The Berlin Wall of U.S. Tax Policy?

By Philip Morrison, Esq.
McDermott Will & Emery, Washington, DC

After a three-month intentional hiatus from all things "tax," this commentator was mildly surprised to return to the fray to find that the biggest kerfuffle in the tax world during his absence was over so-called inversions. The Administration, in letters to Congress and an op-ed piece by the Treasury Secretary, has suggested that companies which invert (or plan to) are unpatriotic.  The Senate Finance Committee chairman calls the recent wave of inversions (and the impending continuation thereof) a "plague." Everyone calls the ability to invert a loophole. Even the Washington Post has editorialized against inversions.
When I left in early May, most tax policy types agreed that the U.S. corporate income tax as applicable to multinational, U.S.-parented, corporate groups was woefully out of step with the rest of the world. The rate, 35%, was the highest of all OECD countries.  The taxation of foreign income, either that imposed on income earned directly by a U.S. corporation's foreign branches or that imposed when a foreign subsidiary's earnings are repatriated, was harsher than most other developed countries.
There was a growing consensus regarding reform of the taxation of multinational groups parented in the United States.  The corporate rate would be lowered, hopefully below 30%. Foreign branch and subsidiary active business earnings would either be exempt or, more likely, subject to a low minimum level of tax. Previously "deferred" tax on old earnings would be levied over some suitably long period.  Given the gridlock in Congress and only modest pushing from the Administration, this was unlikely to be enacted this year, but it did seem to have fairly broad, bipartisan support as the "right" approach.
Most non-tax press reports and even the Treasury's letter to Congress seem to suggest that an inverted company avoids U.S. tax liability altogether ("shifting of tax liability for the combined firm to the new foreign tax domicile" is how the Treasury Secretary describes it). But readers of this periodical know that, that is not true. U.S.-source income and income effectively connected with a U.S. trade or business are, of course, still subject to U.S. tax even if a multinational's parent has inverted. If, as is often the case (and just as often cited as a reason to prevent inversions), the multinational's headquarters remain in the United States, the economic value of the HQ activity will be subject to U.S. tax. So will the value of research conducted here, as, of course, will be the income earned by manufacturing or performing services here.
So, as most readers already know, the chief value of inverting is to assure that non-U.S. earnings of a multinational group are not taxed in the United States. Since this (but for the minimum tax proposed by many) is what the growing consensus on U.S. international tax reform seems to think is appropriate policy for U.S.-parented groups, why the name-calling and wringing of hands about inversions? Inverted companies are merely using self-help to achieve something resulting in only modest U.S. tax savings compared to the system most think is the system we ought to have. If §163(j) works properly, most inverted companies still will have significant U.S. tax on their U.S. operations.
Perhaps the ability to reduce U.S. tax with interest deductions is what bothers the anti-inversion commentators.  But if that's the case, why shouldn't all foreign-parented U.S. subsidiaries be criticized? Why just target those companies that invert? If this is a problem, aren't changes to §163(j) the appropriate remedy?
Perhaps the ability to reduce U.S. tax with deductions for royalties are the problem. A large part of the BEPS discussion is about the proper transfer pricing of payments for the development and or use of intangibles. A foreign-parented group can develop its intangibles abroad (or transfer them there) and use royalties to reduce the U.S. (and other high-tax jurisdictions') base.  But we already have §482 and §367(d). Surely the commensurate-with-income concept added to both more than a generation ago should be adequate to prevent this. So, again, why just target inverted companies?
Unfortunately, Congress and the Administration seem determined to build a veritable Berlin Wall under §7874 to keep currently "U.S.-flagged" multinationals in the United States. While admitting that the taxation of U.S.-parented multinationals needs fixing, there is no recognition that inversion is simply achieving through self-help that (or most of that) which most would-be reformers would give under reform.
An exception to the existing §7874 regime was intended if the new multinational group conducted substantial business activities in the country of the new parent's incorporation.  However, under current regulations, a multinational group's business activities in its parent's country are not considered "substantial" unless, among other things, 25% of the group's total gross income is from unrelated customers in that country. Even Rolls Royce with thousands of U.K. employees, shareholders, and significant U.K. manufacturing, had it started life in the United States, couldn't be considered a U.K. company under such a Draconian rule.
Recent suggested "solutions" are intended to make the §7874 Berlin Wall higher to prevent U.S. corporations from leaving the United States, but those same solutions will leave corporate America more vulnerable to foreign takeovers.  For example, under proposed §7874 legislation (proposed to be retroactive to May), the exchanging shareholders of a U.S. corporation in a merger would need to receive 50% or less of the new foreign parent of the multinational group and management and control for that group would have to be moved out of the United States in order for the new foreign parent not to be considered engaged in an inversion. So even a merger between a U.S. and a foreign entity that is close to a merger of equals would be caught by the amended rules.  This proposed §7874 legislation, as well as other proposed and possible legislative or administrative solutions targeted against only inverting entities, which are intended to stop a perceived loss of corporate America, will only hasten that loss as U.S. corporations become the takeover targets of non-U.S.-based multinationals that are not bound by the new rules.
A solution is available well short of comprehensive tax reform. Simply adopt the cross-border consensus mentioned above — subject future foreign earnings of branches and subsidiaries of U.S. corporations to a suitably low rate of current tax (say 5%) whether or not repatriated. And if a current low tax on such earnings is not adequate to "pay for" such a change, make up the revenue shortfall by taxing, over some extended period, accumulated foreign earnings the tax on which is, under current law, deferred until repatriated. If necessary, make some modest changes to §163(j). None of this requires any "grand bargain" between the Democrats and the Republicans or between the Hill and the Administration. There is already bipartisan consensus that this is good policy. While a lowered corporate rate would be nice, this non-Draconian solution to preventing inversions would raise none of the thorny trade-offs required to make corporate rate reduction revenue neutral.
Inversions would likely stop immediately. Why suffer the bad publicity (whether deserved or not, it is bad publicity) of inverting mainly to avoid a 5% tax on foreign earnings? An additional benefit would be the "unlocking" of billions of dollars of foreign earnings of U.S. multinational groups that are now "permanently" reinvested abroad. Large sums could be repatriated to the United States for research and capital investments by the U.S. parent or, equally good, redeployment by their shareholders when paid out as dividends and invested elsewhere.
Equally important, the Congress and the Administration would stop adding to the Berlin Wall of §7874 to force U.S.-parented multinationals to remain in an outdated, unfair system against their will. Indeed, the current §7874 rules could be either repealed or significantly liberalized. If, instead, the current §7874 proposals are enacted, no one should be surprised if, in the future, some wag doesn't declare, while waving a copy of the Code, "Mr. President/Mr. Chairman, tear down this wall!"
This commentary also will appear in the October 2014 issue of the  Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Davis, 919 T.M., U.S.-to-Foreign Transfers Under Section 367(a), and in Tax Practice Series, see ¶7150, U.S. Persons -- Worldwide Taxation.