Washington Hates Carrots, Loves Sticks

May 14, 2014

A widely-held maxim tells us that money tends to flow from where it is treated badly to where it is treated well. This trend has taken center stage in the ongoing battle between U.S. states to attract and retain top employers. In that conflict, high tax states like California have been losing ground to relatively low tax states such as Texas and Florida. Politicians like to pretend otherwise but the same forces are at work in the global business arena. U.S. tax laws treat business profits badly and corporations have been looking for friendlier fields. But rather than treating profits with more respect, some U.S. politicians just want to heap on another layer of abuse.

At 35 percent, the U.S. has the highest corporate tax rate in the developed world. But this doesn't even factor in the additional taxes heaped on by many of the states. Furthermore, unlike most developed nations, which tax their corporations only on domestic profits, the U.S. taxes its corporations, like its citizens, on worldwide income. These burdens reduce a U.S. corporation's international competitiveness.

To get around these handicaps many globally integrated U.S. corporations have attempted to use complex structural and legal schemes to shift larger portions of their profits to countries with lower tax rates, such as Ireland, Switzerland and even Great Britain. Earnings that don't wind up on the balance sheet of the U.S. corporation don't get taxed, as long as the money stays overseas. Sometimes this means establishing foreign-based subsidiaries to retain earnings that were generated abroad. More brazenly, foreign shell companies can be created as pass through entities that have no other purpose than to lower tax exposure. However, U.S. tax authorities are looking with increasing scrutiny at these moves. 

But when U.S. companies send money overseas, they have fewer funds available domestically for investment and job creation. This has aroused considerable Congressional anger. Although most politicians agree generally that the U.S. tax code is a burden on business, they are unable to take the difficult political steps to change the law. This keeps the country locked in a bad system. So rather than tackle the problem at the root, Congressional Democrats are looking to close off the few escape hatches that remain open to U.S. companies.

One of the most secure means for a U.S. company to shift earnings overseas is a process known as "inversion," where a company buys or merges with a foreign rival. If the target company is of sufficient size, the U.S. company can claim it is headquartered overseas. This is the corporate equivalent of marrying for a green card.

Recently, U.S. drug maker Actavis Plc. bought Irish-based Warner Chilcott Plc. to transfer its tax residence to Ireland. It paid some 30 percent of its stock market value to buy Warner Chilcott. This figure surpassed the 25 percent threshold set by the IRS and allowed Actavis to transfer its tax residency to that of Warner Chilcott in Ireland. However, Actavis was permitted by the IRS rules to leave its U.S. executive offices and operations untouched.

Most recently, the huge U.S. pharmaceutical company Pfizer announced a bid of $105.6 billion for UK based AstraZeneca Plc. Barclays Plc. analyst Mark Purcell estimates that for every percentage point that Pfizer can reduce its tax rate, it will save some $200 million per year. He estimates that, over time, by paying the lower UK tax rate, Pfizer will save a potential $1.4 billion per year.

In the U.S., there is understandable and growing resistance to the corporate policies of inverting tax residence and of parking profits abroad. Robert McIntyre of Citizens for Tax Justice echoed a common frustration when he referred to inverted U.S. companies by saying, "They want all the joys of being American and none of the burdens."

Congressional anger is marked particularly among 'tax-the-rich' democrats such as Senator Ron Wyden, who seeks to prevent the "hollowing out" of the U.S. tax base. Recently, Senator Carl Levin from Michigan introduced a bill looking to put an end to corporate "inversions." Without realizing that the new tax 'host' countries provide many of the same advantages, Levin complained that tax inverted U.S. companies "benefit from the protections and services the federal government provides, including patent protection, research and development tax credits, national security and more."

Notwithstanding the easy political points that can be scored by bashing big business, U.S. politicians should realize that nations compete aggressively now by means of low tax rates. If U.S. politicians could pass a flat rate tax of say 25 percent, it likely would unleash a massive wave of enterprise and would allow for a repatriation of vast hoards of dollars. This would likely increase, not decrease, the total take of U.S. corporate taxes. But in our hyper-partisan environment, no change, no matter how sensible, has much of a prospect.

So instead, we will further drive corporations overseas by limiting the flexibility with which they can merge with companies overseas. This provides yet another reason for entrepreneurs and global capital to set up shop overseas.

For encouragement, U.S. politicians should remember how, by slashing tax rates, Prime Minister Margaret Thatcher encouraged the return of tax exiles and fostered a massive resurgence of enterprise and economic activity within Great Britain. By generating hugely increased profits, this resulted in a greater aggregate tax-take by the Government, albeit at lower rates.

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