This is the easiest way the US can stop corporate tax dodgers

Last week, the New York-based drugmaker Pfizer scuttled its proposed $150 billion merger with Irish-based competitor Allergan after the Obama administration rolled out new rules to curb the tax savings Pfizer hoped to glean from the deal. The episode again highlighted tax-motivated inversions — where a U.S.-based firm shifts its residence abroad by combining with a foreign firm, while typically keeping its US operations and personnel in place.
Like Pfizer, US companies flee abroad to pay fewer taxes, assisted by loopholes in the US tax code. While I applaud the new rules discouraging tax inversions, Congress could certainly do more and close the nation’s tax loopholes without waiting for comprehensive tax reform. And, if Congress does its job right, the US Department of the Treasury could stop patching the corporate tax quilt on its own.

Unlike most other countries, the United States taxes businesses and individuals on their worldwide income. But it delays the tax on the earnings of foreign affiliates of a US multinational companies with business operations across several countries until the earnings are distributed to the multinational or invested in the United States. As a result, US multinationals are stockpiling huge amounts of earnings overseas — $2.4 trillion by some estimates. Pfizer alone has more than $74 billion in untaxed earnings sitting abroad, according to its public financial statements.

How can Pfizer, with much of its sales in the United States, shift almost all of its profits to foreign affiliates? Like many companies with valuable intellectual property, Pfizer transfers rights to its patents to affiliates in low-tax jurisdictions. Pfizer then pays its affiliates to sell the drugs in the lucrative US market. Multinationals use different variations of “transfer pricing” to increase costs in the United States, whose 35% tax rate makes deductions most valuable, while shifting income to a low-tax jurisdiction. Ireland, for example, taxes these profits at 12.5% and, recently, lowered its tax to 6.25% in some cases.

US multinationals frequently invert to permanently sidestep future US tax on their offshore earnings. A multinational group headed by a foreign company often can access offshore earnings without ever bringing the money back to the United States.

Of more immediate benefit, after an inversion, the now-subsidiary US company can trim its future domestic profits through a practice known as earnings stripping, where it ostensibly borrows from its foreign parent. (The US firm does not have to actually borrow—it can just distribute a note and make interest payments.) The firm then deducts those interest costs in the high-tax United States, and the foreign parent pays a low tax rate on the interest earnings in its home country.

In 2004, the Republican-controlled Congress enacted anti-inversion laws aimed at preventing US firms that merge with smaller foreign companies from accessing their deferred earnings without paying tax. But these rules apply only when the former owners of the US corporation acquire 60% or more of the new foreign parent. To avoid the 60% test, companies, such as Pfizer, pursue combinations with roughly equal-sized foreign corporations (or, sometimes, with larger foreign corporations).

Congress could slow this behavior by lowering the 60% test or otherwise limiting inversion tax benefits. But congressional leaders say they will only address inversions as part of comprehensive tax reform, which is unlikely to occur anytime soon. Many politicians want the United States to replace its worldwide tax system with a territorial tax system, which would tax only domestic earnings. They argue that this shift would harmonize the US tax system with most other developed countries and allow US companies to better compete abroad. But critics warn that a territorial system would simply encourage US companies to shift their operations and personnel abroad—reducing jobs and taxes here.

In the face of congressional paralysis, the Treasury has been attempting to stem the pace of inversions on its own, with some success. In September 2014, for example, officials moved to prevent distributions, including loans, by a foreign affiliate that skipped over a US company to an inverted foreign parent corporation (which led Chicago drugmaker AbbVie to call off its $55 billion acquisition of Irish-based Shire). But the Treasury’s rules applied only to inverted companies that met the 60% test, as required by the earlier anti-inversion laws.

Last week, the Treasury issued new rules that prevented Pfizer from accessing its foreign earnings tax-free by combining with Allergan. The Treasury changed the way Pfizer must calculate the 60% test, effectively making Allergan much smaller—and subjecting the combination to the anti-inversion rules. As a result, Pfizer called off its merger.

In addition, the Treasury proposes to treat any note distributed by a US company to a related foreign company as stock. Since, unlike interest on debt, stock dividends are not deductible, the new rules will limit future earnings stripping.

The Treasury’s earnings stripping rule also levels the playing field. It extends to all cross-border combinations: US corporations that merge with smaller foreign corporations, foreign corporations that take over smaller US corporations, and a combination of equals.

Though the Treasury can limit some of these practices, Congress should stop US companies that invert from accessing their deferred earnings tax free, whether they meet the 60% test or not. To be sure that US-based multinationals pay tax on offshore earnings, the United States should charge a toll on US companies that exit equal to the tax they’d owe on their deferred earnings. This is what the United States already does with the IRAs of individuals who relinquish their US citizenship.

An exit tax would discourage both voluntary departures and hostile foreign takeovers. Even a credible threat of an exit charge would deter US companies from accumulating earnings offshore.

By enacting such a levy, Congress could curb tax-motivated mergers between US firms and foreign partners. These steps won’t end all deals, since sometimes good business reasons exist for these combinations. But Congress should stop firms from moving abroad simply to sidestep their obligations under the US tax code.

This article first appeared in TaxVox.