Corporate Tax Inversions: Another Symptom of a Complex Tax Code in Need of Reform

CC BY 2.0 Chris Tolsworthy
CC BY 2.0 Chris Tolsworthy


By: Stephen Welker

Some of the latest corporate “shenanigans” drawing headlines are corporate tax inversions and an Obama administration bent on their extinction. In July, during an interview with CNBC, President Obama decried corporations who change their official addresses to more tax favorable countries such as Ireland or Bermuda as “gaming the system.” In September, the U.S. Department of Treasury announced new rules to combat corporate tax inversions. These efforts simply mark another insignificant bandage on a hemorrhaging tax system, one which can only be fixed by dramatic reforms in Congress.

What are corporate tax inversions? The Department of Treasury defines them as “transaction[s] in which a U.S.-based multinational restructures so that the U.S. parent is replaced by a foreign parent, in order to avoid U.S. taxes.” The transaction is entirely on paper; it entails no movement of offices, factories, or personnel. But by changing the nationality of the formerly U.S. corporation, it enables much of the corporation and its subsidiaries to avoid U.S. taxes in favor of lower foreign taxes.

Why invert? Simply put, U.S. corporate taxes are too high and reach too much income. After Japan dropped its corporate tax rate to 38.1% in 2012, the United States achieved the distinction of maintaining the highest corporate tax rate (39.1%) in the developed world. Additionally, the U.S. adheres to a widely abandoned system of worldwide taxation which penalizes a U.S. corporation for being American. Most developed countries have embraced a territorial system of taxation where income is generally taxed at its source, conversely the U.S. system – with a few exceptions – taxes income of its citizens wherever it is earned. Under a territorial system, the income earned by a U.S. subsidiary in, say, Germany would pay German taxes on its income. Under the U.S. worldwide system, the U.S. company owes U.S. taxes on that income earned in Germany, above any creditable taxes paid to the German government. Thus, U.S. companies, without gimmicks like inversions, could not avoid the steep corporate rate by moving their business offshore. Notwithstanding politicians’ claims of a corporation’s patriotic duty to pay its fair share, the nature of the U.S. corporate tax regime incentivizes U.S. corporations to invert. It is a question of global competitiveness and good business sense. Even after the Treasury’s efforts to plug the holes, inversions are not going away.

The Burger King example is instructive. Burger King is moving forward with its deal to purchase Tim Hortons Inc., a Canadian company, for $11 billion.  As part of the deal, its headquarters will move to Canada where it will bask in the warmth of Canada’s friendly 26% corporate tax rate.

Since money earned in the United States is taxable income regardless of a corporate’s citizenship, a primary concern of the U.S. government in the case of inversions is active income earned by U.S. corporations’ controlled foreign corporations (“CFCs”). Normally, a CFC does not pay U.S. taxes until its earnings are repatriated into the United States via dividends to its parent U.S. company. This has resulted in perpetual deferral of U.S. taxation by leaving the income outside the United States. Congress recently addressed the deferral problem on a temporary basis by granting a tax holiday. Results were disappointing as far as Congress was concerned, but corporations which took advantage of the holiday saved billions. Corporations cannot count on another tax holiday any time soon, so inversions provide a way to bypass the taxes permanently. By incorporating in a country which does not tax the active income earned of these CFCs, the corporation beats the U.S. system.

If one is left exasperated by the complexity of this tax system which encourages these corporate maneuvers, seemingly bereft of any motive other than tax savings, one is in good company. It is general consensus within Washington that tax reform to reduce complexity has bipartisan support. Unfortunately, those general calls for reform seem to be all Congress can accomplish on this front, opting, instead, for more patchwork legislation. The reasons why are obvious: a complex tax code is an exploitable tax code. Given the choice between a lower corporate rate or avoiding taxes altogether through gimmicks, corporations will shell out money to accounting and tax law firms to get those gimmicks. And Congress, while paying lip service to tax reform ideals, appears all too happy to make sure those gimmicks are always available. Until Congress embraces meaningful reforms to its taxation of international transactions, corporate tax inversions are likely to continue, and we may see more classic American companies spurn their native land for friendlier pastures. Given the financial incentives, I’m not sure we could blame them.

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