BONUS CONTENT: Corporate Inversions

Can corporations be patriotic?

They (or their spokespeople) would surely claim so. But as immaterial creations of law, can they really feel that deep welling of pride and civic responsibility that we associate with patriotism?

And if they can be patriotic, can they be unpatriotic as well?

That’s an issue that then-President Barack Obama raised in 2014, criticizing U.S. companies that had undertaken, or were considering, “inversions,” a maneuver where they can establish offshore tax residency.

“For you to continue to benefit from that entire architecture that helps you thrive, but move your technical address simply to avoid paying taxes is neither fair, nor is it something that's going to be good for the country over the long term,” Obama said in an interview.

Technically he never called the inverting companies themselves unpatriotic. Rather, he said it was an unpatriotic “loophole” that allowed them to invert. But the implication was clear. (U.S. Trade Representative Katharine Tai recently made eye-brow-raising comments that echoed the same thought.)

That year, 2014, was the year of inversions. True, they had a history going back to the 1980s, with the appropriately named Helen of Troy Ltd as an early example. But it grabbed headlines 10 years ago as several companies, apparently spontaneously, announced that they were considering establishing foreign incorporation for their parent entities–mostly through mergers, a necessary part of the process. (Early on, a company could do an inversion on its own, by restructuring and “inverting” the large parent organization to be subordinate to a small foreign subsidiary. But following a rash of inversions in the late 90s, a 2004 anti-inversion law allows the IRS to disregard those transactions entirely, if the formerly U.S. company’s shareholders own 80% or more of the reorganized company’s stock. Hence why a merger with a smaller foreign entity became a necessary part of the process.)

The inverting companies included some big-name American brands–Pfizer, Walgreens, Johnson Controls, and ultimately Burger King. The first two eventually backed down, and it was never clear to what degree tax planning drove Burger King’s merger with the Canadian-based restaurant chain Tim Hortons.

But regardless, it was in the news. I was about a year and a half into my job at Bloomberg covering transfer pricing, and suddenly issues related to my beat were part of the national conversation. It was buzzing, not just in the tax press. I think this is partly because it was easily understandable. Everyone hates tax cheats, but you could talk about check-the-box or the Double Irish until you’re blue in the face, and most peoples’ eyes would glaze over.

But moving out of the country to skip on your tax bill? That’s something anyone could grasp, and a lot of folks would have strong feelings about it.

Facing a brutal midterm election, Obama knew a good stump speech issue when he saw it, and it became a staple of his campaign events. He urged Congress to pass something to stem the flow of exiting companies. And if they failed to act, he said he may have to take matters into his own hands.

That’s ultimately what he did, in Section 385 regulations that became somewhat infamous among tax pros. Issued in 2016, they didn’t stop inversions outright, but they curbed many of the incentives behind them. They may have been a blunt tool–many innocent transactions were caught in the crosshairs, practitioners claimed–but they apparently did work, to a degree.

Since then, there have hardly been any inversions of significant companies. Whether that’s due to Obama’s regs or the Tax Cuts and Jobs Act’s reduction in the corporate tax rate, or other issues, is up for debate.

Inversions ceased to be an issue, but that doesn’t mean they won’t return, as the global tax rules continue to dramatically shift. Understanding how they might come back requires some understanding of how they worked in the first place, which could be counterintuitive.

First of all, an inversion doesn’t get you out of paying taxes on U.S. income, despite all the rhetoric to the contrary.

That may seem a bit puzzling. But an inverted corporation still has a company that’s in the U.S.–that company is just now a subsidiary of a foreign group. If all of your income was earned in the United States in the first place, establishing a foreign parent elsewhere won’t change anything.

Also, an inversion likely wouldn’t involve any change with actual operations on the ground, at least directly. It’s mostly an on-paper transaction, shuffling subsidiaries around to gain an optimal tax structure. It’s enabled by the U.S. rules on tax residency, which don’t take into account where a physical headquarters is. (Unlike most of the rest of the world, by the way.)

An easy fix for the inversion issue could be to simply say that a company should be incorporated where its headquarters is–and there were many proposals to do that. It raised questions, however–how do you define a headquarters, anyways? (All the more pertinent in the Zoom Era.) And what if such a rule caused companies to move their HQs–that could be a dent in the New York and California economies.

But while an inversion doesn’t exempt you from your U.S. tax bill, at the time the U.S. taxed (or purported to tax) all worldwide income of its taxpayers. A foreign multinational would owe U.S. tax for U.S. income, but that’s all. A U.S. company owes U.S. tax on all income that it's earned. That’s a huge difference that could be worth leaving the U.S. for.

But it’s not that clear-cut, either. The foreign income that was earned prior to the inversion–some of which could be deferred from U.S. repatriation indefinitely, under the pre-2017 rules–wouldn’t suddenly escape taxation. Some maneuvers are necessary to move the money to subsidiaries that aren’t within the Internal Revenue Service’s reach, and Obama’s regulations clamped down on that practice (often called “hopscotching”).

And prior to the 2017 deemed repatriation, the U.S. often wasn’t taxing that income anyways, thanks to indefinite deferral.

One of the primary motivations for inversions actually had to do with intercompany debt. An inversion would often enable companies to engage in transactions–sometimes called earnings stripping–to move income offshore through tax-deductible interest payments, for loans between the U.S. entity and the newly created offshore parent.

Subpart F does a pretty good job of sucking up those interest payments for U.S. companies. But it doesn’t apply to foreign ones. The two transactions would often go hand-in-hand, creating an immediate infusion in cash as well as a tax-optimized structure for the future.

That’s why Obama’s 2016 reg package focused on interest, using the then-obscure Internal Revenue Code Section 385 to craft new rules on how debt is distinguished from (non-tax-deductible) equity. Those rules were partially rescinded by the Trump Administration, although after the TCJA’s hard limit on interest deductibility they became less relevant anyway.

Whether it was Obama’s regs or the TCJA, inversions went out of style fast, and haven’t been seen since. (The TCJA’s exemption for most overseas income and 21% corporate rate likely had something to do with it, too.) But as the world continues to pursue more aggressive tax policies–and the U.S. mulls sharpening worldwide-based taxes such as tax on global intangible low-taxed income or the corporate alternative minimum tax–it’s possible that those incentives will shift again, and inversions will come back faster than a ‘90s trend.

Contact the author at amparkerdc@gmail.com.