October 5, 2016
The new anti-inversion rules may be politically appealing, but they will cause unintended consequences that could actually undermine U.S. businesses. Here’s why.
Today’s renaissance of nationalism in the United States and Europe – which is replacing cooperation with punitive tax policies that artificially distort the global economic landscape – is making it difficult for multinational corporations to devise tax strategies that can balance the needs of their businesses with their responsibilities to their stakeholders and to the countries in which they are headquartered. Governments are promulgating new rules that seek to appease those who are still blaming big business for the financial crisis of 2007-2009, while trying to increase revenues from taxes and attract multinationals (and the economic growth that come with them). As a result, the global corporate tax environment has become increasingly unsettled, uncertain, and, sometimes, even irrational.
Last June’s Brexit vote, for example, was driven partly by nationalist unhappiness with what was seen by Brexit advocates as a heavy-handed imposition of EU economic rules on British business. That heavy hand could be seen in late August 2016 when the European Commission (EC), the EU’s governing body, ordered Apple to pay more than $14.5 billion in back taxes, accumulated over the last 10 years, during which time, the Commission alleged, Ireland violated European State Aid rules by allowing the company to underpay massively by offering a “select advantage” to one company. Apple’s CFO denied the charge, pointing out that the company was “most likely the largest” taxpayer in Ireland. Ireland protested vigorously, with its finance minister vowing to “challenge the encroachment of EU … rules into the sovereign member state competence of taxation.” New York Senator Chuck Schumer described the move as a “cheap money grab” by the EC, “targeting U.S. businesses and the U.S. tax base,” while Senate Finance Committee chairman Orrin Hatch said the order “encroaches on U.S. tax jurisdiction.”
Brexit advocates had pointed to the specter of the EC pushing for the adoption of the Common Consolidated Corporate Tax Base (CCCTB), which would enforce a single set of rules for computing taxable corporate profits across the EU, removing many national differences that multinationals can use to lower their tax burdens. Brexit proponents argued that its implementation would hamper the country’s ability to compete in attracting multinational businesses – just as Ireland’s finance minister responded to the Apple ruling by calling it an attack on Ireland’s ability to provide “tax certainty to business.”
Immediately post-Brexit, and notionally no longer beholden to the EC, former UK Chancellor of the Exchequer George Osborne floated the possibility of further cutting the UK’s corporate tax rate from the current 20 percent (which is already lower than the 22.6 percent EU average) to 15 percent to encourage foreign investment and partly offset whatever negative economic impacts Brexit might have. It already is set to fall to 17 percent in 2020. (In July 2016, Osborne was removed by new British Prime Minister Theresa May.)
Meanwhile, the UK will have to renegotiate its tax treaties dealing with EU tax law.
The EC’s renewed enthusiasm for the CCCTB (which was first proposed in 2011, and which the UK always opposed) is a hangover from the post-fiscal crisis when multinational corporations were branded as bad guys as a result of the unprecedented disclosures from the LuxLeaks and Panama Papers scandals. U.S. multinationals like Amazon, Apple, Google, and Starbucks, among others, were labeled as tax miscreants that allegedly used questionable strategies to shift their profits from high to low tax jurisdictions to avoid paying what the EU perceived as their fair share of taxes. In the UK, for example, it was revealed that in 2012 Starbucks paid no corporate taxes on £400 million in sales. In 2015, the EC filed suit to recover between €20 and €30 million it believed Starbucks owed in unpaid taxes stemming from what the EC alleged were tax rulings that conferred a “selective advantage” on the company. This, to the EC, qualified as illegal state aid (broadly defined as anything a government allows or provides that gives one company an advantage over its competitors). And now the EC is using the same argument to dun Apple and punish Ireland.
This European tumult directly affects U.S. businesses, which already are operating in a challenging tax environment at home. According to the latest government data, there were over 2,000 U.S.-headquartered companies operating internationally in 2013. They contributed $8.3 trillion to the U.S. GDP and supported 76.6 million jobs in the United States (or 48 percent of U.S. private sector employment). But at 35 percent (and reaching as high as 39 percent when state taxes are added), the United States has the highest corporate tax rate in the developed world and, unlike many other countries, that rate is applied to all income, no matter where in the world it’s earned, if it’s brought back to the United States. Paradoxically, this rule, written to capture tax revenue, has encouraged U.S. companies to park trillions overseas and also has encouraged the practice of corporate tax inversions.
