IRS Data Contradicts Kleinbard’s Warnings of Earnings Stripping from Inversions

September 2, 2014

One of the loudest critics of the recent wave of corporate inversions is University of Southern California law professor Ed Kleinbard, who warns that these transactions will erode the U.S. corporate tax base because these newly relocated firms will use “intragroup interest payments” to “strip” income out of their U.S. subsidiary.

While this is thought to be a common practice with multinational corporations, IRS data actually shows that the U.S. subsidiaries of foreign-based companies have smaller interest deductions relative to their total receipts than do American-headquartered firms and, interestingly, they have higher effective tax rates than their domestic counterparts. Thus, Kleinbard’s warnings would seem to be much ado about nothing.

Earnings Stripping

The “earnings stripping” transaction that Kleinbard and others worry about works like a normal bank loan except that the lender is the parent company headquartered in another country. However, since interest payments are a deductible business expense, the interest payments to the parent company (like any bank loan) act to lower the taxable income of the American subsidiary. And, depending on where the parent is located, the interest income from the subsidiary may be taxed at a low rate or not be subject to tax at all by the home country. Thus, the deductible interest payments are said to “strip” income out of the U.S. tax base and transfer it into the lower-taxed coffers of the foreign parent.

If foreign parent companies are indeed stripping income out of their U.S. subsidiaries we would expect to see a relatively large share of their income dedicated to deductible interest payments, and that these interest payments would be greater than those claimed by domestic corporations. To see if this is true, we used IRS data to compared the deductible interest expenses of foreign-owned companies operating in the U.S. to the interest expenses of U.S. domestic firms.

Chart 1 below shows the interest deducted by foreign-owned and domestic corporations relative to their total receipts between 1994 and 2011. What is immediately noticeable is that the ratio of interest payments to receipts for both firm types seems to track the ups and downs of the business cycle very closely. Indeed, the debt load of all corporations peaked during the boom years of 2000 and 2007 and collapsed during the recessionary periods of 2001 to 2003 and 2008 to 2009.

What is also noticeable is that the interest burdens of both foreign-owned and domestic companies were almost identical during the 1990s, then began to diverge after 2000 when the interest burden of domestic companies began to rise above that for foreign-owned companies. Indeed, since 2000, the interest burden of domestic companies has averaged 6.5 percent of total receipts compared to a burden of 5.5 percent of total receipts for foreign-owned firms. In 2011, domestic firms had an interest burden of 4.1 percent of receipts, compared to foreign-owned firms which had an interest burden of 2.9 percent of receipts.

Why Do Foreign Firms have Lower Interest Burdens?

It is difficult to know exactly what explains why foreign-owned firms have had a lower interest burden than their domestic counterparts over the past decade or so. Perhaps the U.S. “thin capitalization rules” (also known as 163(j) rules after the tax code section) actually work to prevent foreign parent companies from loading up their subsidiaries with too much debt. Or, perhaps foreign parent companies prefer to fund the expansion of their U.S. subsidiaries with equity financing or with domestically-generated profits. Either way, it would take far more granular data than the IRS makes available to understand what is driving these results.

The Effective Tax Rates of Foreign-Owned and Domestic Companies

Another way in which we should see the results of excessive tax planning techniques by foreign parent companies is in the effective tax rates paid by their U.S. subsidiaries. Here again, when we compare the effective tax rates paid by foreign-owned companies to the effective tax rates of domestic companies we don’t see the results of excessive tax planning.

On the contrary, as Chart 2 indicates, IRS data shows that between 1994 and 2011, foreign-owned companies consistently paid a higher effective income tax rate than did domestic companies. Between 1994 and 2011, the effective income tax rate of foreign-owned companies averaged 28.6 percent while the effective income tax rate of domestic companies averaged 24.9 percent.

Here, the differences can be partially explained by the foreign tax credit that domestic companies can claim for the income taxes they paid to other governments on any offshore earnings they bring home. In 2011, for example, U.S. companies claimed $105 billion in foreign tax credits on their repatriated earnings from abroad. Along with the general business credit, the foreign tax credit helped reduce the income tax liability of U.S. companies from $323.7 billion to $200.8 billion.

It is likely that it in the absence of the foreign tax credit, the effective tax rate of domestic companies would tend to look very similar to the effective tax rates paid by foreign-owned firms.

The Number of Inversions is Small Compared to Inbound M&A Activity

It is also interesting to put inversions within the context of the normal amount of inbound M&A activity in the U.S. each year because it illustrates how over-the-top are the dire warnings by inversion critics such as Kleinbard, as well as lawmakers such as Senator Carl Levin and Rep. Sander Levin.

According to Congressional Research Service data posted on Rep. Levin’s website, just five U.S. companies completed inversion transaction in 2013 and 55 have completed inversions since 2000. By contrast, in 2013 alone there were 1,278 transactions—worth roughly $60 billion—involving U.S. assets purchased by foreign companies. It is worth noting that both of these figures were at a ten-year low. Since 2004, however, the number of transactions involving the purchase of U.S. assets by foreign buyers has averaged about 1,500 annually, while the value of these transactions has averaged $105 billion each year.

If these critics were consistent in their logic, they should oppose all foreign acquisitions of U.S. companies. Because, in their view, if inversions are a major threat to the U.S. tax base, then these M&A figures would suggest that the foreign purchases of American firms also ought to be a bigger threat to the corporate tax base.

But as the IRS data indicates, the fears may be greater than the actual threat. Moreover, history has shown that foreign direct investment is very beneficial to the U.S. economy and should be encouraged, not chased away.

The Solution

Of course, the real threat to the U.S. corporate tax base is our corporate tax code itself, with the third-highest overall rate in the world and a worldwide system that requires American companies to pay a toll charge to bring their profits back home. Thus, the solution to the inversion “problem” is to dramatically cut the corporate rate and to move to a territorial tax system, not add even more unnecessary rules to an already complicated tax code.


Data sources:

The corporate tax and interest data for foreign and domestic companies is derived from the IRS Corporation Complete Report, Tables 16 and 24, for years 1994 through 2011. Since Table 16 (Returns of All Active Corporations, Form 1120) includes the returns of foreign-owned companies, it was necessary to subtract the data for receipts, interest, and taxes found on Table 24 from the aggregate data in Table 16 for each year. The residual data is considered from “domestic” corporations.,-Form-1120

The Mergers and Acquisition data is found at the UNCTAD website:

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