© 2016 Prof. Farok J. Contractor, Rutgers University
NOTE: This article first appeared in YaleGlobal Online, a publication of Yale University MacMillan Center, April 12, 2016. Portions reproduced with permission.
Subsequently, it also appeared on The Conversation (US Edition), April 20, 2015. Sign up for their newsletter here.
Companies “…effectively renounce their citizenship…[by using] insidious tax loopholes…fleeing the country just to get out of paying their taxes.” – President Obama speaking on April 5, 2016
The Obama administration’s recent tightening of rules about “inversions” (US companies relocating overseas) has heightened the debate about American corporate tax rates and the resulting impact on the competitiveness of American firms.
As I conclude, even though inversions so far have been relatively few in number, they have figured prominently in the press and political campaigns because they touch upon very sensitive issues facing the US and world economy.
What Is an “Inversion”?
In simple terms, it is when a US company shifts its corporate headquarters to a country like Ireland, where corporate taxes max out at 12.5% compared with the maximum 35% US tax rate. For large multinational firms, the annual savings can be in the billions. But the US would then lose even more than that in tax revenues.
However, it is not just a matter of declaring a new address and printing new stationery. The US company has to acquire (buy) a foreign firm large enough to qualify for the inversion. Some examples since 2012 include Mylan moving to the Netherlands, Burger King to Canada, and Medtronic to Ireland—all of which have lower tax rates than the US. The recent rules announced in April 2016 by the Obama administration make such foreign takeovers even tougher.
Pfizer (US) and Allergan (Ireland) abandoned their proposed merger the day after the Treasury Department announced the tighter rules on April 5, 2016.
The Argument for “Inversions”
Many in corporate America believe that US taxes are already too high and that taking advantage of loopholes to reduce payments is legitimate. Here is a summary of that opinion:
- The US federal corporate tax rate (at a maximum of 35%) is already one of the highest in the developed world. Not only that, but unlike most major countries, the US tax is applicable not only to American operations, but to all worldwide operations of the company.
- Paying taxes only encourages Congress to spend more money on other programs.
- American companies suffer a competitive disadvantage vis-a-vis firms located in lower-tax nations. Paying higher taxes means:
– Less money is left over—and smaller dividends for US shareholders
– Less money is left over to put back into research and development (R&D)—which ultimately determines the competitiveness of the US firm in global competition
- Inversions are legal: If congressional rules allow certain loopholes, it is the company’s fiduciary duty toward shareholders to use such loopholes to (legally) avoid tax payments.
- The change of domicile is only for tax purposes—necessary operations and jobs would remain in the US.
The Argument Against “Inversions”
While most opposition to inversions has come from Democrats, many Republicans, including conservatives such as Chuck Grassley (R-IA), dislike them as well:
- The US federal corporate tax rate actually is not 35%. That is only the marginal rate on the last slab of income. The actual rate—after the plethora of deductions and other loopholes available—is variously estimated to be not more than 19.4% (according to Citizens for Tax Justice) or 27% (according to Price Waterhouse). What American firms effectively pay is a secret known only to the IRS (Internal Revenue Service). Even taking the 27% rate from Price Waterhouse, that would put the US tax burden in the middle of the OECD (Organisation for Economic Co-operation and Development) advanced-nation group.
- Taxing not only the firm’s US profits but also the profits of its worldwide subsidiaries may sound terrible, but actually is not because of a gigantic loophole. Tax on American companies’ foreign source income can be avoided by the simple expedient of simply not repatriating foreign affiliate profits back home to the US, instead parking it in tax havens abroad and/or reinvesting the profits in yet other foreign nations. This deferral of US tax is legal and indefinite in duration, with the result that US multinationals have no reason—and no incentive—to repatriate their foreign affiliate profits back home to the US. This is such an enormous loophole that the accumulated (but not yet repatriated) foreign profits of US multinationals have been estimated between $2.1 trillion and $3 trillion. With the tax on such profits being indefinitely deferred, this is almost akin to tax forgiveness.
