Capital Flight: Can Tax Inversions Be Prevented?

suitcase-cash

At the Morgan Stanley Global Healthcare Conference on September 9, Merck CEO Ken Frazier told investors he wouldn’t join the giant wave of companies pursuing overseas acquisitions so they can move abroad and escape high U.S. corporate taxes. Such deals, known as “tax inversions,” go against Merck’s policy of only making purchases that give the company “quality commercial access and quality scientific access,” Frazier said. “We don’t see that the advantages that we would get from a tax inversion deal would … be durable long-term because I think the U.S. government will do something positive or negative in response to the flight of capital,” he added.

That’s quite a bold prediction, though it’s certainly true that legislators in Washington, D.C., are up in arms over all the recent cross-border deals. The pharmaceutical industry has been particularly merger-happy, with Illinois-based AbbVie buying Shire, for example, Michigan-based Perrigo picking up Elan, and Actavis of New Jersey swallowing up Warner Chilcott. All three takeover targets are Irish. And although Pfizer failed to complete its $118 billionbid to buy British drug giant AstraZeneca, many analysts are predicting it will try again, raising the prospect that what was once a proud New York company may someday be based in London.

Why the rush out of the U.S.? In the simplest terms, says Wharton professor of business economics and public policy Kent Smetters, the overall U.S. corporate income tax rate — the combination of the federal 35% rate and the average tax levied by individual states — is 39%. That’s the highest corporate tax rate among countries in the Organisation for Economic Co-operation and Development (OECD) and vastly above the average OECD tax rate of 26%, Smetters points out. What’s more, the U.S. follows a “worldwide” system of taxation, meaning it slaps those sky-high taxes on all American firms regardless of where they’re earning the money.

Many experts, including Smetters, agree the only way to stem the tide of companies moving overseas would be to switch to a more equitable “territorial” system, which would tax corporations only on the income they earn in the U.S. Most countries follow the territorial model.

“The pharmaceutical industry has traditionally been a much higher profit-margin industry than others, so they have more tax advantages to gain.” –Mark V. Pauly

U.S.-based companies not only pay taxes here, they’re also required to pay taxes to foreign countries on any earnings they make in those countries. Even though the U.S. awards credits for foreign taxes paid, American companies are still disadvantaged, Smetters contends. “U.S. firms … face a higher tax rate than their competitors when they invest in intermediary production in other countries. The toxic combination also creates the incentive of U.S. firms to defer the reporting of foreign subsidiary earnings back to the parent U.S. firm,” he says.

It’s hard to argue with the potential savings a company can derive by shifting its headquarters overseas. AbbVie, which plans to move the headquarters of its newly merged company to the British island of Jersey, expects its tax rate to fall to 13% by 2016.

Although drug companies aren’t the only ones pursuing tax inversions — witness Burger King’s planned $11 billion buyout of Canadian donut chain Tim Horton’s — the advantages of such deals to Big Pharma are clear. “The pharmaceutical industry has traditionally been a much higher profit-margin industry than others, so they have more tax advantages to gain” by doing inversions, says Wharton health care management professor Mark V. Pauly. “And the companies can better incur the cost of an inversion than companies in other industries can.”

Pauly adds that the increasing globalization of the pharma industry only boosts the incentives for drug companies to move offshore. “Now oftentimes the European regulators will approve a new drug before the [U.S. Food & Drug Administration] does. That means that if you move your operations to Europe, you might actually be in a better situation, because you can earn your profits there by introducing your new product sooner there,” he says.

There are no guarantees, of course. Because overseas health systems are often socialized, drug companies face more pressure in other countries to hold down their prices. “It’s not all great. But if you do make a ton of money, you can make it in Europe and avoid a tax on that” if you’re based there, Pauly notes.

Territorial Taxation

In February, House Ways and Means Committee chairman Dave Camp, a Republican from Michigan, released a comprehensive tax reform plan proposing a shift to a territorial system. As part of the plan, Camp proposed that any past foreign earnings held overseas be repatriated and taxed, just one time, at 8.75%. Non-cash earnings held abroad would be taxed at 3.75%. Then, in the future, most foreign income earned by U.S. companies would be exempt from domestic taxes. The top federal corporate tax rate would be lowered to 25%. As for the government’s lost revenue, it would replace it in various ways, such as requiring companies to deduct research and development costs over five years, rather than all at once.

The last big wave of tax inversions occurred prior to 2004, when the government passed the American Jobs Creation Act, which imposed stiff penalties on companies that moved overseas in search of lower taxes.

Even though many economists and corporate taxation experts agree that this plan — or something like it — should be adopted, there’s widespread doubt it will be anytime soon. “The issue is, how do you do this in a revenue neutral way for the U.S. budget?” asks Wharton accounting professor Stephanie Sikes. “They would have to broaden the base, meaning they would get rid of certain tax benefits. So they’re taxing a larger base, but at a lower rate.”

