American companies are merging with foreign firms and relocating their headquarters to those foreign countries because our tax structure is uncompetitive. So what does the Treasury Department do?
Yesterday, it released long-awaited measures to combat the practice of merging with foreign companies to avoid U.S. taxes — known as inversions — that will make it even harder for U.S. businesses to compete.
The U.S. is the only major country that taxes its businesses on income earned outside the U.S.
The Treasury regulations seek to prevent inverted businesses from accessing the U.S. business’ foreign income free of tax through “hopscotching” and by making it more difficult for foreigners to purchase large enough shares of U.S. businesses to qualify for an inversion. Hopscotching involves the foreign subsidiary of a U.S. parent corporation lending money to the parent at favorable rates. Because the money is lent, rather than paid as a dividend, it generally is not considered to be repatriated and subject to U.S. tax.
There are two motivations for inversions. One is a short-term effort for businesses to lower their effective tax rates. The U.S. has the highest tax corporate tax rate in the industrialized world. The other is long-term and focused on increasing the competitiveness of U.S. businesses compared to their foreign competition by eliminating U.S. tax on their foreign earnings. The U.S. is the only major country that taxes its businesses on income earned outside the U.S. This is called a world-wide tax system. Most countries have a territorial system that taxes only income earned in that country.
The Treasury measures will do nothing to reduce the long-term incentive because it does nothing to ameliorate the worldwide tax system that makes U.S. businesses so uncompetitive.
The recent spate of inversions occurred because U.S. and foreign businesses recognized strong potential synergies in each other that made a merger appealing. They decided to invert, or locate the new business’s headquarters outside the U.S., after deciding a merger made economic and business sense.
It makes little sense to locate a company in the U.S. after a cross-border merger in the U.S. because the worldwide system in the U.S. would subject all the newly merged business’ foreign income to U.S. tax at the highest corporate tax rate in the industrialized world. The Treasury regulations do nothing to address this problem.
The solution to inversions remains tax reform that abolishes the worldwide system of taxing multinational businesses, moves to a territorial one and reduces the corporate tax rate. That will require action by Congress. The Obama administration should put its efforts into making tax reform a reality by working with and leading Congress, rather than wasting time with ineffective regulations.