Corporate Inversions

Chairman Thomas and members of the Committee, thank you for inviting me to comment on "corporate inversions". An inversion occurs when a US parent corporation with foreign subsidiaries (controlled foreign corporations, or CFCs) reorganizes itself in the following manner. First it creates a new foreign parent corporation (or FP), based in a low-tax country such as Bermuda. The US operations then become a subsidiary corporation to FP. The former foreign subsidiaries (CFCs) of the US parent corporation also become subsidiaries of FP. Ingersoll Rand, Noble Corporation, and Stanley Works are among recent corporate inversions.

Inversions are motivated both by the US parent corporation's desire to reduce the burden of US taxation on the activities of its foreign subsidiaries and by its desire to partake in the delights of earnings stripping. The core issue is not US taxation of income from business activity transacted entirely within the United States; rather the core issues are US taxation of income from business activity entirely outside the United States (the extraterritorial income problem) and the US deduction for interest paid by US corporations to foreign parent corporations (the earnings stripping problem).

Back in 1975, when I was Director of the International Tax Staff in the US Treasury Department, J.L. Kramer and I coauthored an article titled "Higher US Taxation Could Prompt Changes in Multinational Corporate Structure".¹ Congress was then debating severe limits on the foreign tax credit for oil and gas income, and elimination of deferral. We argued that such changes might prompt corporate expatriation (now called corporate inversion) on a large scale-thus defeating the purpose of the proposed tax laws. The proposals died in the Congress, and corporate expatriation drifted from the public policy debate. But it did not drift from the minds of clever tax attorneys. Every time tax regimes change in the United States or abroad, tax advisors take a fresh look at corporate structures to see whether reorganizations could save a pot of money.

Sure enough, over the last three decades, the United States has created a tax atmosphere that encourages inversions, but not in the way we feared back in the 1970s. Instead, other legislative changes in the 1980s and 1990s gradually made the United States less desirable as a location for parent corporations (the extraterritorial income problem). Meanwhile, foreign corporations with US corporate subsidiaries discovered that the best way to gather income from their US operations was through interest payments, not dividends (the earnings stripping problem). Lately, some US corporations have decided that they, too, would like to take advantage of earnings stripping.
In the Reagan era, the United States sharply lowered its corporate tax rate, initially making the United States a very attractive place to do business. But other industrial countries soon got smart, and lowered their corporate tax rates as well. Today, the United States is the fourth highest corporate tax rate country in the OECD (counting both federal and sub-federal taxes), exceeded only by Japan, Belgium, and Italy.² If all OECD countries had the same system for taxing foreign subsidiaries, this fact alone would make the United States an undesirable location for parent corporations. If the same parent corporation were located not in the United States, but in another industrial country such as Canada, the United Kingdom, or the Netherlands, the parent country tax burden on foreign subsidiary income would be lower.

Other tax facts reinforce this basic point. Most importantly, the norm among industrial countries is de jure or de facto exemption systems for dividends received by parent corporations from most of their foreign subsidiaries (those that are actively engaged in business, not just off-shore pocketbooks). By contrast, the US worldwide tax system taxes the dividends received from foreign subsidiaries, but allows a foreign tax credit. This is a lot more complicated, and often results in additional tax paid by the parent corporation.

Peculiar features of the US foreign tax credit limit also make the United States a less desirable location for parent corporations. The United States has an absurd method for allocating parent company interest expense to foreign source income, and the net result is to reduce the parent corporation's allowable foreign tax credit. Unlike other countries, the United States attributes a substantial portion of R&E expense to foreign source income, and this too reduces the allowable foreign tax credit.

Continuing the list of disadvantages, the United States disallows deferral for so-called "base company income"-income earned by a foreign subsidiary for handling export transactions between members of a corporate family. In other words, base company income is taxed currently under Subpart F of the Internal Revenue Code. Other industrial countries, for the most part, either exempt base company income from home country taxation, or permit deferral.

Meanwhile, the WTO has ruled against the Foreign Sales Corporation and Extraterritorial Income Exclusion Act. If these provisions are simply repealed, that will be another negative score for the United States.

Finally, there's the competitive tax disadvantage to the US parent corporation that competes, in the US domestic market, with a foreign parent corporation that conducts its business through a US subsidiary. The foreign parent can "strip" the earnings of its US subsidiary by using a capital structure high in debt and low in equity. Interest paid to the foreign parent is a deductible expense for the US subsidiary; and after interest is paid, hardly any earnings may be left for the US corporate tax. The US parent can't play the same game, because it files a consolidated return with its US subsidiaries, and interest payments within the corporate family simply net out. But if the US parent inverts, the newly created foreign parent can strip the earnings of its US subsidiaries.

With all these tax disadvantages, it's not surprising that some US parent corporations are jumping ship. Inversions are just the tip of the iceberg. Less noticeable, but more important, foreign multinationals are acquiring US companies at a much faster clip than the other way around. Taxes are not the only reason, but they are a contributing force. So long as the US tax system is unfriendly to parent corporations, and friendly to foreign parent corporations, there will be a strong tendency for multinational companies to locate their headquarters elsewhere. This will show up in the way mergers and acquisitions are structured, the balance between debt and equity in US subsidiaries, the headquarter choices made by firms of the future, and in more US corporate inversions. Purely from a tax standpoint, few attorneys today would recommend putting the headquarters of a multinational firm in the United States. Why subject your foreign subsidiaries to the US worldwide tax system? Why deny yourself the advantages of earnings stripping?

Congress can make inversions more difficult by "look-through" provisions, such as those proposed by Senator Baucus and Senator Grassley, or by raising the toll-taxes under Sections 351 and 367. Congress can deter earnings stripping by applying a stricter debt/equity ratio to inverted corporations under Section 163(j). But such remedies do not address the underlying problem-the fact that, from a tax standpoint, the United States is not a good location for headquartering a multinational corporation.

The extraterritorial income dimension of the underlying problem can only be addressed by centering US corporate taxation on business activity within the territorial borders of the United States, and exempting the activities of foreign subsidiaries engaged in trade or business abroad. The earnings stripping dimension can only be addressed by applying the same debt/equity ratio test to all US subsidiaries of foreign parent corporations, whether the foreign parent is an inverted US parent, or a foreign parent home-grown in another country.

In my opinion, it's far more important for the United States to retain its position as the nerve center for multinational corporations than to collect whatever revenue is gathered from the activities of foreign subsidiaries by the cumbersome US system of taxing worldwide income. And it would be foolish for the United States to enact new tax provisions (such as a discriminatory earnings stripping rule) that would give foreign multinationals a leg up when competing in the US market.

Where headquarters are located, key corporate functions of strategy, law, finance, distribution and R&E activity are likely to follow. For the high-skilled, high-tech society of 21st century America, these are critical functions. Corporate inversions are not the fundamental problem; they are simply the wake-up call.

Notes

1. International Tax Journal, Summer 1975.

2. Chris Edwards, "New Data Show U.S. Has Fourth Highest Corporate Tax Rate", Cato Institute Tax and Budget Bulletin, April 2002.