Obama Administration Targets Corporate Inversions with Regulation Changes

September 24, 2014

The Obama Administration announced this week that it would clamp down on corporate inversions by altering existing regulations dictating the treatment of foreign earnings and foreign controlled corporations.

These rule changes will seek to reduce the incentive for a company to invert by reducing its financial benefit.

These rule changes will undoubtedly reduce the incentive to invert. However, the rule changes are equivalent to giving a patient with pneumonia cough syrup: it treats the symptom, not the disease. The real problem of inversions is the uncompetitive nature of our tax code. Even more, a true reform that would move to a territorial system would make these rule changes unnecessary and would make inversions a non-issue.

What These Rule Changes Do

These rule changes have a few specific goals:

(1) Make it more difficult to invert

The first set of rule changes make it harder to invert in the first place. Under Section 7874, a U.S. corporation can invert (become a foreign corporation) when the foreign corporation owns at least 21 percent of the new combined foreign corporation. The rule change would disregard certain passive assets in this calculation. This means that it will be harder for a foreign company to reach the 21 percent threshold.

As part of this, Treasury will also make it harder for a corporation to meet the above threshold by preventing them from paying out large dividends in advance of an inversion to reduce its size. These dividend payments will be disregarded before applying the 21 percent ownership test.

(2) Prevent “Hopscotching” or transfers of property

The second change redefines certain transactions between an inverted firm and another foreign firm to be taxable under U.S. law.

Under current law, the United States taxes any foreign corporate income that is repatriated (brought back) to the United States as a dividend payment. For example, if a U.S. corporation earns $100 in a foreign country and then moves that money back to the United States, it triggers a U.S. tax liability. However, if that income remains outside of the United States and is reinvested in ongoing activities, tax is deferred.

In order to prevent possible circumvention of U.S. tax liability, the U.S. also deems payments for stocks or loans to the parent company as repatriated income. For example, a foreign subsidiary may purchase $100 of stock from the U.S. parent. $100 goes to the U.S. parent and the U.S. treats that as a taxable dividend.

When the U.S. parent inverts and becomes a foreign company, it no longer has to worry about the rule dictating loans and stock purchases because the income remains outside of the United States. It goes from one foreign country to another foreign country, never triggering U.S. tax liability.

This rule change will make these foreign-to-foreign transactions taxable as if they were dividends paid from a foreign corporation to a U.S. corporate parent.

(3) Prevent “de-controlling”

As stated, the income of foreign controlled corporations are taxable once it is paid to the parent corporation in the form of a dividend. However, if the corporation is not deemed “controlled” it is not liable as it is not considered part of a U.S. corporation.

When a corporation inverts and creates a foreign parent, it is possible for the U.S. corporation to transfer ownership of the foreign controlled corporation to the new foreign parent. At this point, the foreign corporation is no longer controlled and thus no longer liable for U.S. taxes on its income.

This rule change will prevent this. A transferred controlled foreign corporation would still be considered controlled by a U.S. corporation for tax purposes.

The Rule Changes do Not Address the Fundamental Problems with the Tax Code

None of the above rule changes address the underlying incentives to invert. The real problem is the U.S.’s worldwide corporate income tax system and its high corporate income tax rate.

As global operations become an increasingly important aspect of business, multinational corporations are under increasing pressure to lower their overall tax burden. There are two specific problems with the current U.S. corporate income tax that corporations are attempting to overcome through re-incorporation transactions:

The United States corporate income tax rate, 35 percent (39.1 percent combined with state rates) on corporate income, is relatively high by international standards. The U.S. corporate income tax rate is the highest rate among the 34 countries of the Organization for Economic Cooperation and Development (OECD). The fact that inversions have been accelerating reflects the fact that the U.S. is actually falling farther behind as time has gone on.

The second reason, is that the United States taxes domestic companies on their world-wide income, while most other countries tax their domestic companies only on domestically-earned income. This means that U.S. companies face a marginal tax rate of at least 35 percent on every dollar earned whether earned domestically or abroad, while their competitors do not.

Rule Changes are not Compatible with Fundamental Tax Reform

These rule changes not only fail to address the real issue with the U.S. tax code, they move our tax system in the wrong direction. Any fundamental tax reform that would improve the U.S. tax code would move to a territorial tax system. This system would exempt the foreign earnings of U.S. corporations from U.S. taxes. No longer would the Treasury need to concern itself with inversions, or when or how foreign earnings were brought back into the United States.

Read more about inversions here

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