Inversion rules transform US tax reform debate

Inversion rules transform US tax reform debate
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The new US rules to discourage tax inversions are surprisingly tough, and set the table for tax reform debates in 2015.

The ongoing tax inversion debate in the US can be summed up in two phrases: “patriotic duty” and “competitive for business.” But after Treasury Secretary Jacob Lew released new tax rules to govern tax inversions, it became clear that tax inversions are really about something else. In fact, tax inversions and corporate tax reform are both about the same thing: deferred earnings, which are profits US companies have earned outside the US, and how corporations can get access to this cash without paying US taxes.

The rules, which will not require Congressional approval, are much further reaching than most expected and will change the atmosphere around corporate tax reform, an idea that had gained momentum as tax inversions became more common. The substance of corporate tax reform remains largely undiscussed, however, but previous successful tax reform laws indicate that a potential shift of power in the Senate after the November elections may increase the chances of a bipartisan compromise.

Tilting the scale against inversions

The Obama Administration was probably not hoping it would have to deal with tax inversions by issuing a bureaucratic rule, especially since it would helped make inversions a partisan issue, but it had no other choice. Tax inversions became a hot political topic just as Congress, which was unlikely to pass any piece of legislation in the first place, adjourned to campaign for November’s elections. That, and a list of brands with good name recognition like Burger King, Chiquita, and Medtronic announced inversion deals.

The new rules to curb tax inversion are more far-reaching than most expected to see this year. Not only do they tilt the scales to make marginal tax inversion cases look unattractive, they put major limitations on the actions of any companies that still invert. To begin tightening the loophole, the Treasury put more restrictions on what companies will qualify as foreign after inverting by tightening regulations on how much ownership of the non-US corporation and the post-merger corporation could be American.

The bolder part of the rule stops the technique called hopscotching, which allows US companies access to all their overseas cash by inverting. When doing an inversion, US corporations are able to pull some slight of hand to let them begin using cash earned outside the US without repatriating it, and having to pay US taxes on it. There is no doubt this seriously changes the incentives of tax inversion. Publicly traded US-based companies are holding $1.95 trillion overseas. General Electric alone has $110 billion in profits being held outside the US, which is nearly the size of Hungary’s entire economy.

If there is just one factor that is fuelling the popularity of tax inversions, these pools of foreign profits are it. Critics of the Treasury’s rules will point out that the US corporate tax rate is the highest in the world (35%), but the average Fortune 500 company pays less than 20%. These foreign profits however, are sitting idly by while US companies are increasingly cash-strapped domestically.

Tax reform is always a surprise

The Treasury rules were never designed to be more than a short-term fix, but it would not be wise to think they will be removed anytime soon – either by court ruling or Congressional action. Court rulings would only occur retroactively, once companies file taxes, are audited, and go through a long tax court battle. Congressional action is hard to predict, especially given the history of federal tax reform.

The latest polls show that it is a toss-up whether or not the Democrats keep a majority in the Senate after the November elections. Given the ideological chasm between the Republican House and President Obama, a Republican Senate – which would be less conservative than the Republican House – might change the power dynamic and increase the chances of reform. Even that is not a good bet to take, however. That is because major tax reforms are, if previous major reforms are any indication, not easy to predict.

The last major overhaul of the tax code came in 1986 under a Democratic-controlled House and Senate and Republican President Reagan. Ironically, the reforms raised the corporate tax rates to the 35% rate at the center of the debate today. At the time, the Tax Reform Act of 1986 never looked like it would get enough votes to pass until it actually did.

It took extraordinary circumstances, fluid coalitions of liberals and conservatives, and a few powerful legislators looking to define their legacies. As the book chronicling the law’s journey makes clear, the stars must have been aligned for the bill to get signed into law. If tax reform comes in 2015, expect a similarly dramatic and unexpected timeline.

In the lead up to the 2015 tax debate, politicians as ideologically diverse as Rand Paul and Bill Clinton have endorsed a repatriation tax holiday. The plans all revolve around temporarily lowering or eliminating tax on deferred earnings currently sitting overseas, with the goal of corporations spending that money on more workers, capital, and higher dividends.

The US last had a repatriation holiday in 2004, but the results have also spawned a broad coalition against the idea. Officials from the Obama Administration and the Heritage Foundation do not agree on much, but they agree that the costs of the holiday were high and the benefits were nearly non-existent. The non-partisan Joint Committee on Taxation estimates that a tax holiday today would cost the IRS $95 billion.

Far from solving the tax inversion issue, these rules may relieve pressure on next year’s Congress to act. The two things that could change that and refuel Congress on tax reform are starting to be heard in whispers. First, the rules could be seen by Republicans as bad policy or too far-reaching. Second, holes in the rules could allow foreign companies to start purchasing American companies and tapping into their deferred earnings, which could worsen the perception of American competitiveness. If these scenarios play out, tax reform will be more likely – if still unpredictable.

Categories: Economics, North America

About Author

Alex Christensen

Alex is an Editor at Global Risk Insights, who also currently works in investment research. His work on political risk and economic policy has appeared in many forums, including Business Insider, Seeking Alpha, Oilprice.com & The Emerging Market Investors Association. He holds a Master’s in Economics from the London School of Economics and BA from Washington University in St. Louis.