Making Sense of the Corporate Inversion Craze

CC BY-SA 3.0 Anthony92931

CC BY-SA 3.0 Anthony92931

By: Jacob Romeo

Since 2011, 23 major U.S. companies have been involved in so-called “inversion” deals that together are valued in the ballpark of $500 billion. An inversion, or tax inversion, is a cross-border merger or acquisition structured such that “the foreign minnow swallows the domestic whale.” In so doing, the smaller, foreign company, often only as big as a quarter of the size of the larger domestic company in terms of assets, takes on the excess cash of the U.S. firm and files to have the newly formed company domiciled in a territory with a lower statutory tax rate. This process makes the U.S. company effectively foreign-owned, even if all operations remain within the borders of the United States. Apple, Burger King, Chrysler, AbbVie, and Valeant are just a few of the large industry players that have issued takeover bids for companies residing in “tax-haven” countries such as Ireland, Canada, Netherlands, the U.K, and Bermuda. Government officials fear that the steps taken by these corporate giants to lessen their tax burdens are opening the eyes of others with substantial international operations to a healthy financial opportunity – one that cuts the Internal Revenue Service out of the deal.

As it stands, these inversion deals and other similar offshore profit sheltering strategies are indeed legal. That is, they are not in direct violation of the current U.S. tax code, even if it is clear that the underlying motive behind these deals is to dodge the highest corporate income tax rate in the industrialized world. The more pressing issue at hand is not if there is any wrongdoing on behalf of companies who choose to invert, but rather if the existing tax code should be changed. The statutory tax rate on corporate profit in the United States is close to 40% when factoring federal and state taxes into the calculation. Compared to the United Kingdom’s 21%, Ireland’s 12.5%, and even the Netherlands’ 25%, it appears that the U.S. takes its fair share of corporate earnings. In practice, though, most U.S. firms pay taxes at a rate much lower than initially prescribed, as the tax code is littered with tax breaks for businesses. Despite this, the differences are substantial enough to make inversion especially enticing to the largest companies – exactly the ones that provide the greatest tax revenue for the U.S. government. In the case of AbbVie, the pharmaceutical company that was spun-off from Abbott Laboratories in 2011, its move to buy foreign drug-maker Shire PLC would have cut their paid rate from 22% to 13%. For a company that had revenues of $20 billion in the trailing twelve months, the tax-savings is more than just pocket change. Altogether, experts estimate that U.S. firms hold close to $2 trillion abroad as unremitted earnings. Much of this money is never reinvested into the U.S. economy, as money moved across borders is taxed initially at the rate of the country in which the earnings were collected, and then again at the rate of the country to which the money is being brought.

In order to combat the rise in inversions, there are several enlisted plans of attack, each of which may fall into one of two categories: regulation or legislation. On the regulatory side, Treasury Secretary Jack Lew, in his plea for “economic patriotism,” has made his stance on inversions known: they must be stopped. At present, the plan is to threaten to impose heavy penalties later for those who choose to invert now—those penalties may take the form of the administration limiting tax breaks within the U.S. or pursuing protracted litigation against inverting companies that would, at minimum, impose significant legal and public relations costs upon those entities. In the meantime, several democrats have begun working towards a more complete and permanent solution. Senator Carl Levin of Michigan has already drafted an amendment to the Internal Revenue Code of 1986, aiming to modify the rules relating to inverted corporations. Currently, a company must have a 20% foreign shareholder base in order to invert. Levin’s proposal would raise that to 50%, meaning that the U.S. firm would not be able to invert without surrendering more of its autonomy to its acquirer. Others are working towards creating a bi-partisan fix to the problem that would include corporate tax reform that would apply to more than just inverted companies.

Opponents of these inversion deals can take some solace in the fact that Section 385 of the Internal Revenue Code mandates that “the Secretary is authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness.” Section 385 also limits the amount of debt that a foreign company can deduct for interest expenses. Since these smaller companies often do not have the cash on hand to pay in full for the required percentage of stock in their much larger counterpart, they often fund the purchase through financial leverage, or debt, instead of a stock offering. To purchase through debt offers a few distinct advantages. Secured bondholders are entitled to ordinary loss deductions should the company turn insolvent, whereas stockholders are only residual claimants. More importantly, the issuer of a corporate bond may write-off the losses as a result of a decrease in face value of the bond. Stock, on the other hand, is not subject to such treatment. This practice is complicated by the fact that the creditor in this situation is usually the acquired company, meaning that they lend money to have themselves bought out. But debts can be forgiven, and often are when the lenders are also the majority shareholders of the corporate borrower. In J.F. Stevenhagen Co v. Commissioner, the two primary shareholders of John-Way Developers Inc. consistently contributed capital to meet the insolvency issues of the company without receiving any interest payments in return, despite the fact that promissory notes were issued each time. Taxes were initially withheld on such liabilities. The court ruled against Stevenhagen’s actions, questioning if “there [was] a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with the economic reality of creating a debtor-creditor relationship?” As it stands, Treasury requires an “unconditional promise to pay on demand, or on a specified date, a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest” in order to qualify for interest expense deductions. Thus, if Lew changes the rule to state that the foreign company could not deduct any interest on its debt, the financial incentive to invert would be greatly diminished.

While it is true that these large companies, often publicly traded with many billions in revenues each year, are obligated to act in a manner that optimizes returns to shareholders, the numerous accusations of tax evasion—in addition to U.S. Treasury Secretary Jack Lew’s call for a crackdown on such deals—have proven enough to intimidate a few while a change in law awaits. Walgreens sought to invert its operations via the purchase of the Swiss pharmacy Alliance Boot GmbH, but has since backed down for fear of fighting an uphill battle with the IRS. Walgreens CEO Gregory Wasson suggested that to take on the IRS could result in litigation spanning up to 10 years, the potential of having to pay dual taxes in intervening years, and furthermore, the prospect of having to pay back taxes plus interest should Walgreen’s efforts prove unsuccessful. The company has since pledged to preserve its U.S. residency – and the accompanying tax rate. It is for similar reasons that foreign firms are beginning to meet these cross-border transaction requests with due apprehension. While a 15 round fight with the IRS would certainly bruise the success of a cash-heavy corporate behemoth, it may prove to be a devastating blow to its overseas counterparts, who are often much smaller than the U.S. company that initiated the buyout. So although a change in legislation may have to wait until the next election cycle, Washington’s stance against inversions through regulation should prove to be an effective enough method to force U.S. companies to think twice before heading overseas, and likewise, to make foreign companies hesitate before accepting these deals, as opposed to greeting them with open arms.

In the long run, in order to close the loopholes that large corporations are currently exploiting, a more complete overhaul of the existing tax code is necessary. One can only hope that such an overhaul would simplify what is presently the most complicated tax system globally, shake it of its “anti-competitive” reputation, and put the statutory tax rate on par with the rest of the world. Better yet, maybe management will come around to the fact that each degree of domestic expansion on behalf of a company requires a greater usage of American public goods, and as long as operations remain on U.S. ground, they should pull their weight accordingly. Until then, it seems inevitable that without meaningful regulatory and statutory change we will continue to find ourselves regrettably waving to our former companies from across the pond.

Jacob Romeo is a third-year in the College, majoring in Economics.