Close loopholes that let U.S. firms avoid taxes by using inversions

It’s both endearing and infuriating to watch American corporate executives wring their hands about how the injustices of the U.S. tax code are forcing them — forcing them! — to reincorporate overseas through the procedure known as inversion.

Endearing, because one wants to sympathize with the pain felt by a homegrown CEO having to move a homegrown American company’s headquarters to Ireland, Switzerland or some other foreign clime, just to remain competitive.

Infuriating, because they’re so full of it.

Here, for example, is Heather Bresch, chief executive of the generic drug maker Mylan (and daughter of Sen. Joe Manchin III (D-W.V.), telling the New York Times, “You can’t maintain competitiveness by staying at a competitive disadvantage. I mean you just can’t.� The credulous Times quotes her as saying she entered into her inversion deal (by acquiring a European firm and moving the tax base to Holland) “reluctantly, and she genuinely seems to mean it.�

Uh-huh. Is Mylan uncompetitive? Over the last two years its sales have increased 12.7% and profits 16%; among its big competitors paying putatively lower taxes, British-based GlaxoSmithKline gained 3.14% in sales and 11.23% in profits, and Israel-based Teva’s sales gained 11% and its profits declined 54%. Israel’s top corporate tax rate is 26.5%, the equivalent top U.S. federal rate is 35%.

The use of inversions to avoid U.S. corporate taxes has moved onto the front burner in Washington in recent months. The wave seems to be picking up, and some of the candidates are very high-profile, including Walgreens and Pfizer. The Congressional Research Service recently identified 47 such deals in the last decade, many of them in the pharmaceutical industry. In the previous 20 years there were only 29. Conservatives use the trend as an argument for cutting or eliminating the U.S. corporate tax: If ours were as low as those of other countries, no one would have to flee, they say.

The Obama administration has ramped up its efforts to put an end to the practice. In a letter to Congress a few weeks ago, Treasury Secretary Jacob J. Lew called inversions an offense against “economic patriotism.� He asserted that American companies fleeing these shores for tax havens “still expect to benefit from their business location in the United States, with our protection of intellectual property rights, our support of research and development ... and our infrastructure, all funded by various levels of government.� They just don’t want to pay their share of the costs.

Let’s get a few things straight.

First, a definition. An inversion happens when a U.S. company merges with a smaller foreign firm and moves its official headquarters to the partner’s home, typically a lower-tax jurisdiction. Management stays in the U.S., the workforce doesn’t move and the company still sells as much as before to the U.S. market. But the tax treatment of some of its income changes. Walgreens, according to an estimate by the advocacy group Americans for Tax Fairness, could save $4 billion over five years by merging with the drug retailer and wholesaler Alliance Boots and reincorporating in Switzerland.

Defenders of inversions say they don’t really affect the American company’s U.S. taxes — that’s the claim made recently in the Wall Street Journal by Miles White, chairman of Abbott Laboratories, which is conniving with Mylan on its inversion deal.

But like much that’s said about inversions, that’s misleading, says Edward D. Kleinbard, a USC law professor whose role as a former chief of staff to the Congressional Joint Committee on Taxation certifies him as one of our leading experts on the corporate tax.

The claim that the corporate tax makes U.S .companies uncompetitive, he says, is “a complete red herring.�

Inversions aren’t about improving competitiveness, Kleinbard observes. They’re about making use of the huge cash hoards American companies have accumulated overseas. Kleinbard estimates this “stateless income� at roughly $1 trillion. It can’t be spent directly in the United States without incurring a steep tax, and it’s too large a sum to be profitably deployed outside the U.S.

Inversions allow companies to use these stockpiles in the U.S., at much lower cost.

Inversions also allow companies to use their overseas money as intracorporate loans to their domestic operations, charging the loan cost to their U.S. subsidiaries. This effectively pares down their U.S. domestic tax base, Kleinbard explains, which reduces their domestic taxes. Technically, the company’s U.S. tax rate doesn’t change, as White says. But it’s applied to a smaller amount of declared income.

Also, there’s no evidence that U.S. companies are hobbled by a higher corporate tax than their overseas competitors. U.S. companies are masters at reducing their effective U.S. tax rates to levels consonant with those in other big markets, such as Western Europe and Asia. (Tax warriors will cite statutory tax rates — where the U.S. is near the top of the list — but almost no one ever pays those.) And there’s no evidence that corporate growth rates or access to capital have any real correlation to domestic tax rates.

Inordinately loose rules on inversions are bad for the U.S. Skipping out on one’s domestic obligations means leaving others to pay for all the good things that come from U.S. corporate citizenship. It’s hypocritical for American CEOs to praise the U.S. as the greatest country on Earth while beating the bushes for legal tricks to avoid the bill.

Yes, inversions are legal. Congress needs to make some of their more profitable outcomes illegal, or at least less profitable.

Kleinbard proposes a three-pronged approach. First is to close a loophole allowing an American firm to declare itself foreign-owned if at least 20% of its post-merger shareholders are foreign. The threshold should be 50%, which would require inversions to be genuine foreign acquisitions. This would put the kibosh on many, if not most, pending deals. This change has been proposed by the Obama administration and introduced in Congress by Rep. Sander M. Levin (D-Mich.).

Kleinbard also advocates tightening up rules against earnings-stripping, largely by lowering the limit on how heavily a company can saddle its U.S. operations with debt. Finally, he suggests ending “hopscotch� maneuvers, through which an inverted company bypasses U.S. tax rules by advancing its offshore cash stockpile directly to the new foreign company.

The appeal to corporate morality is eye-catching enough. But rhetoric like this has limited effectiveness. The proper way to deal with corporate immorality is to wipe it out through the law.

“There is a breach of moral obligation and fiduciary duty here,� Kleinbard says. “The moral failing is the refusal of Congress to do the most fundamental kind of loophole-closing.�

In other words, the most effective comeback to “it’s legal� is this: “It was legal. But not anymore.�

Michael Hiltzik’s column appears Sundays and Wednesdays. Read his blog, the Economy Hub, at latimes.com/business/hiltzik, reach him at [email protected], check out facebook.com/hiltzik and follow @hiltzikm on Twitter.