The Treasury Department on Monday announced a new rule that will make it harder for companies to game their profits to escape higher U.S. tax rates.
In a call with reporters Monday afternoon, Treasury Secretary Jack Lew announced a new effort by the agency to curb the practice known as “earnings stripping.” That controversial practice allows multinational companies with headquarters overseas load up their U.S. subsidiaries with intra-company debt, the payments on which are tax-deductible in the U.S.
The effect of the move is to shift taxable income out of the U.S. into low-tax jurisdictions. At 35 percent, the statutory U.S. corporate tax rate is the highest among developed nations.
Earnings stripping is thought to be one of the motivations for the rash of corporate inversions in recent years. Inversions involve a U.S. company merging with a business in a low-tax country, and then placing the headquarters of the combined company in that country.
The newest rules represent an effort to “rein in inversions and reduce the ability of companies to avoid taxes through earnings stripping,” Lew said. He promised that the rules would have “an important effect,” but reiterated that only legislation from Congress could halt the trend of U.S. companies looking to move their headquarters out of the country.
That trend has seen U.S. companies such as pharmaceutical giant Pfizer and energy efficiency company Johnson Controls head for the exits in recent months, with the Obama administration and Congress worried that more may be to follow.
With congressional Republicans opposed to stopping inversions with punitive measures, however, the Obama administration has attempted to stem the flow through administrative action. Monday’s announcement is the third announced rulemaking aimed at inversions.
Guidance specifically aimed at stopping earnings stripping has long been anticipated by tax experts and business groups. Democratic members of Congress have introduced legislation that would accomplish a similar goal, although a senior Treasury official said that the rulemaking was not a substitute for legislation.
The Treasury said it would aim to prevent U.S. subsidiaries of multinationals from claiming large interest cost deductions that don’t actually finance new investment in the U.S. Also, the agency will require companies to spell out up front how such intra-company loans suit investment purposes, and tax them as equity rather than debt if the explanations fall short. Lastly, the Internal Revenue Service will be given more latitude to probe such transactions.
Only “the most sophisticated and the largest firms” will be affected, said a senior Treasury official, because only loans of $50 million or more will be scrutinized.
Separately, the Treasury also announced that it will write rules aimed at preventing foreign companies that are the products of previous inversions from merging with U.S. companies in future inversions. Such serial inversions are not uncommon in industries that are tilted toward intellectual property income, such as the pharmaceutical industry. Allergan, the Dublin company seeking a merger with Pfizer, was previously based in the U.S.
Allergan’s stock decline nearly 20 percent in after-hours trading following the news.
In a statement, Sen. Chuck Schumer, D-N.Y., called the new guidance a “great step forward,” but called for legislation to stop the “despicable practice” of inversions.
While legislation to lower the corporate tax rate is currently stalled, members of both parties have been working toward a deal on reforming the taxation of overseas profits to eliminate some of the other pressures on companies to move out of the U.S. That effort, however, is seen as unlikely to succeed before President Obama leaves office.
