Inversions and versions of tax truths

The Obama administration’s recent tightening of rules about "inversions" (or U.S. companies relocating overseas) has heightened debate about American corporate tax rates and the resulting impact on the competitiveness of American firms.

What is an inversion?

In simple terms it is when a U.S. company shifts its corporate headquarters to a country like Ireland where corporate taxes max out at 12.5 percent compared to the maximum 35 percent U.S. tax rate. For large multinational firms, the annual savings can be in the billions. But the U.S. government would then lose even more than that in tax revenues.

But it is not just a matter of declaring a new address and printing new stationery. The company must acquire a foreign firm large enough to qualify for the inversion. The recent rules announced in April 2016 by the Obama administration make such foreign takeovers even tougher.

The argument for inversions

Many in corporate America believe that U.S. taxes are already too high and that taking advantage of loopholes to reduce payments is legitimate. Here is a summary:

• The U.S. federal corporate tax rate (at a maximum of 35 percent) is already one of the highest in the developed world. Not only that, but unlike most major countries, the U.S. 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 are paid to   U.S. shareholders. Less money left over to put back into research and development (R&D), which ultimately determines the competitiveness of the U.S. firm in global competition.
• Inversions are legal: If congressional rules allow certain loopholes, it is the company’s fiduciary duty towards 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 U.S.

The argument against inversions

• While most opposition to inversions has come from Democrats, many Republicans, including Conservatives such as Chuck Grassley (R-Iowa) dislike them as well.
• The U.S. federal corporate tax rate really is not 35 percent. 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 percent, according to Citizens for Tax Justice or 27 percent, according to Price Waterhouse. The estimates of what American firms effectively pay varies because the actual data are a secret known only to the IRS (Internal Revenue Service). Even taking the 27 percent rate from Price Waterhouse, that would put the U.S. tax burden in the middle of the OECD advanced-nation group.
• Taxing not only the firm’s U.S. profits but also the profits of its worldwide subsidiaries may sound terrible (and is unlike what most other nations do to their multinational corporations). However, the U.S. tax code allows indefinite deferral of taxes on foreign subsidiary income, as long as those profits are not repatriated back to the U.S. In effect then, few U.S. multinationals actually pay any U.S. tax on their foreign earnings. (According to many, this provision is a gigantic loophole big enough to let a truck pass through).
• Multinationals enjoy yet other tax avoidance schemes such as export shipment "transfer-pricing" (for tax and tariff avoidance); international licensing (royalty payments) between affiliated entities; intra-corporate loans; charging central fixed costs and overheads to various foreign affiliates.
• Loss of tax revenue has to be made up elsewhere from domestic individual taxpayers and domestic U.S. companies that would otherwise pay less. Most U.S. 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 who 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 U.S. despite relocation of corporate headquarters. However, once having shifted the strategic locus of the company abroad, that increases the chances of additional job creation in the rest of the world, rather than in the U.S.

How big is the inversion phenomenon?

All said and done, it is not big or consequential, so far. Bloomberg estimates that between 50 and 70 large US firms have relocated headquarters abroad since the year 2000. However these data are not comprehensive. Moreover, they do not include new foreign direct investments in the U.S. that have chosen, from the beginning, to not establish headquarters in the U.S. as a result of the perception (real or rhetorical) that U.S. 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.”

Unanimity about the U.S. tax code

In a raucous and fractious U.S. democracy, can one dare to use the word unanimity? Yes, in one respect, virtually all factions agree that the U.S. tax code is a bloated monstrosity with thousands of arcane provisions and loopholes, and should be simplified. Small firm owners, and individuals who cannot afford the legal, accounting and lobbying clout of large multinational firms in Washington, D.C. feel they have no voice in simplifying the tax code, or making it more equitable. But, despite the virtually unanimous opinion about rationalizing the U.S. 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, D.C. (Out of the 3,007 counties in the nation, seven of the top ten counties – using median income as a measure – are Washington, D.C. suburbs.)

Inversions themselves are not ubiquitous or of great consequence. But they serve as a rallying cry to highlight some inherent contradictions:

• Separate country-by-country taxation in a globalized world.
• Maximizing shareholder value versus keeping jobs and activity in the U.S.
• The disenchanted "bottom 40 percent" of the U.S. working population (whose effective income has declined or remained flat for two decades) versus the STEM-enabled "upper 20 percent" which has prospered.
• Vested interests concentrated in seven counties surrounding Washington, D.C. versus the interests of the rest of the U.S.

Farok Contractor is a distinguished professor of management and global business at Rutgers Business School. He teaches international business. Learn more about the study of Management and Global Business at Rutgers.

Photo illustration: Thea Design/iStock/Thinkstock.