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The Good, the Bad and the Ugly of Tax Inversion Practices

Are Tax Inversions an Ethical Practice?

Apple, the world’s biggest company by market capitalization, captured attention last month with the introduction of a digital watch, larger iPhones and a slick electronic payment system. Amid all the hype, there was scarcely any mention that much of its hardware is made outside the U.S.— or that Apple’s sophisticated lawyers and accountants could be expected to keep its American taxes low, partly by stashing much of its profit overseas.

It seems that most American consumers, investors and politicians have tacitly accepted that if a company is profitable, doesn’t violate the law and produces appealing products and services, it can operate wherever and however it likes. That’s why the furor over tax inversions is so intriguing.

If you haven’t kept abreast of the latest fashions in accounting, tax inversions are an increasingly popular maneuver among American companies seeking to save money by moving their tax domiciles abroad. While the markets have generally applauded them, the tactic has drawn fierce condemnation from many American politicians and consumer groups.

In an inversion, a large U.S. firm acquires a much smaller target company domiciled in a tax-friendly jurisdiction such as Ireland, Switzerland or the U.K., but the deal is structured so that the foreign minnow swallows the domestic whale. U.S. shareholders of the U.S. firm must pay immediate capital gains tax for the privilege of inversion, and the U.S. Company ends up as the nominal subsidiary of a publicly held foreign corporation.

The deals are driven by a desire to avoid paying U.S. corporate income taxes that are the highest in the world (35%) by relocating to a tax-friendly country. The UK tax rate is 21%, Switzerland is 18% and Ireland, with the lowest corporate income rate, at 12.5%. U.S. companies avoid paying any corporate income taxes by shifting profits overseas so that taxes are avoided until and unless those profits are repatriated from their low-taxed foreign earnings to the U.S. By simply keeping the profits overseas a U.S. company avoids paying U.S. corporate income taxes.

Inversions threaten to reduce the amount of corporate income tax paid into the U.S. treasury at a time when taxable income is rising as the economy recovers. The U.S. expects to take in $332.7 billion in corporate income tax this year, more than 20% above the $273.5 billion it collected last year. That figure could rise as high as $528 billion by the end of 2017, according to White House projections. But as more companies leave U.S. shores for lower tax havens, that figure could shrink. Inversions could cost the U.S. government about $19.5 billion in lost tax revenue over the next decade, according to recent projections from the bipartisan Joint Committee on Taxation.

In a speech in Los Angeles in July, President Obama denounced tax inversions as “unpatriotic.” He added that while he would prefer to settle the issue through comprehensive tax reform legislation, his administration would stop tax inversions through other means, if need be. Treasury Secretary Jacob J. Lew chimed in that the Treasury had been going over the details and would come to a decision soon.

The explicit nature of tax inversions has attracted negative publicity. Burger King was pilloried last month after it said it would buy Tim Hortons of Canada and move its tax headquarters there. And Walgreen, which had been contemplating moving its tax domicile to Zug, Switzerland, as part of a merger with Alliance Boots, found itself the focus of controversy for simply entertaining the possibility.

In the end, Walgreen decided that the outcry over tax inversions was too much to bear: Gregory D. Wasson, the Walgreen C.E.O., decided to go ahead with the Alliance Boots merger — but not with a tax relocation overseas. “We had to consider the consumer backlash,” Mr. Wasson said in a meeting with employees in August. “We had to consider the political backlash.”

Investors appear to like tax inversions. After Burger King said it would embark on one, its shares rose an astonishing 19.5 percent in a single day. No wonder that earlier this month, Newedge USA, a unit of Société Générale, said that “the rising tide of opposition in Washington, D.C., toward reincorporating for tax reasons may, in fact, accelerate deal-making as companies rush to complete conversions and other tax strategies before legislative changes.”

After years of a rising stock market and buoyant profits, much of them held abroad, American companies are engaging in a spree of mergers and acquisitions. And the U.S. is nearly alone among major industrialized nations in taxing — or, more realistically, trying to tax — all the worldwide income of corporations domiciled within its territory. Canada, Switzerland and nearly every place else tax only the income earned in their own territories. This makes tax planning much simpler.

Of course, many American corporations with foreign operations haven’t needed tax inversions; they’ve found other ways to minimize taxes in the U.S. By keeping profits overseas, American tax bills can be deferred. Bloomberg estimated in March that the foreign cash hoard of American companies had reached $1.95 trillion. And congressional hearings last year disclosed that companies like Apple have reduced taxable earnings in the U.S. and shifted them to lower-tax territories overseas.

The results of a study of “the first wave of tax inversions” — those that took place before Congress tightened the rules in 2004 —found that companies that moved their tax domiciles outperformed the overall stock market. It’s too early to tell whether the current wave will be similarly lucrative, but corporate motivations are clear. While inversions prompt immediate tax bills for some shareholders, they often end up being beneficial.

By prohibiting techniques that enable corporations to cut their tax bills, new Treasury regulations could make inversions less attractive. Yet inventive lawyers and accountants are likely to find ways to keep taxes low without drawing as much attention. Fundamentally, low taxes are in corporations’ narrow self-interest — but if corporate taxes dip low enough, individuals must pay more or the government must cut services or borrow money.

Facing this quandary, Republicans and Democrats alike have called for comprehensive tax reform for years, with little to show for it. In the meantime, amid rampant globalization, American corporations are doing what they do best: finding ways to profit, regardless of national borders.

From an ethical perspective the issue is “ethical legalism.” Ethical legalism is an approach to ethical reasoning that equates ethics with being legal. As such, since tax inversions are legal they must be ethical. The problem is ethical decision-making is done at a higher level than merely following the law. It may be legal to practice tax inversions but we can question the ethics of the practice because the benefits to the corporation engaging in inversion techniques may be outweighed by the harms to the government and society because of lost tax revenue. Moreover, inversions often lead to fewer jobs in the U.S. as jobs are transferred overseas as a result of the combining of a U.S. corporation with a foreign corporation and the shifting of corporate headquarters overseas.

While tax avoidance is legal, tax evasion is not. U.S. corporations are, no doubt, motivated by tax avoidance to minimize global taxes using inversion techniques. While it may be legal there are important questions to address from an ethical perspective that gets crowded out by the practicalities of monetary policy. It would be nice to see Congress tackle the ethical issues. Then again that is the wrong body to address such issues as Congress has shown, over and over again, a disdain for ethics in their own behavior.

Blog posted by Dr. Steven Mintz, aka Ethics Sage, on October 16, 2014. Professor Mintz is on the faculty of the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at:

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