The Obama administration’s plan for executive action against corporate tax “inversions” is finally out, and it’s a potentially significant one. Inversion is the process by which a U.S. corporation merges with a foreign one so as to pay taxes on overseas income at the other country’s lower rates. The new plan, announced late Monday by Treasury Secretary Jack Lew, would crack down on it in several ways. It would prevent inverted companies from deferring U.S. taxes via “hopscotch” loans from the U.S. company’s foreign subsidiary to the new foreign parent. It would prevent inverted companies from restructuring foreign subsidiaries so as to give the new foreign parent access to their earnings, tax-free. And it would put extra teeth in the current law’s requirement that an inverted entity’s former U.S. owners own less than 80 percent of the new combined one.
Tax-law experts generally agree that Treasury’s moves amount to an aggressive use of its existing legal authorities, not an illegitimate overextension of them, though that assessment may be tested in court. The new policies will be effective immediately; they won’t affect previously completed inversion deals but could apply to some that are in process and any that might be proposed hereafter. In short, the measures could chill the use of a tax-avoidance strategy that had been increasingly popular among U.S. corporations in recent years — and increasingly unpopular among voters — saving the government some or all of about $2 billion in revenue lost annually.
As Lew was the first to admit, however, the new actions are in no way a substitute for a broader reform of the U.S. corporate tax code. They are, at most, a short-term fix for one specific manifestation of the code’s overall inefficiency. The main reason that U.S. firms sought to “reflag” themselves as foreign companies was that the top federal tax rate for corporations, 35 percent, is the highest in the developed world (not counting state levies). To be sure, many firms pay less than that because they can take advantage of various loopholes; still, the high U.S. rate, in combination with the United States’ unique claim to tax worldwide earnings of its firms, drove many companies to seek new headquarters abroad.
Ironically, if the administration plan works, it may actually set back the cause of tax reform. To the voters, there was no more vivid demonstration of the current system’s shortcomings than the spectacle of American firms that benefit from U.S. government services reflagging themselves as foreign entities; without that, the cause of a more competitive tax system might lose momentum. Yet if there is room for post-election agreement between Republicans and Democrats on any economic issue, it could be an overhaul of the loophole-ridden system of business taxation, the broad principles of which are recognized by leaders of both parties. It will be up to them to keep the issue alive and to pursue a compromise, even if the tax inversion bogeyman has, for now, been tamed.