Recently, a number of new tax regulations have been proposed to discourage the practice of inversions, in which a U.S. company acquires a smaller foreign business to change its tax domicile to that of the acquired foreign company to avoid paying the higher U.S. tax rate and thereby increase earnings. (For example, with its low 12.5 percent corporate tax rate, Ireland has produced an astonishing 2015 reported growth rate of 26.3 percent.) Unfortunately, these new anti-inversion rules will place U.S. companies at a greater competitive disadvantage than they already are.
This problem is widely understood. Right now, there is bipartisan Congressional support for some corporate tax reform, and widespread criticism, from both sides of the aisle, of the new regulations that its critics contend will affect negatively a far broader swath of businesses than intended. However, the Presidential candidates of both parties have spoken out against inversions and positioned themselves against rationalizing corporate tax law, and the Congress is still locked in seemingly perpetual gridlock.
The need for broad reform of U.S. corporate tax policy to improve the competitive position of U.S. companies should be obvious but, unfortunately, the actions that have been taken recently, by what amounts to federal fiat, will have the opposite effect.
Corporate tax inversions are widely viewed in the United States as a scheme companies employ to avoid paying their fair share of taxes. More than 50 U.S. companies have reincorporated in lower-tax jurisdictions since 1982. More than 20 have done so since 2012. Critics say there is an inverse relationship between the increase in inversions by larger companies and the amount of revenue flowing into the federal government.
Consequently, on April 4, 2016, under what some consider an unduly broad reading of their regulatory authority, the U.S. Treasury and the IRS announced new proposed anti-inversion regulations under IRS Code Section 385. Under these proposals, if, after an M&A, the U.S. shareholders of a former U.S. company own at least 80 percent of the combined firm, the new company would be considered subject to U.S. corporate taxes, even if domiciled abroad, thereby negating the inversion’s tax benefits. And to keep the stock owned by U.S. shareholders at or over that 80 percent threshold, the proposed regulations would disregard “foreign parent stock attributable to certain prior inversions or acquisitions of U.S. companies.” The rules would exclude three years of past mergers with U.S. corporations when determining the size of the foreign company, disregarding the value of U.S. assets acquired by the foreign company, to ensure that it stays below the 80 percent threshold.
Also, moving earnings from a new foreign headquarters to what, after an inversion, would be a U.S. subsidiary (known as earnings stripping) would be considered an equity movement, not a debt transaction, and therefore subject to the U.S. corporate tax rate. Any movement of earnings would be subject to an IRS audit, and the IRS would have the authority to divide the cash into equity or debt, as it saw fit. The company would have to provide the IRS with evidence of a “reasonable expectation of repayment and evidence of ongoing debtor-creditor relationship” to claim a deduction. This would have to include a binding, documented obligation for the issuer to repay the principal amount borrowed. According to some estimates, that would mean that about 10 million intercompany transactions would be subject to documentation requirements every year – an extraordinary burden on corporate time, compliance, and resources.
This anti-earnings stripping rule is not confined to inverted companies, but could affect any company based outside the United States that has operations in the United States, and, according to the trade group Organization for International Investment, would “increase the cost of investing and expanding across the United States for all foreign companies.”
The effect of this proposal was significant and swift. Just two days after the new Section 385 regulations were announced, the planned $160 billion deal in which U.S.-based Pfizer would have acquired Dublin-based Allergan – which would have been the largest pharmaceutical deal in history – was called off. Pfizer CEO Ian Reid told the Wall Street Journal that the driver behind the merger was the fact that Pfizer was at a “tremendous disadvantage” under the U.S. corporate tax regime, and it was competing against foreign companies “with one hand tied behind our back.”
Section 385 effectively ties the other hand. It significantly increases the cost of doing business in the United States, creates further obstacles to investment, as well as job and economic growth, and prevents U.S. companies from competing with foreign companies. Section 385 goes far beyond inversions and applies to a wide range of ordinary business transactions both in and outside the United States. It creates uncertainty, and a host of unintended consequences for U.S. business. In this, it is all too consistent with recent U.S. corporate tax policy.
U.S. companies have been operating under a competitive disadvantage for a long time. As noted, the statutory U.S. corporate tax rate, currently 35 percent, is the highest in the developed world. But the problem runs deeper.
Uniquely among developed countries, U.S. companies are taxed at the U.S. rate regardless of where their income is earned. In the rest of the developed world, profits earned outside the headquarters country either are not taxed or taxed at a very low rate. And they can be repatriated tax-free. This is a territorial approach to taxation, and, in effect, provides foreign companies with free capital U.S. companies cannot access.
