Sunday, November 23, 2014

The Inverted World of Mobile Capital

BERKELEY – A growing number of American companies are seeking to move their legal headquarters abroad by acquiring or merging with foreign companies. In the latest case, Medtronics plans to acquire Irish-based Covidien, a much smaller company spun off by US-based Tyco, and move its legal headquarters to low-tax Ireland, culminating in the largest ever “inversion” or “redomiciliation” of a US company. Walgreens is reportedly considering moving its headquarters to the United Kingdom by acquiring the remaining public shares of Alliance Boots, the Swiss-based pharmacy giant.

Such deals reflect the deep flaws in the United States’ corporate tax system. The US has the highest statutory corporate tax rate among developed countries and is the only G-7 country clinging to an outmoded worldwide tax system under which the foreign profits earned by US-headquartered companies incur additional domestic taxes when they are repatriated.

By contrast, all other G-7 countries have adopted “territorial” systems that impose little or no domestic tax on the repatriated earnings of their global companies. This difference puts US-headquartered multinationals at a disadvantage relative to their foreign competitors in foreign locations. To offset this, US multinationals take advantage of a deferral option in US tax law.

Deferral allows them to postpone – potentially indefinitely – the payment of US corporate tax on their foreign earnings until they are repatriated. Not surprisingly, as their foreign earnings have grown as a share of total earnings, and as foreign corporate tax rates have plummeted, US companies’ stock of foreign earnings held abroad has soared, now topping $2 trillion.

The US system thus implies significant costs, as companies hold more cash abroad, borrow more to finance domestic cash requirements, and invest more in foreign locations. Deferred earnings are “locked out” of the US economy: the government receives no tax revenues from them, and they are not directly available for domestic use by US companies. This undermines their ability to compete with foreign companies in acquiring other US companies. It also makes investments by US shareholders in domestic companies less attractive relative to investments in foreign companies that can distribute their foreign profits in the US without an additional tax penalty.

Overall, deferral distorts corporate balance sheets, imposing efficiency costs on US companies that are estimated to be 5-7% of deferred earnings. As the stock of deferred earnings grows, these costs accumulate, and moving legal headquarters abroad through cross-border acquisitions becomes a logical step for US companies with a large stock of deferred earnings abroad. Companies like Medtronics can then use future foreign earnings in the US with little or no repatriation tax. Such companies have a strong incentive to redomicile abroad even to finance their US investments.

To be sure, strategic rather than tax considerations drive corporate mergers and acquisitions. The recent surge in cross-border M&As to a seven-year high is the result of ample cash, strong balance sheets, cheap financing, and buoyant stock markets. But tax considerations play a major role in corporate decisions regarding how acquisitions are financed and where a merged entity is located. Large balances of foreign earnings are available to many US firms to finance their foreign acquisitions, and the competitive disadvantages of the US corporate tax system militate against locating the merged entities in the US.

Though American officials rail against “inversions” as unpatriotic, they are an efficiency-enhancing response to the flaws in the corporate tax system. As the prospects for corporate tax reform deteriorate, cross-border mergers with redomicilation are becoming an attractive option for many of America’s most competitive global companies. And the pressure on other companies to follow suit intensifies as more inversion deals are done.

Under current law, US companies can move their legal headquarters abroad for tax purposes by buying a smaller foreign company as long as the acquired company’s shareholders end up owning at least 20% of the combined company. To discourage inversions via cross-border M&A, President Barack Obama’s administration and several Democratic members of Congress have proposed legislation that would increase that percentage to at least 50%.

Moreover, a merged foreign company would be treated as a US company for tax purposes (regardless of share ownership) if its management and control functions and a substantial share of its economic activity – sales, employment, or assets – are located in the US. If enacted, the legislation would apply these new conditions retroactively to inversions occurring from May 2014.

Such policies will not address the underlying causes of inversions, will add to the widely acknowledged distortions in the corporate tax regime, and are likely to have negative unintended consequences. To meet the tougher new ownership requirements, US companies might respond by breaking up their business units into smaller pieces – reducing their market value and the returns to their shareholders and workers. Likewise, to meet the tougher new management and control conditions, US companies might respond by shifting more of these functions, and the jobs and investment (especially in research and development) associated with them, to foreign locations.

The proposed anti-inversion measures would also make it more likely that US companies are the target, rather than the acquirer, in cross-border M&A deals. Corporate tax reform should make the US a more attractive place for business activity; threatening US corporations with tougher rules on cross-border M&A and retroactive tax increases will have the opposite effect.

The US should learn from the British example. In 2008, several large UK companies threatened to redomicile in Ireland because of its lower corporate tax rate. The British government responded by cutting its corporate tax rate from 28% to 20% by 2015; introducing a territorial tax system that exempts UK-based companies’ foreign earnings from domestic taxation; enacting a “patent box” that provides a 10% corporate rate on patent-related income; and adopting a new 10% non-incremental, refundable R&D tax credit. So far, these innovations appear to be attracting companies, investment, R&D, and jobs to the UK.

Bold and prompt US action to reform the corporate tax system is essential. Sadly, that is not likely in a deeply divided Congress in an election year.

Laura Tyson is an economic adviser to the Alliance for Competitive Taxation, an independent group of US companies committed to corporate tax reform.

