Corporate Inversions Are all about Avoiding Taxes, Congress Should Act Now
Tuesday’s New York Times ran two interesting articles with the rather alarming headlines: “U.S. Drug Firms Seek Inversion Deals to Evade Taxes” and “Reluctantly, Patriot Flees Homeland for Greener Tax Pastures.” Both articles reported on U.S. multinational corporations trying to merge with smaller foreign corporations to move the parent corporation offshore to a lower tax country, known as corporate inversions. In essence, the corporations are giving up U.S. “citizenship” so as to avoid U.S. taxes. It is time for Congress to put a stop to the erosion of the corporate income tax base.
The corporate inversions that have been in the news recently are Pfizer wanting to become a U.K. firm (the deal has been temporarily withdrawn), and Walgreens wanting to become a Swiss firm. Now AbbVie, a Chicago-based firm, wants to become an Irish firm, and Mylan, a Pittsburgh firm, wants to become a Dutch firm (ironically, the CEO of Mylan was named “Patriot of the Year” in 2011 by Esquire magazine).
These mergers have several things in common. First, the current shareholders of the U.S. firms will own the majority of the stock in the new foreign firm (typically 70 to 79 percent). Second, little or no economic activity will be moved from the United States to the new home country. Third, the corporate tax bill of the new firm will be substantially lower. Last, some of the current stockholders could face higher tax bills. Let me discuss each in turn.
Most recent corporate inversions involve a large U.S. corporation merging with a much smaller foreign corporation. The resulting merged corporation would then be incorporated in the foreign country, which, unsurprisingly, has a lower statutory tax rate than the United States and does not tax foreign-sourced income (i.e., has a territorial tax system). For the merged corporation to be considered a foreign corporation under U.S. tax law the current shareholders of the U.S. firm can own no more than 79 percent of the merged corporation, otherwise the merged corporation is treated as a U.S. corporation for U.S. tax purposes.
In each case, the U.S. firm is not closing shop and moving overseas. Almost all of the production and current jobs in the U.S. will remain in the U.S. Even the headquarters will remain in the UnitedStates and the new foreign firm may even be listed on a U.S. stock exchange. What could happen is any future job expansion and investment may be overseas rather than in the United States, but that is highly uncertain.
Of the four proposed inversions mentioned above, three will have their home in a tax haven (the home country)—Ireland, Switzerland, and the Netherlands (which has many features of a tax haven but is not usually included on official lists of tax havens). The fourth involves the United Kingdom, which recently reduced their corporate tax rate (from 25 percent to 20 percent) and moved to a territorial tax system. (Under EU rules, the U.K. cannot prevent firms from moving to other EU countries.) The U.S. statutory corporate tax rate is 35 percent (though the average effective U.S. corporate tax rate is about 28 percent or even lower) and is higher than, say, Ireland’s 12.5 percent corporate tax rate. But more importantly, these countries have territorial tax systems in which foreign-sourced corporate earnings are not taxed in the home country. Earnings from U.S. operations will be taxed by the United States, but earnings from operations in third countries will not be taxed by the United States or the home country, regardless of where the money ultimately flows to (which could very well be U.S. shareholders).
In the case where the current U.S. shareholders own 60 percent to 80 percent of the new merged firm, the shareholders will owe capital gains taxes on the appreciation in their shares when they are converted into the stock of the new company. This would not be true for foreign shareholders or tax-exempt shareholders such as 401(k) plans and IRAs, which is why some shareholders controlling large blocks of stock do not oppose corporate inversions even though it is not in the best interests of all shareholders.
Most analysts agree on what the problem is: our dysfunctional corporate tax system. But there is much less agreement on the solution. Some argue that the corporate tax rate should be reduced and/or the United States move to a territorial tax system. However, corporate tax revenues would likely fall, thus exacerbating long-term fiscal problems and increasing the perceived unfairness of the tax system. Others argue that the problem should be dealt with in the context of fundamental corporate tax reform. Unfortunately, major tax reform is unlikely in the near- to medium-term with the current political climate and mid-term elections drawing near.
This leaves us with the more targeted solution of tightening the U.S. anti-inversion rules. Several bills have been introduced (e.g., H.R. 4679 and S. 2360) that would allow U.S. corporations to invert only if they truly became a foreign firm. The current shareholders of the U.S. firm would have to own less than 50 percent of the new merged firm. Furthermore, the new merged firm would be treated as a U.S. corporation if it is managed and controlled in the United States, and had “significant domestic business activities” in the United States.
U.S. firms merge with smaller foreign firms for many good reasons such as to take advantage of economies of scale and scope, gain easier access to new markets, and obtain new product lines. But none of these reasons require the U.S. firm to give up their U.S. “citizenship.” U.S. firms invert solely to escape paying U.S. corporate taxes. At least 47 corporations have inverted in the past 10 years; Congress should act now to prevent further inversions and loss of much needed corporate tax revenue.