Suppose you live in a high-tax state--New Jersey, perhaps--but you decide you're tired of paying taxes there. So you decide you'd rather pay taxes in Florida, where there isn't a state income tax.
You register an address in an apartment building in Miami. But you don't actually move there. You continue to work, sleep and shop in New Jersey, while hoping to pay taxes in Florida.
Unfortunately for you, that's not how state taxes work.
But it's not far from how the law works for multinational corporations. The designation the IRS makes for where a company is located is largely based on where the company says it is.
Well, sort of. As always with international taxation, it's complicated.
This issue has come under the spotlight recently after several U.S. companies have looked to merge with European firms--motivated at least in part by the desire to establish tax residency outside of the United States. Pfizer Inc., Medtronic Inc. and, most recently, AbbVie Inc., all American firms, have attempted to complete or are in the process of completing corporate mergers with European rivals, which ultimately will allow them to declare tax residency outside of the U.S. and save billions of dollars in worldwide taxes.
They'd still pay corporate taxes in the U.S.--but only on income generated within its borders. Many of these moves have been to jurisdictions such as the United Kingdom or Ireland, which have not only lower corporate tax rates, but more flexible rules in terms of taxing a company's worldwide profit.
To many, these deals feel intuitively unfair, because while the U.S. company will be expanding overseas, it won't be moving there, at least in the way that most would perceive it. For instance, if Pfizer's acquisition of AstraZeneca Plc had gone through, the new, merged company would have had a British tax residency, but Pfizer's New York headquarters would continue to call the shots. (Paradoxically, Astrazeneca's London office likely would have been decimated in the deal--even as the new company claims to be British.)
The issue has garnered the attention of lawmakers, many of whom say this is a loophole that needs to be plugged. Many of the proposals--including one from President Obama in his 2015 budget--would squarely target these types of transactions.
But they raise a bigger issue--and, potentially, a simpler policy fix. Why doesn't U.S. law stop looking at where companies say they're based, and instead look at where they are actually being controlled from?
The U.S. bases tax residency on where a company is incorporated, essentially allowing U.S. companies to decide for themselves where their headquarters are. There's one exception. A U.S. company can't wave a magic wand and declare itself to be foreign if its shareholders own 80 percent or more of the new company's stock. In that situation, the IRS treats the new company as if it were still based in the U.S.
That law, passed in 2005, deals with expatriations that are purely on paper and for tax reasons. These mergers present a slightly different challenge. They are legitimate mergers between two independent companies, likely executed for several reasons. But the potential tax savings on the table are perhaps an overwhelming incentive pushing them forward.
The U.K., Ireland and many European countries take a different approach--the so-called "managed and controlled" test. In the U.K., for instance, tax residency can be based on where management decisions are made by a board of directors. (The U.K. system also uses incorporation as a basis, to ensure the widest net.)
If the U.S. were to switch to a similar system, Pfizer might still be able to become a British tax resident through this merger--thus ridding itself of the need to pay U.S. taxes on the majority of its profits--but it would have to demonstrate that the decisions were being made in London, not New York. Would that still be acceptable, from a policy standpoint? Tax specialists have plenty of different opinions on that. But at least it would be more than a relocation on paper.
This approach brings its own set of challenges, however, which are only amplified in the digital age.
For starters, different countries have different customs regarding the board of directors. In the U.K., the board is more likely to comprise officers from the company itself--employees such as the chief executive officer, chief financial officer, chief operations officer, and so forth. On the other hand, a typical U.S. board doesn't often include many who are otherwise employed by the company itself.
This can be a problem, because it can be harder to pin down a more diffuse board, with members possibly spread out across the country. U.S. law could perhaps be more specific, and identify where the chief officers--the so-called C-suite--meet. But that, too, could be difficult to define in an age of telecommuting and Web conferencing.
"As with any factual case, there are issues that come up," said Ian Roxan, a professor of tax law at the London School of Economics. "But that doesn't mean there aren't ways of resolving those issues."
There is another solution to the corporate inversion question. Rather than trying to refine the definition of a corporate headquarters, the U.S. could simply stop caring, and focus only on taxing economic activity that occurs within its own borders. When corporations have offices, factories and customers across the globe, why should it matter where their headquarters are?
This is the question that has dominated tax policy debates over the past several decades: Should the U.S. try to tax the worldwide income of its companies, or should it just tax profits generated in its territory under a so-called territorial system? Policymakers are divided--Republican tax overhaul proposals would switch to a territorial system, while Democrats would prefer to refine the worldwide system.
(In truth, no tax system is purely worldwide or territorial. For instance, the U.S. system is designed to be worldwide, but corporations can delay--often indefinitely--taxes on earnings from offshore, so long as they keep the earnings invested abroad. The result is a system that seems more territorial. Other systems use a territorial approach, but include some provisions to ensure that profits aren't artificially moved overseas.)
A territorial system has its own drawbacks, including the difficulty of determining where income is generated with highly valuable intangible properties and online-only businesses, which are the pillars of many of today's biggest corporations. (For more on how beguiling this can be, see the case of Google and its British quasi-salespeople.)
"The trouble is," said Edward Kleinbard, a professor of law at the University of Southern California, "the only thing more artificial than corporate residence is the source of corporate income." Kleinbard, the former chief of staff of the Joint Committee on Taxation, added, "They're two artificial or unknowable concepts that are central to international taxation."
Alex Parker, Staff Writer, Transfer Pricing Report
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