The U.S. Treasury department’s announcement on Monday of new rules to discourage U.S. companies from resorting to “inversion deals” to relocate to lower-tax countries has shaken the corporate world by its unprecedented force and reach. The proposed $150 billion merger between Pfizer and Allergan took a direct hit, and the two companies have called off the deal.

Essentially, the rules sought to curtail tax inversions by addressing two controversial themes: One is the rise of the “serial acquirer,” a phenomenon where foreign companies grow too big through M&A deals, ostensibly to make inversion deals with a U.S. company compliant with U.S. law. Two, the rules target a practice called “earnings stripping,” where U.S. companies borrow money from their overseas subsidiaries and thereby generate large interest deductions without financing new investment in the U.S.

While the Treasury Department’s new rules would prevent many such inversion deals, they merely treat the symptoms of the problem, said experts at Wharton and Washington University Law School. A complete overhaul and of the U.S. tax regime is badly needed, and those efforts must go much beyond lowering tax rates, they added.

The Treasury Department says its main objective is to ensure that these companies pay their fair share of taxes. “After an inversion, many of these companies continue to take advantage of the benefits of being based in the United States, while shifting a greater tax burden to other businesses and American families,” it said in a press note. Companies like Pfizer have said the relocation to the U.S. would help them compete better with foreign companies that pay lower taxes, among other advantages.

“When you are fighting the last battle, you are not necessarily prepared to win the next one.” –Adam Rosenzweig

The new rules are unlikely to put a stop to inversion deals, although they may significantly dampen enthusiasm for them. Washington University Law School professor Adam Rosenzweig said that while the lawyers at the Treasury Department are “incredibly good” at what they do, “they are always chasing the last deal, and always fighting the last battle.” That captures the essence of the challenges the U.S. tax system faces, he added.

“When you are fighting the last battle, you are not necessarily prepared to win the next one,” said Rosenzweig. “The real problem here is they are chasing the symptoms of the problem and not [the underlying causes].” He acknowledged that the Treasury Department is constrained by time pressures and the limited scope of its powers without the necessary supporting legislation. “So we never resolve the underlying source of these problems.”

Even so, the Treasury Department has taken an extra-long stride with its latest move. Wharton accounting professor Jennifer Blouin said she was “stunned at the approach the government had taken with this announcement.” Earlier attempts to check inversion deals in 2014 and 2015 broadened the interpretations of existing laws, she added. But with its actions on earnings stripping and serial acquirers, the government has begun talking tougher, she noted.

Blouin and Rosenzweig weighed the potential benefits and shortcomings of the Treasury Department’s new rules on the Knowledge at Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

The first round of rules targeting inversion deals was announced in September 2014, while the second round was in November 2015. In the second round, U.S. companies were prevented from excluding their existing foreign operations from U.S. tax coverage, but the issue of earnings stripping was not addressed. It did attempt to discourage companies from growing too big before a merger, though.

“These actions took away some of the economic benefits of inverting and helped slow the pace of these transactions, but we know companies will continue to seek new and creative ways to relocate their tax residence to avoid paying taxes here at home,” said Treasury Secretary Jacob J. Lew in Monday’s press release, explaining why he thought the latest third round was necessary.

Victims and Survivors

The serial acquirer rule directly addresses the Pfizer-Allergan proposal, Blouin noted. It specifies that deals that occurred in the 36 months prior to a merger proposal would not be considered for the purposes of determining the size of the acquirer. That single stroke renders Allergan too small to make sense for a merger with Pfizer.

Blouin noted that Actavis of Ireland, which bought Allergan last year and changed its name to Allergan, had essentially grown rapidly to its current size through a string of acquisitions over three years. She explained that under tax laws, an inversion is a transaction where the U.S. company’s shareholders own 60% or more of the combined entity afterwards. “So when you have a very large company like Pfizer, to get that 60:40 split, they have to be acquired by a very large non-U.S. company,” she said. “The trouble is, Allergan got there by acquiring not foreign companies, but U.S. companies.”