The gridlock on tax reform generally isn’t being driven by companies, Sikes says. “It’s very political. Most companies are in favor of it. But there’s always someone on the other side who doesn’t agree with the proposals, and some industries that will feel they’re worse off if you broaden the base.”

The last big wave of tax inversions occurred prior to 2004, when the government passed the American Jobs Creation Act, which imposed stiff penalties on companies that moved overseas in search of lower taxes. “Prior to that, we mostly just saw companies going to the Cayman Islands and Bermuda — basically tax shelters,” Sikes says. “Now they have to have more of a business purpose, so they’re finding other synergies in the companies they’re acquiring.”

Piecemeal Fixes

In late August, medical device giant Medtronic — which is buying Ireland’s Covidien for $43 billion — disclosed that it plans to reimburse its CEO, Omar Ishrak, for a $24.8 million tax bill he will incur for doing the inversion. The tax emanates from a 2004 Congressional action requiring that a 15 percent tax be imposed on stock and option awards given to officials of companies that undertake inversions.

The tax was designed to discourage inversions, to be sure, but responses such as Medtronic’s show these types of Band-Aids rarely work, says Wharton accounting professor Jennifer Blouin.

Blouin offers a hypothetical example of a U.S. company that’s thinking about making a Swiss acquisition and inverting. “Say I expect to make $5 billion over the next 10 years, and it’s taxed at 5% in Switzerland vs. 30% in the United States. Thirty percent of $5 billion is $1.5 billion,” she notes. “Reimbursing executives for $2 million of taxes is a drop in the bucket. And by the way, those reimbursed taxes are tax-deductible themselves, so it doesn’t cost the company $2 million, it costs them 65% of that. The benefits of the [merger] are still too large relative to having to pay that tax.”

“If AstraZeneca and Pfizer want to join, how would the U.S. government be able to put the kibosh on that? I think these proposals are going to be a tough sell.” –Jennifer Blouin

Blouin says she’s also skeptical about a recent proposal by Senate Finance Committee chairman Ron Wyden, a Democrat from Oregon, who suggests that no inversion should be considered legal unless the foreign company owns 50% of the U.S. company’s stock. The ownership stake required currently for such deals to be cleared is 20%. “If AstraZeneca and Pfizer want to join, how would the U.S. government be able to put the kibosh on that? I think these proposals are going to be a tough sell,” Blouin says.

There is one proposal that Blouin says might have teeth, which would involve limiting the interest deductions that companies can take. “Part of the issue with inversion is that Pfizer still sells lots of drugs in the United States, and it pays taxes in the United States. But once you get a foreign company on top, what it can do is allow you to push down as much of your interest expense in the worldwide organization to the United States as possible,” a practice known as “earnings stripping,” she explains.

On September 8, Senator Charles Schumer, a Democrat from New York, introduced a plan to reduce the amount of interest inverted companies can deduct to 25%. What’s more, he wants to apply it to any inversion that’s happened since April of 1994. “That would get any U.S. company that’s stripping earnings, but also U.S. affiliates of foreign companies that are doing the same thing. I don’t think trying to apply it retroactively is going to work, but it will mitigate some benefits by at least preserving the tax base in the United States,” Blouin says.

In August, the U.S. Treasury Department said it might do an end-run around Congress and take action itself to stem tax inversions. The agency put out a statement saying it was “reviewing a broad range of authorities for possible administrative actions” that would both limit the ability of companies to pursue the deals and reduce the tax benefits of doing inversions.

Whether anyone in Washington will actually succeed at halting the run of tax inversions remains to be seen, but one fact is certain: Without such limits, many more companies could very well look seriously at how they might acquire a foreign address. The multiple layers of taxes imposed by the U.S. government on companies “gets more and more troublesome the more the capital market becomes global,” Pauly says. “Capital and labor and management can flow all over the world, so I’m actually amazed that so many American companies are still here.”

Citing Knowledge@Wharton

Close


For Personal use:

Please use the following citations to quote for personal use:

MLA

"Capital Flight: Can Tax Inversions Be Prevented?." Knowledge@Wharton. The Wharton School, University of Pennsylvania, 16 September, 2014. Web. 25 September, 2016 <http://knowledge.wharton.upenn.edu/article/can-tax-inversions-be-prevented/>

APA

Capital Flight: Can Tax Inversions Be Prevented?. Knowledge@Wharton (2014, September 16). Retrieved from http://knowledge.wharton.upenn.edu/article/can-tax-inversions-be-prevented/

Chicago

"Capital Flight: Can Tax Inversions Be Prevented?" Knowledge@Wharton, September 16, 2014,
accessed September 25, 2016. http://knowledge.wharton.upenn.edu/article/can-tax-inversions-be-prevented/


For Educational/Business use:

Please contact us for repurposing articles, podcasts, or videos using our content licensing contact form.