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    1. CommentedJonathan Lam

      gamesmith94134: The inverted world of Mobile Capital

      It was interesting in reading de Lafayette's Double Irish Dutch Sandwich that how Corporate America turned into Corporate Bermuda; and I believe it is true that the inversion took place as the America Tax Law would allow company to M&A in foreign soil; and It sound like US tax system have created the magnet that attracts foreign investment but their merger to US. So, like Ms. Tyson complains, "This undermines their ability to compete with foreign companies in acquiring other US companies. It also makes investments by US shareholders in domestic companies less attractive relative to investments in foreign companies that can distribute their foreign profits in the US without an additional tax penalty." To offset this, US multinationals take advantage of a deferral option in US tax law, instead, they took the deferred tax to merge or buy off the foreign company to make inversion or redomicile inevitable. perhaps, I would remind Ms. Laura Tyson globalization could be the factor to the behaviour how corporate can circumvent US tax law with deferred tax by diversify its profits from inversion. I do not think 50% corporate Tax and domestic tax enhance R&D or anything. I see Mr. de Lafayette's “Double Irish Dutch Sandwich” is more convincing and patent in other nations are also protected under the law; and many find TIPP is lopsided in favoritism and apply protectionism to their defense.
      First, I would recommend Ms. Laura Tyson to research on the Chinese policy on the purchases on housing that the homestead clause, and limitation to financing or merger to own land or to build that applies 'do it or leave it' cut turnovers in pricing for housing industry. It cut prices to 12% and sustains in stable manner in the recent study.
      Second, tax reform under Mr. Obama is not going to work in the Congress now; even with the 50% Corporate tax. It only adds more weight to the 200 lbs more and more profits to the lawyers. Another add-on is just like another Obamacare that is promising but not practical to users who are disadvantage to merge in US.

      Thirdly, we can focus on the import and export that are taxed on the dock; perhaps, World Trade Organization can use an Universal anti-trust law and Sherman act to limit merger and acquisition on the homestead clause like the percentage on operations and productivity for all corporation. It may not be applied to Corporate America but an universal treaty that eliminates shell companies and inversion that are presently abused.
      Eventually, many would see the tax war cannot resolve the inversion; we must take another approach in reviving the genuine quality of tax law. We cannot delay the process of application on foreign and domestic tax law; if Mr. Obama is finding the hard time to pass his tax law in our Congress. personally, I prefer the third option in the universal Tax Law that would cut waste and time. Let World Trade Organization to prepare a plausible resolution of further damage of merger and defiance of tax supportive measures.
      I think our Congress is overweight with it tax loophole and deferred tax. They builds protectionism to fend off invasion and created its jumping board to invade other is not a good defense. Fair trade must apply.

      May the Buddha bless you?

    2. CommentedPrasanna Srinivasan

      The difference in tax rates issue won't be resolved till all major locations of business are on par. However, suggesting that non-repatriated profits don't benefit the US is putting this simplistically. The surplus earnings will be invested through investment funds and may well find their way back to the US (which is still the "safe" economy.). If the government now combines the 'largely managed" clause to capture taxes, they'll end up doing the thing they don't want, viz, shifting the jobs. Several nice places (like a Singapore, Hong Kong, Ireland) will happily take on the shifted jobs.

    3. Commentedde Lafayette

      There is a grievous miscarriage of justice being perpetrate by Corporate America, and it is astounding that the US A.G. allows it to happen.

      Or, perhaps, it is just Tax Law that permits it because the legal hand of the law is not sufficiently long?

      Regardless, you are invited to read about the “Double Irish Dutch Sandwich” here:

    4. CommentedMark Louis

      Seems to me this "solution" is simply rewarding bad behavior. Yes, the US has a high statutory rate, but very few companies actually pay it due to the plethora of tax breaks available. The rate actually paid by US companies is not out of line with OECD countries.

      Second, we are in a period where corporate profits are at a record high as a % of GDP while the corporate tax rate is nearer to the low end of the historical this really the time to further help that segment of the economy? That seems particularly questionable when you consider the broad swaths of the economy that are faring well below historical norms (e.g., labor, the poor).

      If individuals were to threaten to leave would we respond with a lower tax rate? Highly doubtful since we know it is hard for them to actually move. Corporations can simply make some cosmetic changes and make the move. Should we reward that double-standard? Perhaps we should simply make it harder for corporates to move. Perhaps your profits are actually earned where your sales occur and/or where your executives and their families reside. Seems reasonable, no?

      I can't help but think that all this talk of helping corporations (who clearly do not need the help due to record profit levels) reeks of corporate influence on DC. Not surprising considering the massive sums of money they contribute to the political process.

      Let's get more creative (and logical) than simply rewarding bad behavior in the face of a fairly weak threat by those who are benefiting most from the current system.

    5. CommentedStamatis Kavvadias

      Laura Tyson is absolutely right and wrong at the same time! The UK example she advocates, is a global race to the bottom of corporate tax rates! This is not in the interest of sovereigns and the largest percentage of their populations. Instead, International deals on corporate taxation should be aimed, with disadvantages for non participating countries.

      This is the reasonable way forward ...and not to the bottom! In this case, the market mechanism for setting competitive corporate tax "prices" is a mechanism for increasing inequality, to the benefit of deregulating taxation and of those countries that provide inequality enhancing tax systems. What happened with bank deposits in the eurozone is happening with companies in the US.

    6. CommentedG. A. Pakela

      If President Obama were to propose significant corporate tax reform, lowering the after-tax cost of capital, and have his consigliere, Harry Reed, push the bill through the Senate, is there any doubt that it would get passed overwhelmingly by both Houses of Congress?

    7. CommentedPaul Daley

      Essentially a complaint that the United States is losing the race to the bottom. But it might make more sense to expand current trade deals to cover the purchase and sale of capital assets. It's not that hard to define predatory behavior in that area.