Treasury Targets Corporate Inversions, Drawing Ire of CEOs

SMITH BRAIN TRUST — The Treasury Department continues to tighten its rules to prevent corporate "inversions" — the move in which a U.S. company merges with a smaller foreign company, then shifts its official location abroad to avoid the U.S. corporate tax. After Treasury announced its new rules, the American drug company Pfizer and Ireland's Allergan promptly dropped a proposed $150 billion merger, which would have shifted the new company's official base of operations—though not necessarily its physical headquarters—to Ireland, which has a notably low corporate tax rate. The U.S. federal corporate rate, at 35 percent, is among the highest.

There was a war of words between the Obama administration and leaders of the companies affected. President Obama called corporate inversions "one of the most insidious tax loopholes out there," while Pfizer CEO Ian Read wrote: "This week’s Treasury action interprets the tax laws in ways never done before. This ad hoc and arbitrary attempt to single out and damage the growth opportunities of companies operating within the current law is unprecedented, unproductive and harmful to the U.S. economy."

Existing Treasury rules aimed at discouraging inversions say that if shareholders of the inverting U.S. company own 80 percent of the post-merger company, it will remain, for tax purposes, a U.S. company. The rules restrict the tax benefits of inversions in which shareholders of the U.S. company end up owning 60 to 80 percent of the new company.

The new rules close off some pathways around those restrictions. Namely, Treasury says that the last three years of corporate mergers will be disregarded when calculating the relative size of the two companies. Ignoring Dublin-based Allergan's recent mergers with U.S. companies drops it down to a size where the inversion no longer makes sense.

Given the limits posed by the lack of congressional action on this issue, "The Treasury rules appear to be reasonable attempts to distinguish between international mergers that are done for business reasons versus those done for purely tax reasons," says Michael Faulkender, associate professor of finance at the Robert H. Smith School of Business.

But Faulkender adds that it is indisputable that the U.S. corporate tax system is "broken," and that, until it is fixed, it is inevitable that firms will waste a lot of intellectual energy and working hours trying to avoid its penalties. "Full-scale tax reform is needed to make the U.S. tax code more competitive," he says, "but that will not happen this election season. However, this is a must-do for the next Congress and President, as firms and their tax advisors will continue to find ever-more creative ways to reduce their exposure to the highest corporate tax rate in the industrialized world." 

"It is time for the U.S. government to once again make America a place where multinational corporations want to invest," Faulkender concludes.

The new rules also forbid "earnings stripping" after mergers, arrangements in which the formerly foreign company lends money to its U.S. subsidiary.  Previously considered untaxable debt transactions, these would now be taxable equity movements. Some observers worried that this rule would have unintended side effects, affecting all sets of corporate transactions unrelated to inversions.

The rules will not derail all inversions under discussion, such as the possible joining of Johnson Controls Inc. and Ireland's Tyco International. That's because, as The Wall Street Journal observes, Tyco International has made few acquisitions in recent years.