On April 4, the Treasury Department issued new regulations directed at corporate inversions -- in which a U.S.-parented multinational changes its tax residence in order to reduce its tax burden through a number of different strategies. Last Monday’s new rules were the Obama administration’s third round of efforts to obstruct inversions, following others from 2014 and 2015.
These are the toughest yet, surprising analysts and observers with their stringency. Some critics charged that the new regs were aimed specifically at a nascent mega-tie-up between U.S.-based Pfizer (NYSE: NYSE:PFE) and Ireland-based Allergan (NYSE:AGN), which as of this writing have market capitalizations of about $200 billion and $95 billion, respectively (both have declined sharply in share price since the new regulations were announced). The administration denied this accusation, saying, “The Treasury Department is not focused on a specific transaction, it’s focused on specific loopholes.”
Nevertheless, the new rules did indeed lead PFE and AGN to scrap their prospective deal. Some other deals currently in the works -- such as those between U.S.-based Johnson Controls (NYSE:JCI) and Ireland-based Tyco International NYSE:TYC) -- are likely to go ahead because they do not fall afoul of the most aggressive changes, which train their fire closely on “serial inverters.”
“Serial Inverters” Under Fire
Those changes hinge on the existing rules governing inversions, which place a size threshold on a foreign acquirer relative to its U.S. acquisition target. The agency notes:
“Some foreign companies may avoid… the tax code’s existing curbs on inversions by acquiring multiple American companies over a short window of time... thereby enabling the foreign company to complete another, potentially larger, acquisition of an American company to which [existing rules] will not apply. Over a relatively short period of time, a significant portion of a foreign acquirer’s size may be attributable to the assets of these recently acquired American companies.
“It is not consistent with the purposes of [the existing rules] to permit a foreign company (including a recent inverter) to increase in its size in order to avoid the inversion threshold under current law for a subsequent acquisition of an American company. For the purposes of computing the ownership percentage when determining if an acquisition is treated as an inversion under current law, today’s action excludes stock of the foreign company attributable to assets acquired from an American company within three years prior to the signing date of the latest acquisition.”
It was that final sentence that was the death-knell of the PFE/AGN tie-up, since AGN has increased rapidly in size through acquisitions over the past three years. With those acquisitions excluded, the deal would yield no benefits.
The other new rules are aimed at “earnings stripping,” in which after an inversion, a foreign parent company can use internal financial engineering to reduce the tax burden of its U.S. subsidiary.
The Big Picture: A Broken U.S. Corporate Tax Code Suppresses Growth and Job Creation
Last October, after the second wave of Treasury’s new rules, we wrote about the negative effects of the U.S. corporate tax system, and noted that as long as the system’s perverse incentives remained unaddressed, phenomena such as corporate inversions would be inevitable. In fact, it could get worse. We wrote:
“Human economic actors will respond to incentives, and will act rationally within a system to maximize the value of their assets. Where there is an opportunity for tax arbitrage -- by effectively moving income from high-tax to low-tax jurisdictions -- and economic actors have the capacity to take advantage of that arbitrage, they will. Can rules or legislation stop the process? We doubt it. Incrementally, the effect will be to redouble the efforts of tax engineers to locate and exploit opportunities for arbitrage… If inversion deals are discouraged while the basic drivers that make them happen remain unaddressed, a simpler process will happen as U.S. companies are just bought by foreign companies. For individual firms such deals can make good sense under the current U.S. tax regime -- even though on a macro level, they lead to the erosion of the U.S. tax base and the incremental migration of good, highly skilled jobs abroad.”
Yes, Treasury could stop the PFE/AGN deal -- and others like it -- from going forward. But it will not stop the bleed of growth and high-quality jobs that results from an ineffective and punitive corporate tax policy.
Further, the continued issuance of jerry-rigged regulations contributes to an environment of uncertainty for business, in which future planning is derailed by the fear that unexpected new regulations will make those plans fruitless. (Even though AGN and PFE were not that far along in the process, they had still spent millions pursuing the potential merger.)
What Is To Be Done?
The solution is straightforward, as we noted in October, but it is a political solution that neither U.S. party shows signs of being interested in:
“Most member states of the OECD have acclimated themselves to an environment in which business is global. While the U.S. and a few other members maintain a worldwide taxation system -- in which the profits of their domestic companies are subject to tax no matter where they are earned -- most have gone to territorial systems where only domestic earnings are taxed… The most obvious solution is for the U.S. to move in the direction of a properly managed territorial tax system, rather than a worldwide one; but even that will produce perverse incentives and distortions unless the effective U.S. corporate tax rate is transparently lowered to be more in line with OECD peers.”
Further, the revelations of shadowy offshore tax-haven activities in the leaked “Panama papers” should reinforce our awareness of this fact: when people are denied legitimate avenues for reducing their tax burdens to levels deemed reasonable by most global jurisdictions, more of them will resort to illegal means. This is not to excuse such behavior -- far from it. But it is to observe, realistically, that the heart of the matter is the tax code -- and that trying to achieve compliance with a fundamentally flawed tax code without reforming it will ultimately create far more and far bigger problems than it solves.
Investment implications: The U.S. corporate tax code needs to be overhauled, and the top rate (the highest among developed nations) needs to come down. Corporate inversions -- in which U.S. companies reduce their U.S. tax burdens by acquiring a foreign firm and redomiciling themselves in a lower-tax jurisdiction -- result in great part from this high tax rate, and curbing inversions does not solve the problem. The U.S. needs economic growth and high-quality jobs. Both of those are delivered by U.S. businesses that have confidence about the regulatory environment, and can compete on a fair playing field with companies from other national tax jurisdictions. The Department of the Treasury has issued tough new regulations to stop inversions, but these regulations can ultimately only worsen the perverse incentives that result from a U.S. corporate tax system that is completely out of step with its peers in the OECD. Absent tax reform, actions such as last week’s new Treasury rules will only increase the perception that government is the adversary of business, creating unexpected roadblocks for business planning and strategy. And they will do nothing to stop the bleed of growth and high-quality jobs that results from an ineffective and punitive corporate tax policy.