With that, a bit of Q&A:
Q: Didn’t [Treasury Secretary Jack Lew] say there was nothing the administration could do on their own about this? What changed?
A: He did, but apparently they either got new information or decided the politics/economics of the situation had changed such that they now want to take a run at this. One important new piece of info is that after Sec’y Lew made that assertion, the respected international tax expert Stephan Shay published a piece suggesting precise areas in the tax code that could be tapped to reduce two of the major tax benefits from inverting.
Q: What are those two changes?
A: They involve “earnings stripping” and “hopscotching,” which both sound more fun than they are. The former occurs when the new U.S. subsidiary takes on a lot of debt from its new foreign parent, and then deducts interest payments from its U.S. tax bill as a business expense. The latter allows formerly U.S. subsidiaries to repatriate deferred, overseas earnings while avoiding taxation. Read Shay for the details, but he argues that various sections of the code can be interpreted to at least partially block both of these moves by inverted companies. As he see it, and it looks like the administration agrees, the code provides the IRS with the latitude to identify both of these moves as tax avoidance, thus reclassifying debt as taxable equity and treating repatriated “loans” as taxable distributions of untaxed earnings.
Q: Are these changes big enough to keep U.S. firms from “re-domiciling?”
A: They look to me like they’d be a significant deterrent as there’s little question that these two techniques are prime motivators for inverting, but a lot depends on the ability of the IRS to enforce them. Some tax experts argue that Shay’s interpretation is too broad and surely inverted corporations would want their day in court if the tax agency tried to block these moves.
Q: Is this good tax policy?
A: Blocking inversions, which I view as wholly unproductive tax avoidance—remember, nothing fundamental to these businesses is changing here except where they put their mailbox—is very good tax policy, both in terms of protecting our revenue base and reducing the incentives for wasteful, unproductive behavior.
But while I’d endorse the administration’s effort as a far distant second best, doing this through administrative versus legislative action is a lousy way to make tax policy. For one, the rules in the code are less clear cut than legislative measures, such as raising the stock ownership bar in the new company, as Senator Levin has proposed. Second, this route raises the distinct chance that on day one or two of the next administration, i.e., assuming it’s from the other party, the rule gets changed back. That kind of ping-pong is no way to manage complex tax policies as it creates a counter-productive context of uncertainty.
Q: That sounds scary! So why would the administration do this?
A: Because they recognize that the pace of inversions has accelerated and they legitimately fear a wave that would seriously damage our tax base, and again, for no reason other than a) loopholes that allow such avoidance, and b) the tattered condition of our corporate tax code.
Q: Speaking of the latter, isn’t it reasonable for these firms to invert given the state of our corporate code? Otherwise, how can they compete?
A: Yes, the code’s a mess and yes it should be reformed. But the extent to which that would dampen inversions has been overblown. Does anyone think we’re going to get our top corporate rate, now 35 percent, down to Ireland’s 12.5 percent? And remember, many of these firms are already highly profitable and pay effective rates well below 35 percent. Pfizer, a firm that was–and probably still is–strongly considering inversion, paid a 3 percent effective rate on their worldwide income in 2012. This is all about tax havens.
So, end of the day, Congress is not likely to reform any part of the tax system any time soon, admonitions of “economic patriotism” won’t change many minds, the administration has a responsibility to protect the revenue base, and Treasury has the right and responsibility to enforce the tax code.
Perhaps their threat of unilateral action will bring Congress to the table, but I doubt it. Thus, I’d say there’s a real chance they’ll give this unilateral route a try. I don’t love it at all, but I think it’s the right move.