Under the right circumstances, international adoption is among the most benevolent acts an American family can take. Children who would otherwise be neglected, poor, and sick are given the opportunity to grow up healthy, educated, and loved.
Of course, it’s not entirely selfless. Parents’ lives are reciprocally enriched. Usually, we accept this as a fair trade.
I’d imagine the consensus would change if, through an obscure legal loophole, parents could invert the custodial hierarchy, acquiring citizenship in their adoptive child’s home country—and exploiting the arrangement to avoid U.S. taxes.
We’d be aghast.
Yet, as TCF Fellow Ed Kleinbard describes in his latest paper, “‘Competitiveness’ Has Nothing to Do With It”, this is exactly the sort of thing we’re allowing our red, white, and blue-blooded American companies get away with.
Inside-Out and Upside Down: Inversions Explained
At issue is the recent spate of corporate inversions. Mind-bending even by corporate accounting standards, an inversion is a loophole that allows a large U.S. company to annex a small foreign firm, who then—through the contorted laws of corporate physics—becomes the titular parent.
Business-wise, nothing changes. Factories and boardrooms stay put, CEOs keep their jobs, and stockholders retain their stakes. But when the child becomes the parent, there’s a transfer in corporate citizenship—and with it, tax responsibilities. Not by accident, the erstwhile adoptees are headquartered in low-tax countries, such as Ireland and the U.K. Kleinbard likens the logic-defying (and revenue-blind) situation to a minnow swallowing a whale. And it’s American taxpayers who are left gaping from the shore.
100% Fact-Free Competition
Corporate inversions—largely unheard of during the past decade—are accelerating at a frightening pace. Since 2011, there’ve been twenty-two such announced mergers, with fourteen in 2014 alone. Most recently, two pharmaceutical giants, AbbVie and Mylan, revealed deals, as did the device maker Medtronic. According to Congress’ Joint Committee on Taxation, inversions will cost taxpayers roughly $20 billion over the next decade.
To justify their renunciation of U.S. “citizenship,” executives usually invoke the rhetoric of competition. At 35 percent, the U.S. corporate tax rate is among the highest in the world. As a result, U.S. multinationals are at a disadvantage in a global marketplace.
Or are they? As compelling as this story sounds, there’s one problem, says Kleinbard. It’s “almost entirely fact-free.” True, the nominal rate is too high and, yes, the vast resources deployed in corporate tax planning are wasteful. But U.S. firms are really, really good at it. Profitable U.S. firms paid an effective tax rate of 13 percent in 2013—less than half the statutory rate.
Even so, corporate America and its defenders go on to argue that the U.S. tax rate results in “trapped cash”—earnings “permanently” invested abroad, to avoid taxes—that damages the U.S. economy. As Kleinbard points out, this is also mostly a myth.
Few firms of multinational scope have trouble borrowing funds to make investments, and cash stockpiles can make for convenient collateral, no matter where in the world it sits. Indeed, using earnings generated on offshore cash to pay interest on domestic debt is one clever strategy to repatriate money tax-free, as Apple did in 2013.
It’s also unlikely that offshore cash is hurting the broader economy. When Congress last offered amnesty in 2004, much of the $300 billion that came back was used to prop up stock prices, not create jobs. And since most offshore cash is invested in dollar-denominated assets, such as Treasury securities, it’s already flowing through our economy.
In sum, the corporate tax code is inefficient, needlessly complex, and distortionary—but it is rarely a competitive burden.
Hopscotch and Strippers
So if it’s not about competitiveness, what’s really going on? According to Kleinbard, there is one simple explanation for the flood of inversions: U.S. companies realize there’s no hope for corporate tax reform anytime soon. So they’re taking things into their own hands (and pockets).
For firms with significant offshore cash—which, collectively, has reached a staggering $1 trillion—it’s about generating higher returns and compensating shareholders. As Kleinbard puts it, inversions give these firms a chance to play the corporate version of hopscotch. The new foreign parent borrows offshore cash from (the former) U.S. firm’s tax haven subsidiary, and then uses it to buy back its own stock (which in reality is the stock of the former U.S. company), creating a windfall for investors that wholly bypasses U.S. taxes.
Only the other hand, for firms that are mostly domestic—and thus pay near the headline 35 percent rate—inversions are attractive for another reason: earnings stripping. The strategy is similarly tried-and-true: load up the U.S. entity with debt and use the internal leverage to shift profits to the tax-advantaged parent. Voilà—taxes disappear!
Fittingly, Kleinbard’s solution to this mess is as simple as the tax code is complicated.
First, raise the tax code’s corporate foreign citizenship threshold. Currently, an inversion can occur so long as the foreign partner comprises 20 percent of the combined entity; we should increase it to 50 percent.
Second, place a meaningful limit on earnings stripping, so that income generated in the United States is also taxed here.
Third, create an anti-hopscotch rule that mandates offshore cash generated by U.S. firms is eventually taxed as intended.
But the most important part of this solution is to act now. As sorely needed as comprehensive tax reform is, we can’t afford to wait to address inversions. When a company inverts, it is gone for good. And although Treasury Secretary Jacob Lew and others are exploring the possibility of executive action, Kleinbard believes legislation is necessary to stem the tide.
Building political will in an election year will be difficult. The good news is that, with everyone from Barack Obama to Jon Stewart ringing the alarm bells, the public is taking notice. Just last week, Walgreens abandoned an inversion bid in part due to negative publicity. Legislation has been introduced in the House. Kleinbard’s paper enriches the conversation by exposing the competitiveness fallacy and outlining an achievable solution.
It is a view worth adopting.