What Everyone's Missing About the Inversion Debate

Corporate inversions--when a U.S. company expatriates by merging with a foreign entity, to plant its tax flag offshore--have become a political flash point.

Driven by many high-profile departures--most recently, Illinois-based biopharmaceutical firm AbbVie Inc.--lawmakers of both parties are calling for a legislative fix to what is being described as an egregious tax loophole. (You can read more about the discussion here.)

That these deals are encouraged largely, if not primarily, by tax considerations in undeniable. But there's a point about the nature of the tax savings that has gotten somewhat lost in the discussion.

The assumption behind much of the commentary is that inversions let companies grab the billions of dollars of cash they've accumulated offshore, free from U.S. taxation.

That's undeniably part of it.

But, according to many tax practitioners and observers, that's not the whole picture.

Tax inversions aren't just about avoiding taxes on profits that are generated overseas. They're also about avoiding taxes on profits that are generated right here in the U.S. It's a subtle distinction, especially in today's online world where national borders can be blurry. But it can color the debate--as well as the proposed policy fixes.

"A lot of people don't seem to necessarily get that," said Willard Taylor of Sullivan & Cromwell LLP. "It's very neglected."

When a U.S. company inverts, it becomes a newly created (on paper), foreign-based parent company. What's remaining in the U.S. will probably become a subsidiary of that parent. That subsidiary is still taxable in the U.S. But the parent company now has more options available for aggressive tax planning.

One of those options is so-called earnings stripping, which uses intercompany debt as a tool to erode the tax base.

According to Taylor, this method usually begins with the parent loaning cash to the U.S. subsidiary. Through a series of transactions too complicated to explain here, the U.S. subsidiary will eventually pay this back to the parent in the form of dividends.

But now, the U.S. subsidiary also owes the foreign parent interest--which is tax deductible. Those tax deductible payments can often wipe out the U.S. company's profits, greatly reducing its U.S. tax bill.

There are rules against this, but they're still loose enough to make this a profitable transaction, according to Taylor.

The international component--grabbing the offshore cash that has been indefinitely deferred by corporations--is still an important part of the inversion maneuver. But remember, corporations have alreadyrecorded those tax savings in their books. It's one of the main reasons they defer the income in the first place--by designating it as "permanently reinvested" overseas, they can report those earnings to their shareholders, but not the corresponding U.S. tax obligations. That affects their overall financial report, which in turn affects their stock value.

Of course they'd prefer to have the cash as well as the savings in their books. Among other things, it allows them more flexibility in terms of how to spend it. But that flexibility doesn't necessarily translate into the billions of immediate tax savings that reportedly have been fueling this recent flurry of inversion deals.

It's not just Taylor raising these concerns. In the Department of Treasury's so-called Green Book accompanying President Obama's 2015 budget proposal, the administration said "inversion transactions raise significant policy concerns because they facilitate the erosion of the U.S. tax base through deductible payments by the remaining U.S. members of the multinational group to the non-U.S. members and through aggressive transfer pricing for transactions between such U.S. and non-U.S. members."

A 2007 report from the Department of Treasury said that inverted companies "are shifting substantially all of their income out of the United States, primarily through interest payments."

So why does this matter? It can affect the policy discussion--especially the debate over whether the U.S. should tax worldwide profits of its corporations, or only those within the U.S. borders (a "territorial" system).

"The PR line is, 'If we switch to a territorial system, all of this would go away,'" Taylor said.

But a territorial system wouldn't prevent this kind of earnings stripping. Nor would reducing the U.S. tax rate, unless to a degree comparable with Ireland's 12.5 percent, he added.

And finally, while it's always tricky to discuss morality in taxes, people may feel differently about avoiding taxes on overseas profits than they do on profits that are generated right here--even though it can sometimes be hard to tell the difference.


Alex Parker, Staff Writer, Transfer Pricing Report