Executive Action on Inversions? Not So Fast.


Can President Obama deal with corporate inversions-which occur when a U.S. company merges with a foreign competitor in order to create a parent organization with a tax residency abroad--on his own?

After pressure from his fellow Democrats, Obama and the Department of Treasury have said they're looking into it. Some former officials--including Stephen Shay, a professor of law at Harvard University and a former deputy assistant secretary at Treasury-- have suggested that Obama can use his executive authority to deal with earnings stripping, one of the chief incentives for inversion deals.

The dynamic might make it seem like the issue is mainly a political one--that, as with immigration and climate change, the main consideration for the White House is whether the policy goal is worth enraging Congress even further.

But, in fact, the legal authority for Obama or the Treasury Department to act is far from certain. In fact, many tax experts--some who share the goal of cracking down on inversions--believe the president has very little leeway to act without support from Congress.

"The arguments for Treasury regulation are based on laudable policy instincts, which I share. But they are very strained readings of the relevant regulatory authority," said Edward Kleinbard, a professor of law at the University of Southern California and the former chief of staff for the U.S. Congress Joint Committee on Taxation. "In fact, they are so strained, I think in the long term they would do more harm than good in terms of Treasury's ongoing relationships with Congress, and its ability to take courageous stands through regulation in the future."

Kleinbard compared arguments for unilateral action on inversions to the platinum coin controversy that arose during the debt ceiling standoffs in 2013. During that minor kerfuffle, some commentators claimed that a virtually unnoticed bill on platinum coins for collectors had inadvertently given Treasury the ability to mint unlimited U.S. currency--which it could then use as a tool to avoid hitting the statutory debt limit. The opinion was eventually refuted by the administration.

Why isn't the issue clear?

Critics claim that advocates of this view aren't considering the whole picture.

"The tax code is a very comprehensive, very complicated, very specific model of all economic activity," Kleinbard said. "And that model has an owner, like any economic model. And the owner of that model is the Congress of the United States. The Treasury authority is dependent and delegated from the owner of the tax model."

The relevant law, Section 385, gives Congress seemingly broad authority to designate debt as equity. The 45-year-old law was a result of some issues that arise from domestic corporate mergers. The text itself reads:

"The Secretary is authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness."

The law further states that Treasury can look at a corporation's ratio of debt to equity in order to make this determination--a consideration of most anti-earnings stripping laws.

So, the argument goes, this law--if applied to inverted companies--could be used as a way to convert debt, which creates a tax-deductible interest payment, into equity, which does not. The tax benefits therefore would be greatly reduced.

However, the law has never been used to combat tax avoidance or base erosion.

"My reading of this rule is that they are authorized to have a general rule that distinguishes debt from equity," said Reuven Avi-Yonah, director of the international tax LL.M. program at the University of Michigan Law School. "If they try to do that, I think the companies would sue them."

Complicating matters even further is that Congress in fact passed an anti-earnings stripping law in 1989, creating Section 163(j). That law set a debt-to-equity ratio that limits the tax deductibility of inter-party interest. Critics claim that doesn't go far enough. But would the courts buy the argument that the older, more general law allows the administration to enact limits stricter than those already enshrined into the law?

Much of tax law is written in a way that implies broad discretion. Section 482, which governs the transfer of assets from related parties, might give one the impression that the government has broad powers to combat tax evasion. But the seeming ambiguity is filled in through decades of regulatory history, court decisions and international norms that inform tax policy. (International norms may not seem so important for the application of U.S. law, but considering that the U.S. is a big supporter of the Organization for Economic Cooperation and Development--which sets de facto global standards for international taxation--they cannot be ignored.)

And overly aggressive interpretations of the existing law could threaten to make the international tax system more unpredictable and uncertain than it is today--which could have harmful effects on international trade.

In fact, there are other areas where the administration could conceivably flex its regulatory muscle to combat perceived tax evasion. The administration could look to close the so-called check-the-box regime, a product of current regulations that critics claim allow many multinational firms--especially those in the tech and pharmaceutical fields--to avoid taxes both in the U.S. and abroad. It  also could look to issue a more expansive definition of intangible assets that would include concepts such as "goodwill" or "workforce in place," which could be used to try to tax multinational corporations more aggressively. These have both been stated as policy goals by the administration, but so far it has sought to achieve them only legislatively. The structural pressure to avoid using regulations to achieve tax policy goals that cannot be achieved through law changes has been too strong, at least so far.

Ultimately, the statement that Treasury was looking into possible anti-inversion regulations may be more important than any actual regulations the department might issue.

"I frankly think it's a question of whether they could make enough noise to scare people," said Willard Taylor, an adjunct professor of law at New York University, who has written about inversions in the past. "As to specific options, I really don't see very much there."

And in that regard, they may be succeeding. Earlier this month, Walgreen Co., which had been considering inverting to Europe, decided against the move.

 

Alex M. Parker, Staff Writer, Transfer Pricing Report