Businesses and tax lawyers waited for years for President Obama’s Treasury Department to crack down on companies shifting income out of the country. When the rules finally came this month, they were broader than anyone thought they would be, with the potential to raise taxes on a wide range of multinational companies.
The new rules were aimed at what Obama once termed “corporate deserters”: U.S. companies that move their headquarters out of the country to lower their tax bills.
But part of the rule, directed at a tax trick known as “earnings stripping,” will hit not just companies fleeing the country, but also any multinational corporations that manipulate intracompany loans to skimp on taxes and possibly even some innocent businesses.
Treasury’s embrace of such a far-reaching rule developed from its desire to eliminate the tax benefits of the ways U.S. businesses try to get around tax laws.
It isn’t easy for companies to relocate to tax havens. Congress has passed laws making it impossible for a business to simply set up a mailbox in the Bahamas and claim that as their headquarters.
In recent years, however, as governments around the world have slashed corporate tax rates, there has been a rash of U.S. companies seeking to get around those laws by merging with a company located in a low-tax country, and then placing the headquarters of the new company in the low-tax jurisdiction.
Executives and tax lawyers love such corporate “inversions,” as they’re known, for several reasons. One is that it allows the business to escape the United States’ 35 percent statutory tax rate, the developed world’s highest, on profits their foreign subsidiaries earn overseas.
Another is that companies may be able to, effectively, shuffle paper around to shift taxable income out of the U.S. and into the low-tax country where the new headquarters is located.
The Treasury’s latest rules were meant to crack down on such profit-shifting. Without Congress acting, the Obama administration cannot simply outlaw inversions. But, Treasury Secretary Jack Lew has argued, his agency can undercut the tax benefits of the deals, making them less attractive.
The Treasury took aim at one type of corporate profit-shifting in particular: “Earnings stripping.”
Here’s how it works: A U.S. company merges with a business in a country with a low corporate tax rate, such as Ireland. Once the inversion is completed, the U.S. company, now a subsidiary, will issue bonds to its Irish parent company. The U.S. company can then deduct the interest payments from its taxes as a business expense. The payments show up as taxable income in Ireland, where the corporate tax rate is just 12.5 percent.
Although it may sound arcane, some tax experts believe that earnings stripping is a big deal.
Unfortunately, there are no reliable estimates available for how much earnings stripping saves corporations and costs the Treasury.
There are some rough calculations, however, of how much corporate America saves overall by funneling money out of the country.
Kimberly Clausing, a tax scholar at Reed College, published an analysis in January that found that the U.S. Treasury was losing between $77 billion and $111 billion annually a year to profit-shifting in 2012, a number that has likely risen significantly since then.
In comparison, the Treasury took in just $344 billion in corporate taxes in 2015. In other words, it’s possible that corporations are maneuvering their way out of a quarter to a third of taxes.
Clausing’s estimate, however, is a rough calculation that doesn’t distinguish among outright corporate evasion, earnings stripping and other kinds of tax planning.
Yet there is some evidence that earnings stripping goes on at large scale. The George W. Bush Treasury, in 2007, examined the financial statements of companies that had undergone inversions versus ones that had not, and found that the inverted companies had significantly higher foreign profits, lower effective tax rates and higher intracompany debt — tell-tale signs of widespread earnings stripping. “There is strong evidence that [inverted companies] are stripping a significant amount of earnings out of their U.S. operations,” the study concluded.
However, a 2014 analysis of IRS data from the Tax Foundation, a think tank that often advocates lower taxes, found that foreign companies in the U.S. have actually claimed fewer interest deductions and earned lower profits in recent years.
Regardless of which companies are doing earnings stripping, or how much, the Treasury’s new rules would crack down on them all.
Treasury’s guidelines are meant to prevent U.S. subsidiaries of multinationals from claiming large interest cost deductions that don’t actually finance new investment. It will require companies to justify intra-company loans, and if the explanation falls short, classify the loans as taxable equity. The IRS will be given more latitude to probe the transactions.
Furthermore, the rules will apply not just to inverted companies but to all multinationals. In that way, the rules are much broader even than legislation proposed by liberal Democrats in Congress.
“I think they got out a rule that surprised people on how serious it was,” said Steve Rosenthal, an analyst at the nonprofit Tax Policy Center.
The new guidelines, Rosenthal said, would apply to companies that were the products of non-tax-driven mergers, foreign companies in the U.S., or even start-ups founded by foreign companies. And, he said, “there’s bound to be some routine transactions that are caught up … in the rules that perhaps should not be caught up.”
Asked if the new rules would hit U.S. companies that haven’t engaged in inversions, a Treasury representative simply pointed to an explanation of the guidelines that said “businesses that are investing in American workers and infrastructure will not be penalized by these regulations.”
Rosenthal favors such a broad rule, on the grounds that all companies that are gaming the system should be treated the same.
Opponents of anti-inversion rules, however, including multinational businesses, disagree on the grounds that the Treasury is aggravating the underlying problem, which is that the corporate tax rate is too high.
“You’ve got the Treasury changing the rules every few minutes because they’re trying to plug up a system that just doesn’t work,” said James Glassman, a former State Department official who helped organize a letter from former Treasury officials to Lew opposing the new rules. “Inversions are a symptom of a much deeper disease,” Glassman said. “You wouldn’t have anything approaching earnings stripping if the U.S. had a tax rate of around 25 percent.”
That has been the response of top GOP tax-writers such as Senate Banking Committee Chairman Orrin Hatch, who accused the Treasury of tinkering around the edges of regulations, while not addressing the underlying problem. “Proposed regulations aimed at curbing earnings stripping may limit some incentives of inverting, but it will not prevent companies from restructuring for tax purposes,” Hatch said in response to the Treasury’s announcement, calling instead for tax reform.
