Political campaigns are not generally known as ideal laboratories for devising sensible, innovative policies. Yet Hillary Clinton’s proposals to combat corporate inversions — in which U.S. companies move their tax homes abroad — are just that. They would largely eliminate the tax incentives to invert.
A U.S. company currently has many such incentives. It can lower its taxes by creating a home base in a low-tax country, even if it leaves its headquarters and other operations in the U.S., and even if the U.S. operations represent as much as 79.9 percent of the new combined company (though the rules are stricter if the share is 60 percent to 80 percent). In many cases, the re-domiciled company can avoid tax on profits that it accumulated tax-free abroad while it was still a U.S. company. And it can further reduce its U.S. taxes through “earnings stripping,” in which the U.S. company loads up on debt owed to the parent; the payments on such debts are deductible in the U.S., even as the corresponding income is received in the low-tax country.
In the past two years, the Treasury Department has imposed tighter restrictions on inversions when the U.S. company represents 60 percent to 80 percent of the combined entity. It’s now harder, for example, for these companies to access foreign earnings without triggering tax in the U.S. But corporations are getting around this by devising transactions that barely avoid the 60 percent threshold. It’s clear that more has to be done, and while further administrative action is possible, the most substantial changes will require legislation.
The question is, what kind of legislation. Many people emphasize the need for comprehensive tax reform. Yes, the U.S. corporate tax code is a complex mess. Yes, it would be good to clean it up, and, yes, this might discourage inversions — though not as much as you might think, especially if the tax reform were designed to be revenue neutral. After all, the point of inverting is to reduce a company’s overall effective tax rate, regardless of whether its initial rate is high or low. A revenue-neutral change to the corporate tax system, by definition, would reduce some companies’ effective tax rates only if those of other companies went up.
Similarly, some strategies for reform would raise the tax rate on American companies’ foreign income, while others would reduce it. The net effect on the overall incentive to invert is thus not clear.
Also note that a so-called territorial tax system, in which the tax on foreign profits is eliminated, might reduce the incentive to invert, but at the same time it would increase incentives to play other games to shift foreign profits on paper. For example, it would encourage companies to abuse transfer pricing, in which profits are shifted abroad by manipulating the prices that a U.S. company pays its foreign subsidiaries.