- Multinationals enjoy yet other tax avoidance schemes, such as international licensing (royalty payments) between affiliated entities, charging central fixed costs and overheads to various foreign affiliates, and creating intra-corporate loans or export shipment “transfer-pricing” (all of which can reduce tax or tariffs ). Suppose a multinational American company (A) has an Irish subsidiary (I), which enjoys a far lower tax rate in Ireland. Instead of manufacturing the item—such as a drug—in the US, (A) manufactures it in Ireland and has (I) export the drug to its US parent at an inflated price. This has the effect of increasing profits in (I), while reducing taxable profits (and tax) in the US. (The higher profits in Ireland are taxed at a lower tax rate, while the reduced profits in the US reduce US tax liability). Similarly, even though the R&D for a new drug may have been done in the US, patent rights could be transferred to a Bermuda shell company (Bermuda has near zero tax), which then charges royalties for the patent to both (I) and (A), thereby further reducing Irish as well as US taxes while increasing profits in the Bermuda tax haven.
- Loss of tax revenue has to be made up elsewhere from domestic individual taxpayers and domestic US companies (who would otherwise pay less). Most US companies are small or medium-sized, do not have foreign operations, and consequently end up paying higher taxes than their globalized counterparts. It is no surprise that many “Tea Party” sympathizers are owners of small and medium-sized businesses that cannot take advantage of the international business loopholes provided by Congress.
- Yes, it is true that if a multinational firm pays higher tax, less money would be left over to declare shareholder dividends or to replenish the R&D budget. But critics argue that the gains from tax avoidance do not go to R&D or dividends, but instead can be diverted into fatter bonuses and stock options for top executives.
- Inversions may be legal, but they are amoral and unpatriotic.
- Necessary jobs and operations could remain in the US despite relocation of corporate headquarters. However, once having shifted the strategic locus of the company abroad, the chances of additional job creation increases in the rest of the world, rather than in the US.
How “Big” Is the Inversion Phenomenon?
After all is said and done, this phenomenon is not big or consequential—so far. Bloomberg estimates that up to 70 large US firms have relocated headquarters abroad since the year 2000 (see below). However these data are not comprehensive. Moreover, they do not include new foreign direct investments in the US that have chosen, from the beginning, not to establish headquarters in the US as a result of the perception (real or rhetorical) that US taxes are high. The latter category has far greater economic consequence than the mediagenic reports of well-known American companies such as Pfizer that have tried to “invert.”
Source: Bloomberg QuickTake, April 6, 2016: “Tax Inversion: How U.S. Companies Buy Tax Breaks”
Unanimity About the US Tax Code?
In a raucous and fractious US democracy, can one dare to use the word “unanimity”? Yes. Virtually all factions and economists agree that the US tax code is a bloated monstrosity with thousands of arcane provisions and loopholes and that it should be simplified. Small firm owners, and individuals who cannot afford the legal, accounting, and lobbying clout of large multinational firms in Washington, DC, feel they have no voice in simplifying the tax code or in making it more equitable. But, despite the virtually unanimous opinion about rationalizing the US tax code, nothing is done because of the concentrated vested interest on the part of international tax experts, lobbyists, lawyers, and the large firms that can afford to hire them with generous professional fees. Hence the growing political disenchantment with concentrated political power in Washington, DC. (Is it coincidental that out of the 3,007 counties in the US, seven of the top ten counties—using median income as a measure—are Washington, DC suburbs?).
Conclusion: Inversions are such a sensitive issue because they illustrate fundamental “fault lines”
Inversions themselves are not ubiquitous or of great consequence . . . thus far. Why, then, all the hue and cry? Inversions have crystallized debate on critical dilemmas facing the US and global economy. An inherent contradiction (and jurisdictional disputes) prevails in a world where
- Separate country-by-country taxation exists while multinationals can treat the world as one economic space.
- An inherent tension exists between maximizing shareholder value by relocating jobs or profits abroad versus keeping jobs and activity in the US.
- Over the past two decades, the “bottom 40 percent” of the US working population has seen its effective income stagnate, while the “upper 20 percent” comprising highly skilled personnel working for large companies has prospered because of their technical skills and education.
- Small businesses that cannot take advantage of international tax loopholes are resentful of large multinational firms that can shift operations, earnings, and tax payments across countries.
- Vested interests and their lobbyists, concentrated in seven counties surrounding Washington, DC, do not necessarily reflect the interests of the rest of the US.
Hence, the issue of “inversions” highlights fundamental issues and tensions that the US needs to confront in the 21st century—issues that have been building steam over the past two decades, but that have been avoided by a political establishment content to “kick the can down the road” and avoid making the hard decisions.