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Treasury Proposes Third Set of Anti-Inversion Rules

4 min readBy: Scott Hodge

In keeping with the reputation that “The United States can always be relied upon to do the right thing — having first exhausted all possible alternatives”, the Obama Treasury has announced (here) yet its third set of rules aimed at preventing U.S. companies from merging with foreign companies based in low-taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. countries such as Ireland. These transactions are known as inversions.

Of course, since the 35 percent U.S. corporate tax rate is the highest among all industrialized nations, the right thing to do is to cut our tax rate to a competitive level, not build a higher wall to prevent companies from leaving.

Treasury’s new rules do not change the fact that the U.S. corporate tax rate is dramatically out of step with global norms. Instead, this exercise looks like the manager of a Niemann Marcus store blocking the door in an attempt to prevent shoppers from rushing down the street to Walmart in search of a better deal.

For more than a decade, U.S. lawmakers have been trying legislative and regulatory solutions to inversions when the obvious solution was to cut our corporate tax rate. In 2004, when Congress first enacted legislation aimed at stopping inversions, the combined (federal plus state) U.S. corporate tax rate of 39.3 percent was second-highest among OECD nations, 10 percentage points higher than the simple average of non-U.S. OECD nations and 5 points higher than the weighted average.

Today, the simple average of non-U.S. OECD nations has fallen to 24.5 percent, 15 percentage points lower than the U.S. rate. The OECD weighted average is now nearing 27 percent, at least 12 points lower than U.S. rate.

The new Treasury rules attempt to discourage inversions in two ways. First, in what seems like a blatant attempt at blocking the Pfizer-Allergan merger, Treasury is changing the interpretation of the so-called 80/20 rule that was intended to prevent a large U.S. firm from acquiring a very small foreign company, then moving the joint headquarters abroad. Some formerly small inverted companies, such as Allergan, have become very large after a series of acquisitions. So the new rule allows Treasury to ignore the current size of the company in measuring compliance with the 80/20 rule, and use a prior year’s market capitalization. If the foreign firm was considerably smaller in prior years, then it would presumably fail the 80/20 test and the merger would be denied.

The second way in which Treasury is trying to discourage inversions is by tightening the rules governing intra-company loans to prevent what is known as “earning stripping.” Officials worry that foreign-based multinationals can “strip” profits out of the U.S. tax free by loaning their subsidiaries money instead of using traditional bank loans.[i] Since the subsidiary’s interest payments are deductible as a normal business expense, this transaction acts to lower the subsidiary’s taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. in the U.S. and transfer that interest income to the parent, which is often headquartered in a country with a lower corporate tax rate.

Treasury’s new rules would give the IRS the flexibility to reclassify certain transactions between a subsidiary and a parent as an exchange of equity, not interest. Since earnings stripping is said to be one of the motivations for inversions, it is thought that this rule will remove one more incentive for U.S. companies to move offshore.

However, Treasury’s new rules are so broad that their impact could be felt far beyond inverted companies and harm the long-standing operations of U.S. subsidiaries of foreign multinationals. Let’s say, for example, that a subsidiary of a British-based company wants to build a new factory in Iowa. The Iowa subsidiary can either borrow from a bank—including a London bank—or it could borrow the funds from its parent at a competitive interest rate.

If for some reason, that the IRS suspects that the intra-company loan is earnings stripping, it could unilaterally reclassify the loan as an equity swap and, thus, denying the interest deduction. Naturally, that decision could mean the difference between a profitable enterprise and a failing one.

It is also possible that Treasury’s new rules could discourage foreign takeovers of U.S. companies. Many people have speculated that Treasury’s anti-inversion rules would simply make U.S. companies more likely targets for acquisition by foreign firms. These new debt rules, however, could make all manner of foreign direct investment less attractive. Discouraging FDI is not good for the U.S. economy.

Until lawmakers reform our corporate tax code, U.S. companies will continue to seek self-help solutions such as inversions. Treasury’s rules do not address the underlying issues with the corporate tax code. A corporate tax reform that reduces the corporate tax rate and moves toward a competitive territorial tax systemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. would not only discourage inversions, it would encourage investment, create jobs, and boost wages for all workers.

[i] IRS data doesn’t support the assertion that the U.S. subsidiaries of foreign firms have higher debt-to-earnings ratios than domestic firms. See: Scott A. Hodge, “IRS Data Contradicts Kleinbard’s Warnings of Earnings Stripping from Inversions,” Tax Foundation, September o2, 2014. (found here)