The Rise of Corporate Inversions

American corporations are getting better at not paying U.S. taxes. According to the Congressional Research Service, over the past ten years, at least 47 U.S. companies have changed their legal residence for tax purposes—a move known as corporate inversion. Inversions occur when a U.S. business shifts its tax domicile abroad through an acquisition or merger with a non-U.S. partner, thereby reaping the benefits of a lower tax rate. Policy makers are starting to fear the drain on U.S. tax revenue but so far have done little to change the situation.

What makes inversion so attractive for companies? Thomas Lys, a professor of accounting at the Kellogg School and an expert on corporate restructuring, says the answer lies in the tax code. “The U.S. has the highest corporate tax rate in the industrialized world,” he says. “It’s 35 percent, and that’s just federal tax. If you factor in state tax, you’re pushing 40 percent. Combine that with the fact that the government taxes global income, and you can see why companies want to leave. The incentives are simply too strong.”

An obvious benefit of a corporate inversion is that companies can avoid paying taxes to the U.S. Treasury on unrepatriated foreign income and future income earned abroad. “If Apple sells an iPhone in France, it pays U.S. tax on the income resulting from that sale,” Lys says. Given that much of Apple’s revenue comes from international sales, this policy has a significant impact on after-tax profits. “Many U.S. companies generate large amounts of foreign income,” Lys says. “What if they could avoid paying U.S. taxes on past and future foreign income? For a company like Apple”—which, by last count, holds $137 billion in unrepatriated foreign cash—“there are billions of dollars’ worth of reasons to redomicile.”

Another benefit of corporate inversions is “earnings stripping,” or the ability to shift earnings from a U.S. subsidiary to a non-U.S. parent corporation in order to gain the most from that country’s lower tax rate. Earnings stripping can also be achieved through changes in the company’s capital structure. Typically, this is done by shifting the domestic subsidiary’s capital from equity to debt, the latter being tax deductible. In other words, a company can save on taxes if its U.S. business borrows heavily.

“Inversions are particularly attractive for companies that have a lot of intangible assets,” Lys says. Patents, trademarks, or brand names—unlike brick-and-mortar stores—can be transferred abroad and then leased back to the U.S. subsidiary, which decreases the income the company earns in the U.S. while increasing the income it earns abroad. “For General Motors, this wouldn’t make a lot of sense as most of its assets are brick-and-mortar. But it does make sense for many pharmaceuticals, which typically have a lot of intangible assets.” This explains Pfizer’s proposed takeover of British pharmaceutical AstraZeneca, or Walgreens’ bid to acquire Alliance Boots, a Swiss-based drug retailer. In each case, the parent company was in a position to save hundreds of millions of dollars a year by keeping more of its global revenue.

In a recent study, Lys and Kellogg School Ph.D. candidate Rita Gunn show that corporate inversions result in significant increases in shareholder wealth. From a sample of 122 corporate inversions, they found that, after accounting for variables such as unrepatriated foreign cash, expected future foreign income, and media attention, the average company benefited by $2.1 billion.

There are downsides to inversions, however. A company may lose valuable tax credits, and its domestic shareholders may have to pay tax on the gains they earned as a result of the inversion. The most obvious drawback, however, is not financial, but reputational. Inversions are highly unpopular with the public and several key members of Congress, and they can lead to waves of negative publicity—something that Walgreens learned the hard way when congressional activists deemed its proposed strategy unfair and unpatriotic.

“Walgreens was basically shamed out of its inversion,” Lys says. “People called them unpatriotic—but that’s nonsense. Companies must answer only to their shareholders, the majority of whom are middle class Americans. There’s nothing illegal about this. It’s simply a way of increasing shareholder value.”

The Internal Revenue Code has long struggled to keep up with the strategies companies use to avoid paying taxes. As assets become more easily moveable, and governments—from Bermuda to Ireland—keep their tax rates appealingly low, the Obama administration is taking steps to prevent American companies from reincorporating abroad. But Lys—who has worked on tax issues for the Department of Justice, the Department of the Treasury, and on behalf of corporations—says it is impossible to close all of the loopholes. “You cannot write a rule that these companies can’t figure out how to get around,” he says. “The tragedy is that all of the effort that goes into inversions is unproductive energy. From a national perspective, it is just shifting rents around—no net wealth is being created.”

The study did yield one paradoxical result. While the Ways and Means Committee estimates that inversions will cost the U.S. Treasury some $34 billion over the next ten years, Lys and Gunn found that the inversions might not have had an adverse impact on the taxes collected by the U.S.—in fact, they likely resulted in significant increases in tax collections by the U.S. Treasury. The reason is that before their inversions, U.S. corporations were not repatriating foreign profits but leaving them “permanently invested” abroad; after they inverted, the companies repatriated those funds to the tune of approximately $103 million per company and increased cash dividends. In addition, the inversions themselves resulted in taxable gains to U.S. shareholders through share-price appreciation.

“There’s a very simple solution if you want to eliminate inversions,” Lys says. “You have to make the corporate tax rate internationally competitive. If corporate tax rates were 15 or 20 percent, you would see inversions disappear.”

Photo credit belongs to Woodley Wonder Works. Published under a Creative Commons license.