Obama administration officials freely admit that their new effort to deter corporate inversions -- a form of accounting fiction U.S. corporations are increasingly using to avoid taxes on income they earn in foreign countries -- won’t actually stop the practice. As a senior Treasury Department official put it Tuesday, “Legislation is the only way to close down inversion effectively.”
Said official’s analysis was right on target, although the administration’s legislative fix isn’t so well aimed.
An inversion happens when a U.S. corporation buys a smaller foreign firm, then creates a new foreign holding company (on paper, mainly) to own the combined assets. Although it doesn’t move its operations or even the location of its top executives, the company declares that its corporate home is now in the country where the new holding company is officially based.
Congress has tried at least twice to block this sort of maneuvering, but it’s still available whenever the takeover target winds up owning more than 20% of the new holding company. The most enthusiastic inverters have been drug manufacturers, but deals announced this year by retailer Walgreens (which later dropped the plan) and Burger King show that the tactic is spreading to other industries.
On Monday, Treasury Secretary Jacob Lew announced several steps to make inversions more difficult to pull off and less beneficial to the companies involved. On the former front, it tightened the rule barring companies from inverting through a merger when they owned 80% or more of the merged company. And on the latter front, it outlawed three techniques used by inverted companies to avoid paying U.S. taxes on profits made by the foreign subsidiaries of U.S. corporations.
In a press conference Tuesday, the aforementioned senior official -- speaking anonymously, in that curious Washington tradition -- acknowledged that the administration’s unilateral efforts to guard against tax evasion wouldn’t eliminate all the incentives to invert. For example, inverted companies would still be able to engage in “earnings stripping,” an accounting gimmick used to transfer profits earned in the United States to corporate siblings in lower-tax countries.
That’s why Congress has to act, the official said. President Obama has called on lawmakers to broaden the corporate tax base by eliminating some tax breaks, generating enough money to offset the revenue lost by lowering the rate. The United States currently has the highest corporate tax rate -- 35% -- in the developed world; Obama has proposed to lower it to 28% in general and 25% for manufacturers.
So far so good. Big U.S. companies may not pay the full 35%, thanks to the many credits, exemptions and preferences available for favored industries and activities. But researchers have shown that the high rate encourages tax avoidance strategies, which shift the tax burden onto companies and individuals that can’t -- or aren’t sophisticated enough to -- keep their profits out of the IRS’ reach. It’s better to have a tax system with lower rates and fewer breaks than one with higher rates that many businesses avoid paying.
The other half of Obama’s legislative solution is to make inversions all but impossible by preventing a company from expatriating its corporate home through a merger unless the foreign company involved acquires at least 50% of the shares. But here, the administration is just treating the symptoms instead of the problem.
Bear in mind that an inversion doesn’t stop a U.S. company from owing taxes on its U.S. profits -- that’s why multinational companies engage in earnings stripping, among other questionable tactics. Instead, a prime motive for inverting has been to avoid U.S. taxes on a company’s overseas profits.
The United States is the only country that taxes profits earned in foreign countries. The profits are taxed by those countries too, so the United States collects just the amount owed above the foreign tax payment, and only when the profits are brought back into this country. Nevertheless, given how much higher the U.S. rate is than other countries’, many multinationals don’t repatriate their foreign profits. Instead, they reinvest them outside the United States or let them sit unused on their balance sheets.
That doesn’t help investment or economic growth here at home, which may explain why every other developed country has abandoned the idea of taxing foreign profits. The best argument for taxing global income is that it gives the United States a measure of protection against multinationals shifting profits to shell companies in foreign tax havens, but the protection isn’t worth much if the profits are never repatriated.
Ultimately, stopping the global game of tax hide-and-seek involves addressing both the incentive and the opportunity. Lowering the U.S. corporate tax rate to a level closer to the rest of the developed world is part of the equation. So is getting more international cooperation to stop companies from hiding profits in the cracks between different countries’ tax laws. The Organization for Economic Cooperation and Development recently announced a series of steps it is undertaking along those lines, and they will help.
What’s missing from the administration’s approach is a way to stop discouraging U.S. companies from repatriating overseas profits without encouraging more gimmickry that shifts profits overseas. That may require Congress to take a new approach to taxing multinational corporations. One intriguing proposal comes from District Economics Group, which suggests that a multinational’s profits be apportioned for tax purposes based on where it makes its sales, not where it assigns those profits.
U.S. corporations have been holding a growing amount of money overseas to avoid U.S. taxes. Last year alone, according to one study, the total exceeded $2 trillion. That’s a powerful incentive to engage in tax-avoidance gyrations, and if all the administration and Congress do is bar inversions, they’ll just invite a different kind of twist.
Follow Healey’s intermittent Twitter feed: @jcahealey