Ending corporate inversions is great. But America needs to do a lot more.

Tax dodgers beware

Closing the American business loophole.
(Image credit: Illustrated | Image courtesy Doug Ross/ImageZoo/Corbis)

By all accounts, the U.S. government stopped playing nice with corporate tax dodgers this week. This is great news, but it's also just one victory in the context of a larger war.

By now you've probably heard of "corporate inversions." That's where a big American company gets bought by a small company in another country with a lower corporate tax rate. The American company's practical day-to-day business stays here. But the deal shifts its legal address to the other country, so it pays the lower tax rate. Around 40 companies have done this in the last five years, and lawmakers have been getting more and more incensed.

So the White House brought the hammer down on Monday.

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The law already puts some limits on inversions. If 80 percent or more of the company is still owned by American shareholders after the inversion, then our tax law simply doesn't recognize the change and still treats the company as if it's U.S.-based. If American shareholders still own 60 to 80 percent, the inversion is recognized but with restrictions. And if they own less than 60 percent, the inversion goes through.

As you can probably imagine, this left open an important loophole: If a company was on the cusp of 80 or 60 percent, it could go through multiple inversions in a row to skirt taxes. That's what the Treasury Department issued new regulations on: From here on out, inversions won't be recognized by U.S. tax law if they occurred within three years of a prior inversion, even if they'd otherwise pass muster.

Fallout was swift. A massive $160 billion inversion, where the drug company Pfizer was going to be bought by the Ireland-based Allergan, has already been scuttled. There's a possibility Treasury's new rule could be vulnerable to a court challenge, but apparently Pfizer decided it wasn't worth the hassle; they'll eat $400 million in fees to Allergan instead for breaking off the deal.

As Matt Levine put it, this is a dramatic demonstration that "the government has a lot more power than anyone thought to stop tax-minimizing transactions that it doesn't like." It's squishy and non-technical, but the government's willingness to throw its weight around can count for a lot when it comes to shaping corporate behavior. And David Dayen pointed to other agencies that could use a shot of similar courage, particularly those that deal with antitrust issues. Inversions are ultimately a subspecies of the bigger drive towards corporate mergers and monopolies in the last few decades. It's the job of antitrust agencies to break up these clusters of business power, but they've demurred from doing so since the 1980s — thanks to logic that rather explicitly says higher prices from mergers are a problem, but less competition isn't.

Treasury did something else to combat inversions as well. Another popular loophole would be exploited when a new parent company in a foreign country loaded its U.S. subsidiary up on debt. This wouldn't affect the overall company's finances, but it meant the U.S. subsidiary would pay interest on that debt to the foreign parent. And corporations in America can deduct such interest payments from their tax bill, which effectively lowers the tax rate that the U.S. subsidiary is still paying under our corporate tax code.

It's called "earnings stripping," and Treasury's new rules nixed it. The government now has more authority to treat those transactions as movements of equity, which isn't deductible, rather than debt transactions.

This has a lot of multinationals howling. Foreign companies with U.S. subsidiaries that weren't created through inversions do these sorts of internal debt transfers too, and they're mad that their tax bills could also see a rise. "They're trying to go after those companies that are doing something they think is problematic and carelessly hitting a whole class of employers," said the president of one trade group representing foreign corporations in U.S. politics.

But this kind of criticism assumes the tax deductibility of corporate interest payments is a good idea under some circumstances. It probably isn't, for the simple fact that it encourages corporations to finance new investment by borrowing. This is especially problematic for banks and financial firms, which already rely on leverage and debt bundling for a lot of their profits, and are simply encouraged to do so even more by the tax deduction. In a post 2008 world, I think it should be rather obvious why this isn't the kind of behavior the U.S. tax code should be encouraging.

And the incentive can be pretty massive. The White House estimates that corporations generally pay as much as a 37 percent marginal tax rate on equity financing, while enjoying a 60 percent negative tax rate on debt financing. The money they get back from the tax code for using debt is even higher than the money they lose for using equity. As of 2012, the tax subsidy America offers companies for using debt financing was almost three times the average for advanced economies.

One way to balance the scales would be to make equity equally deductible. But this would of course lose the government more tax revenue. It also wouldn't be as simple as it sounds, since lawmakers would have to decide how to value equity for the deduction. That would introduce all sorts of definitional minutiae. The simpler and cleaner route would be to simply get rid of deductions for both equity and debt — a process the White House just advanced slightly by eliminating the deduction in the specific case of inversions.

And of course this all occurred in tandem with the release of the Panama Papers, which opened a window on the extent to which individuals and businesses avoid taxes by yet another method: international shell companies.

So the government's moves against inversions this week were welcome. But they also shine a light on deeper, ongoing problems that extend well beyond that one topic. Let's take this as an opportunity to widen our gaze.

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