One unintended consequence of the U.S. policy of taxing income at the U.S. rate no matter where it’s earned is that it incentivizes companies to keep revenue earned overseas, where it is taxed at the local (lower) rate. For example, if a U.S. company’s revenue is earned in the UK, it is taxed at the 20 percent UK rate. If the company attempts to bring the money back to the United States, it will be taxed at the U.S. rate, minus the UK rate – an effective 15 percent. In other words, it is taxed twice. That means that U.S. companies have 65 cents to spend for every dollar foreign companies have to spend – a significant disadvantage.
This is partly the reason U.S. companies reportedly have parked over $2 trillion overseas, where it cannot be used to invest in growing business and jobs in the United States.
Apple, according to a 2013 report by the U.S. Senate Permanent Subcommittee on Investigations, allegedly reduced its corporate income tax by $10 billion per year over the prior four years by locating earnings in lower tax jurisdictions, where its profits remain. When the EC presented Apple with its $14.5 billion tax bill in August, it noted that it had paid only 50 euros in taxes for every 1 million euros in profits in 2014. Reports like this add fuel to the anti-inversion, anti-big business fire, as does the recent news that by transferring certain assets to Ireland, Gilead Sciences’ U.S. share of 2015 pretax profits dropped to 37 percent even though its U.S. share of revenue was 65 percent, thereby reducing its U.S. taxes by $9.7 billion.
Tax considerations should never be the primary driver of business strategy. M&As should be about operational synergies, market growth, and creating shareholder value. However, in the current U.S. environment, tax strategies perforce take precedence, especially when one considers the increasingly hostile attitude toward U.S. companies overseas.
The anti-competitive impact of U.S. tax law on U.S. business has led to a far more aggressive competitive landscape vis a vis U.S. companies in Europe. Tax shaming of iconic U.S. companies has become the new order of the day.
In the UK, the revelations about Starbucks made the front pages and led to a brief boycott of Starbucks stores. Google’s offices in France have been raided repeatedly by tax authorities. In 2015, the EC opened investigations into Google’s tax settlement in the UK, and opened new inquiries in Spain and Italy.
At the same time, recognizing the advantages of lowering the corporate tax rate to attract investment and boost local economies, European nations are competing to lower their tax rates in a race to the bottom.
Last year, Ireland announced that it would cut its already low 12.5 percent rate in half for company revenues related to patents and intellectual property held in Ireland. This is much like the UK patent box, which taxes companies only 10 percent on income earned after April 1, 2013, that derives from patented inventions located in the UK. Similar rules apply in Luxembourg and Holland.
For a variety of reasons, including gridlock, lack of political will in Congress, and the need to find funding for government programs, the United States cannot respond or compete with the rest of the world’s more business-friendly tax policies.
This is not a pretty picture for U.S. business.
If U.S. companies are left with a permanent, intractable, and disadvantageous tax burden, they may become targets for foreign takeover. The addition of the proposed new anti-inversion and earnings stripping rules makes that even likelier. Indeed, according to The Economist, in 2015 foreign entities swept up American targets valued at $315 billion. This year, Chinese firms – which, with state support, are tax indifferent – have acquired (or announced their intent to acquire) Starwood Hotels, Ingram Micro, and GE Electric Appliances.
It also is becoming more difficult for U.S. capital to be invested abroad. In 2014, 42 percent of all venture capital-backed startups acquired in Europe and Israel were bought by U.S. firms. In 2015, that dropped to 35 percent, and in the first quarter of 2016 it fell further to 21 percent. And the broadly written earnings-stripping rules of Section 385 could easily interfere with legitimate, efficient, and routine mechanisms for funding operations, such as cash pools and loan facilities, further discouraging investment and constraining growth both for U.S.-headquartered companies and their overseas subsidiaries.
Accordingly, on July 6, 2016, the U.S. Chamber of Commerce submitted a letter to the IRS deploring the rush to implement Section 385, and requesting further clarity on debt incurred in the ordinary course of business and in the use of normal funding mechanisms such as cash pools and revolver loan facilities. Indeed, the House Ways and Means Democrats noted that the regulations could affect negatively ordinary transactions between businesses that are not attempting to avoid taxation, and in June asked the Treasury Department to protect industries “that may be hurt by its proposed debt or equity regulations.”
All these negative impacts create a situation where U.S. corporate boards might, in the discharge of their fiduciary responsibilities to their stakeholders, find themselves in the position of advising management to find the best foreign buyer they can, based on sound tax synergies.
This may be the best course for individual U.S. companies; it is, obviously, not the best course for the U.S. economy, or its people.
© 2018 FTI Consulting, Inc. All Rights Reserved.