Corporate Inversions Aren’t the Half of It

By STEVEN DAVIDOFF SOLOMON

If you thought there was a problem with inversions — deals that allow American companies to relocate their headquarters to lower their tax bills — wait until you hear about the real secret to avoiding corporate taxes. It’s called earnings stripping, and it is a technique that the Obama administration has so far failed to stop.

The public outcry over the use of inversions is now entering its third year. Pfizer is trying the biggest one yet, a $152 billion deal for Allergan, the maker of Botox, which is based in Dublin. The flight of American icons like Pfizer has led to complaints that corporations are gaming the system to lower the taxes they pay to Washington. 

At the same time, the companies stay in the United States, getting all the benefits of our country. But the tax games don’t stop with a relocation to Ireland, Britain or anywhere with a lower corporate tax rate than the United States.

The real gains from an inversion can come from earnings stripping, and here’s how it works:

A company completes an inversion deal and moves its headquarters for tax purposes outside the United States. The now-foreign company still has operations in the United States. These American operations are still taxed in the United States and pay taxes here.

The point of the inversion, of course, was to reduce taxes as much as possible. So, the company arranges for the United States parts of its operations to borrow large amounts of money from the now-foreign parent. The indebted American subsidiary will pay interest on that debt to the parent. Under the United States tax code, the interest payment can be used to offset the American earnings.

Voilà! The earnings of the company are now offset by these interest payments. What used to be a significant tax bill disappears.

To be fair, the earnings-stripping option is available to any foreign company with earnings in the United States.

But it does appear that American companies that have inverted are particularly poor expatriates, willing to take aggressive acts to exploit this tax loophole. A 2004 study of 12 corporate inversions found evidence that after inversion, companies engaged in earnings stripping. The authors found that four of the companies had engaged in almost 100 percent earnings stripping, costing the United States Treasury roughly $700 million over two years. The authors also concluded that “most of the tax savings” found in corporate inversions was attributable to this earnings stripping.

The findings of this study were also confirmed in a 2007 Treasury study that said that there was “strong evidence” that inverted companies were stripping.

To put this more starkly, it means that not only do inverted companies often lower their taxes, they also eliminate large chunks of the United States taxes they previously owed. Indeed, the bulk of the benefits of an inversion may come not from the lower foreign tax rate but from substantially reducing taxes on the American subsidiary.

We don’t have figures on the latest inversions to know if they are engaging in this practice. But it seems unrealistic to expect that companies that took the bold step of renouncing their United States citizenship to move abroad would then not also seek to engage in earnings stripping. We’ll find out more over the next few years.

If you are an American taxpayer, it means the burden of making up lost revenue falls more heavily on you. It also creates an uneven playing field for other companies that end up feeling like fools for staying put. All in all, it highlights the problems of the United States tax code, which shows again and again how it just does not work in an increasingly global world.

Still, earnings stripping has some benefits. The American subsidiary must do something with the money it borrows. It may be that it invests the money in the United States in research or plants. But it is hard to see how this benefit offsets the corrosive nature of this tax maneuver.

The Internal Revenue Service has repeatedly adopted rules to make inversion transactions harder, trying to prevent these companies from leaving in the first place. Just last month the I.R.S. proposed yet another set of tighter regulations that included making it harder for an inverted company to relocate to a tax-friendly jurisdiction.

But these regulations do not address earnings stripping head on and they are not going to stop inversions. There is too much money at stake. Companies like Pfizer are still trying to flee the United States, and they will continue to find a way to do so as long as our tax system provides incentives to go abroad. Only if Congress acts to update the modern corporate tax system will the incentives be eliminated. And although Congress is quite aware of this issue on both sides of the aisle, it is still unlikely to act until after the presidential election at the earliest.

There have been legislative proposals for short-term fixes. In 2004, Congress engaged in its first attempt to legislatively stop inversions and limited companies’ borrowing for earnings stripping to 50 percent of their earnings in the United States.

A decade later, the Democratic senators Chuck Schumer of New York and Richard J. Durbin of Illinois proposed that the 50 percent be reduced to 25 percent and that this limitation apply only to inverted companies. Their proposal also called for foreign companies to obtain I.R.S. approval for related-party transactions between the parent and subsidiary to ensure fair pricing so that the foreign parent did not overcharge the subsidiary to create more tax deductions.

But that legislative measure did not go anywhere, leaving the I.R.S. limited in what it could do.

Still, an influential article by Stephen Shay, a Harvard law professor, has argued that the I.R.S. could act by adopting regulations that would term this type of debt equity. Under the tax rules, this would mean that the payments from the American subsidiary would now be nondeductible dividends rather than interest payments, ending this type of earnings stripping. The I.R.S. has said it was considering adopting earnings stripping rules in the near future, and this could be it.

But for now, rules limiting this type of behavior seem to be a pipe dream. Instead, the corporate runaways are winning — winning no good-American awards, but taking easy money out of the pockets of the United States taxpayer.

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