“The fundamental debate that needs to be addressed is what defines corporate citizenship.” –Jennifer Blouin

Critics have said the Treasury move was designed to trip the Pfizer-Allergan deal. “[Treasury] could not figure out how to shut down Pfizer-Allergan but to write a specific set of proposed laws that targets that transaction,” said Blouin. The Treasury Department denied this and said in a note seeking to dispel several myths, “This claim is baseless. Treasury’s most recent guidance is the result of an extensive policy process that began nearly two years ago, long before the Pfizer-Allergan deal was even announced.

The serial acquirer rule, however, will not affect pending inversion deals that have not taken Allergan’s route to grow big, Blouin noted. They include Ireland-based Tyco International seeking to buy Milwaukee, Wisconsin-based automotive parts maker Johnson Controls, Progressive Waste Solutions of Canada pursuing Texas-based Waste Connections, and a deal between Englewood, Colorado-based information services firm IHS and Markit, a British data services provider.

Rosenzweig said a legal challenge to these rules is difficult, and that much depends on the size and the scope of the transaction and the issues involved. He noted that earlier actions were issued as Internal Revenue Service notices. But the latest rules were issued as regulations, and “when finalized, they have the binding force of law,” he explained. Courts tend to support the Treasury Department in such actions, but here again, one challenge could be that the agency acted beyond the authority delegated to it by Congress, he added.

Longer-term Problems

According to Rosenzweig, the fundamental question lawmakers have to address is: “What does it mean to be an American company, now in 2016, as opposed to when these rules were first developed in the early 20th century?” He noted that while current law defines a U.S. company as one that is legally organized as a corporation in the U.S., other definitions have often been put forward. Theories are that a company’s base should be where the board of directors meets, or where it is publicly traded, or if it was founded and started up with U.S. subsidies and assistance, he added.

Blouin agreed. “The fundamental debate that needs to be addressed is what defines corporate citizenship,” she said. “Congress is not ready to take this on, as evidenced by the fact that these proposed changes are coming directly from Treasury [and] not through changes in law.” She explained that while the Treasury Department did what it could do within its powers, the gaps remain. “A lot these fixes are like Band-Aid on the tumor — it doesn’t fix the underlying problem.”

Blouin said lawmakers need to consider other questions here. “Why do companies want to leave the U.S.?” she asked. “Part of the reason they want to leave the U.S. is we have a high, 35% corporate tax rate.” She noted that in several recent deals, U.S. companies are heading to Canada or the U.K. “They are not going to tax-haven Ireland,” she said. She added that one reason the U.K. is attractive now is Prime Minister David Cameron’s proposal to reduce the corporate tax rate to 17% — or about half the U.S. rate.

“A lot these fixes are like Band-Aid on the tumor – it doesn’t fix the underlying problem.” –Jennifer Blouin

Inversions Will Continue

Blouin expected inversion activity to continue. “People view inversions as purely abusive transactions, but there are three reasons why you invert,” she said. “You can invert to strip earnings out of the U.S., and that was partially what was addressed by Treasury on Monday. You invert to access the trapped cash and the profits of the U.S. entity that would be subject to double tax.” She noted that the latest Treasury rules address those two options.

Blouin said the third reason why companies invert continues to exist. “If you [as a company] invert out of the U.S., all future profits and earnings that U.S. companies earn, not in the U.S. but overseas, will now only be subject to tax rates in the [foreign] jurisdictions in which they are earned,” she said. “[Those foreign jurisdictions] turn out to all have tax rates lower than the U.S. That is why you will continue to see what we deem inversions.”

Its Not Just About Taxes

According to Rosenzweig, the reforms have to address not just the tax rate, but also surrounding issues such as definitions of income recognition and so forth. “Even if you lower that [tax] rate, it is still built on that faulty structure,” he said. “Solely lowering rates leads to a race to the bottom among countries.” The Treasury Department clearly is aware of those needs. “Ultimately, the best way to address inversions is to reform our business tax system,” the agency said in the note referenced earlier. “That is why Treasury is releasing an updated framework on business tax reform, outlining the administration’s proposals to date as a guide for future reform.”