also profits earned by American firms are taxed regardless of where they were earned. Most governments do not tax foreign earnings, only those earned by foreign firms within their borders. However, American companies often face two rounds of taxation – domestic and foreign. There is somewhat of a loophole; earnings cannot be taxed in the U.S. until they return from abroad. Consequently, many companies choose to avoid the United States’ high corporate tax rate by accumulating profits overseas where earnings are out of the IRS’s reach. This has led to a “large accumulation of unrepatriated foreign cash,” now totaling more than $1.95 trillion, which Clausing argues has driven companies to invert. After shifting their tax jurisdiction abroad, firms can pay the new, lower tax rate and invest their earnings anywhere, including the United States, without having to pay the IRS on the earned profits.
Pharmaceutical firms in particular have seen a wave of tax inversions. Many pharmaceutical companies generate massive overseas revenues, leading to large buildups of foreign cash that make inversions particularly enticing. On September 19th, Horizon Pharma finished its $660 million acquisition of Ireland-based Vidara Therapeutics International, enjoying a much lower corporate tax rate of 12.5%. Medical device maker Medtronic (MDT) is currently undergoing a $43 billion merger with Covidien (COV), based in Ireland as well, and expects to see significant tax savings. Even Pfizer, who has accumulated $69 billion overseas, attempted a bid for inversion with its failed acquisition of Astrazeneca, based in London.
Other sectors have seen tax inversion growth, but have tended to be less obvious. Many tech firms have accumulated massive overseas holdings; Microsoft, Apple, and IBM have collectively doubled their foreign cash to more than $180 billion. After pharmaceuticals, service industries have seen the greatest corporate flight. For example, Burger King (BKW) finalized a merger with Ontario-based Tim Horton’s for $11.5 billion on August 26th of this year. Although Ontario has a lower top rate than the United States, at 26.5% it can hardly be considered a tax-friendly jurisdiction. The merger fits with Burger King’s focus on international expansion and offers menu resources and diversification to better compete with McDonald’s McCafe and Starbucks Coffee. Although the merger would have been a reasonable investment even without the prospect of lower taxes, its timing and nature suggest it to be an inversion.
The most vocal concern about tax inversions is the loss in tax revenue. However, this loss could be offset by new investment. The nonpartisan Joint Commission on Taxation predicted a tax revenue loss of $20 billion over the next ten years. This is considerable, but a relative drop in the bucket for the federal budget, and it excludes new revenues generated from the potential investments. After tax inversions, firms will be more willing to bring earnings to the United States, knowing that their earnings will not be taxed. This incentive would make investing the tremendous quantity of cash held overseas in the United States much more appealing and common, contributing to economic growth. The net impact would be more jobs, greater profits, increased shareholder value, and potentially higher tax revenues from the new growth (as the United States still taxes foreign firms’ profits earned on American soil, capital gains, and income from dividends, all of which could increase). Tax inversions are less effective than meaningful tax reform, but for now they appear to be the lesser of two evils.
In an ideal world, Congress would either repeal or significantly lower the corporate tax rates; however, such action is highly doubtful. Inversions have led to more political rhetoric than policy solutions, peaking with Obama’s statements that, “Some people are calling these companies ‘corporate deserters.’” Since then, he has used Congress’s gridlock as an excuse for sending Secretary of the Treasury Jack Lew to punitively combat inversions. The Treasury imposed restrictions on overseas asset restructuring and loans between subsidiaries of foreign corporations, making overseas cash harder to bring into the U.S. tax-free even after an inversion. There is some evidence, such as the collapse of the AbbVie (ABBV) -Shire (SHPG) merger, that its measures are making an impact. Although AbbVie CEO Richard Gonzalez admits that the “unprecedented unilateral action taken by the U.S. Department of Treasury” had “destroyed the value in this transaction,” the Treasury has created an insufficient solution to a systemic issue: the U.S. tax system needs reform. It is too complex, too expensive, and disproportionately harms domestic firms. Punishing inversions will not change these underlying facts.
Despite all of the bluster and rhetoric surrounding tax inversions, meaningful tax reform is unlikely. Congress’s inclination towards inaction has only intensified with corporate taxation’s addition to the policy agenda. Even with Republican control of both houses of Congress, the issue remains too divisive for a tax bill to garner the votes and presidential signature to become law. And as long as the tax system remains ineffectual, it is hard to blame businesses for wishing to circumvent it. Inversions are neither radical enough to be corporate deserters nor mundane enough to be overlooked; they are simply firms’ solution to a broken system. Until we fix our tax system, we must wait to use the corporate cash waiting at the border.
Disclosure: None
