Nations struggle and compete with separate tax codes while multinationals treat the world as a single economic space.
By Farok J. Contractor*
The US presidential election campaign triggers debate every four years over off-shoring, outsourcing and tax-avoidance schemes by corporations. This year is no exception, and the issue of “inversions” – companies moving their headquarters abroad to reduce taxes – has candidates from both parties crying foul. The issue highlights the negative consequences of globalization and serves as an effective battle cry to rally voters. A closer look shows why this is a visceral political issue even though the economic impact is less than meets the eye.
In simple terms, an inversion is when a US company shifts corporate headquarters to a country like Ireland where corporate taxes max out at 12.5 percent, as compared to the maximum 35 percent US tax rate, not including additional taxes imposed by states. For large multinational firms, the annual savings for companies – and lost tax revenues for the government – can be in the billions.
Inversions are not just a matter of declaring a new address and printing new stationery. A US company must acquire a foreign firm large enough to qualify, and US shareholders must own less than 80 percent for the new firm to be considered a foreign firm for tax purposes. More than 20 US firms shifted headquarters since 2012, including Mylan to the Netherlands, Burger King to Canada and Medtronic to Ireland – all countries that offer lower corporate tax rates than the US.
Anticipating new waves of inversions and the inability of a polarized Congress to impose limits, the US Treasury under President Barack Obama tightened rules for inversions with a series of measures in September 2014, November 2015 and April 4 of this year to prevent what the Treasury secretary called “serial inverters.” Loopholes closed most recently include foreign firms pumping themselves up in size with stock-based transactions and mergers over a short period of time or generating large interest deductions by increasing debt without financing new investment in the United States.
There are arguments for inversion:
- The US federal corporate tax rate at a maximum of 35 percent is already among the highest in the developed world.
- The US tax is applicable not only to US operations, but all worldwide operations of the company.
- US companies suffer a competitive disadvantage vis-à-vis firms located in lower-tax nations with smaller dividends for shareholders and less money invested in research and development.
- Companies have a fiduciary duty towards shareholders to take advantage of any legal loopholes created by Congress for avoiding tax payments.
- The change of domicile is for tax purposes only, with operations and jobs remaining in the United States.
But there are arguments against moving headquarters abroad:
- The US federal corporate tax rate of 35 percent is a marginal rate on only the last slab of income. The actual rate, after a plethora of deductions and other loopholes, is estimated at no more than 19.4 percent, according to Citizens for Tax Justice, or 27 percent per Price Waterhouse. Only the nation’s Internal Revenue Service knows the total tax payments. The higher estimate from Price Waterhouse would put the US tax burden in the middle of the OECD advanced-nation group.
- Taxing the profits of a firm’s worldwide subsidiaries is not how most nations handle their multinational corporations and may sound terrible. However, the US tax code allows indefinite deferral of taxes on foreign subsidiary income, as long as those profits are not repatriated back to the United States. In effect then, few US multinationals actually pay significant US tax on foreign earnings – a provision regarded as a gigantic loophole by many critics.
- Multinationals enjoy yet other tax avoidance schemes such as export shipment “transfer-pricing” or charging royalties to affiliated companies. Suppose an American company A has subsidiary I with a far lower tax rate in Ireland. Instead of manufacturing the item, such as a drug, in the US, the multinational instead manufactures in Ireland and has subsidiary I export the drug to its US parent at an inflated price. This has the effect of increasing profits for the Irish subsidiary, while reducing taxable profits, and taxes, in the US. The higher profits in Ireland are taxed at a lower tax rate; reduced US profits 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, which has near zero tax, which then charges royalties for the patent to both the Irish subsidiary as well as the US operation, thereby further reducing Irish and US taxes, while increasing profits in the Bermuda tax haven.
- Loss of tax revenue must 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. They do not have foreign operations and consequently pay higher taxes than their globalized counterparts. It’s no surprise that many so-called Tea Party sympathizers are owners of smaller businesses and cannot take advantage of the international business loopholes provided by Congress.
- Critics suggest that lower taxes are diverted into fatter bonuses and stock options for top executives rather than directed toward increases in shareholder dividends or R&D budgets.
- Despite relocations of corporate headquarters, jobs and operations may remain in the United States. But the shift in strategic locus may increase chances that additional job creation takes place elsewhere in the world.
- Inversions may be legal, but they are amoral and unpatriotic. Reviewing April’s round of changes, President Obama suggested that companies “effectively renounce their citizenship” by using “insidious tax loopholes… just to get out of paying their taxes.”
Most opposition to inversions comes from Democrats, and many Republicans dislike them as well.
Despite the political outrage, inversions are neither big nor consequential. Bloomberg estimates that up to 70 large US firms have relocated headquarters abroad since the year 2000. However, data are not comprehensive and do not include new foreign direct investors that have chosen, from the beginning, not to establish headquarters in the United States due to perceptions, real or rhetorical, that the country’s taxes are high. The latter category has far greater economic consequence than the mediagenic reports about attempts by well-known US companies, like Pfizer, to “invert” by merging with Allergan in Ireland, a deal killed by the US Treasury’s April announcement.
Consensus is emerging. Virtually all political factions and economists agree that the US tax code is bloated, with thousands of arcane provisions and loopholes, and should be simplified. Nothing is done because of the concentrated vested interest on the part of international tax experts, lobbyists, lawyers hired by large firms. Owners of small firms and individual taxpayers who cannot afford such legal, accounting and lobbying power feel they have no voice in simplifying the US tax code or making it more equitable. Hence the growing political disenchantment.
Inversions themselves are neither ubiquitous nor 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. There is an inherent contradiction, as well as jurisdictional disputes, in a world with separate country-by-country taxation while multinationals treat the world as one economic space. There is an inherent tension between maximizing shareholder value versus keeping jobs and activity in the United States. Small businesses, which cannot take advantage of international tax loopholes, resent large multinational firms that can shift operations, earnings and tax payments across countries. 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,” comprised of highly skilled personnel working for large companies, has prospered because of technical skills and education.
The issue is not settled. If a polarized US Congress continues inactivity, the Treasury Department promises to continue to explore more ways to address inversions.
*Farok J. Contractor is a professor in the Management and Global Business Department at Rutgers Business School. He has researched foreign direct investment for three decades and also taught at the Wharton School, Copenhagen Business School, Fletcher School of Law and Diplomacy, Tufts University, Nanyang Technological University, Indian Institute of Foreign Trade, XLRI (India), Lubin School of Business, Theseus, EDHEC and conducted executive seminars in the US, Europe, Latin America and Asia. He produces a blog on Unbiased Perspectives on Global Business Issues.