Obama Just Struck A Blow Against Corporate Tax Dodging

The U.S. Treasury Department's new rules making it harder for U.S. companies to perform “corporate inversions” that allow them to escape taxes were hailed Tuesday by Democratic politicians, including President Barack Obama , and liberal groups.

The rules announced Monday could save money for American taxpayers over the long term, since they shoulder a larger share of taxes when corporations find ways to avoid paying. Already, the announcement has cast doubt on the largest corporate tax-inversion scheme yet: the planned purchase by New York-based Pfizer, the world’s largest drugmaker, of Irish competitor Allergan, the maker of Botox. The fusion of the two companies would allow Pfizer to move its headquarters outside the U.S. and benefit from Ireland’s lower corporate tax rate.

Treasury announced the rules a day after the release of the “Panama Papers,” a trove of leaked documents from a Panamanian law firm that provided new insight into complex and lucrative tax-dodging techniques of the global super-rich.

Obama pointed to the revelations on Tuesday as evidence of the importance of Treasury’s new rules.

“We've had another reminder in this big dump of data coming out of Panama that tax avoidance is a big, global problem. It’s not unique to other countries,” Obama told reporters at the White House.

He characterized tax inversion as one tax-avoidance technique that harms the broader public.

“When companies exploit loopholes like this, it makes it harder to invest in the things that are going to make the American economy strong for generations to come,” he said. 

The practice of inversion also elicits public ire because of its transparent gimmickry. Inversion entails the purchase of, or combination with, a smaller foreign company. The deal allows the U.S. company to reincorporate in a lower-tax country.

The new rules include a change that would tighten a September 2014 notice barring companies from enjoying foreign tax benefits if 60 percent of the merged company’s shareholders were also shareholders of the original U.S. parent company. Now, the foreign ownership shares will not count toward the requisite percentage of foreign ownership if they were acquired from assets of an American company in the previous three years.

Treasury’s increased regulation of foreign ownership at inverted companies jeopardizes Pfizer's $160 billion agreement to buy Allergan. The deal was designed to comply with Treasury's old rules on inversions, with Pfizer acquiring a 56-percent stake in Allergan.

Americans for Tax Fairness, a liberal tax reform advocacy group, estimates that under the rules Treasury announced on Monday, Pfizer’s American shareholders would now exceed Treasury’s American ownership threshold, making it subject to U.S. corporate taxes -- and eliminating the motivation for the “corporate inversion.” Treasury will likely not count a significant percentage of shares in Allergan as those of the foreign-owned target company, because Allergan is a “serial inverter” that has already merged with several American companies in recent years.

“We are conducting a review of the U.S. Department of Treasury’s actions announced today,” Pfizer and Allergan said in a joint statement on Monday. “Prior to completing the review, we won’t speculate on any potential impact.”

But investors clearly interpreted the new rules as a sign that the deal was off. Allergan shares declined almost 15 percent  at the close of New York Stock Exchange trading on Tuesday.

Treasury’s new rules also seek to limit a feature of corporate inversion known as “earnings stripping,”  in which the newly formed, foreign-based company lends money to its U.S.-based subsidiaries. When the U.S. company repays the debt, the interest on it is tax deductible, reducing the profits taxed at the higher U.S. tax rate. Meanwhile, the lower-taxed foreign company’s profits rise as it takes in the interest payments.

Treasury would count several types of debt typically associated with this practice as equity, presumably limiting benefits of this practice.

The progressive Economic Policy Institute argued that the earnings-stripping  provision could have been more comprehensive, and speculated that companies will craft a new way around it.

Obama acknowledged on Tuesday that the measures were incomplete. But he said that was because of limits of what the executive branch can do without congressional action.

“I want to be clear. While the Treasury Department’s actions will make it more difficult ... to exploit this particular corporate inversions loophole, only Congress can close it for good,” Obama said.

The rise in the number of corporate inversions in recent years has sparked public outrage that in some cases has forced companies to back away from their plans to acquire foreign competitors.

In a testament to the issue’s political salience, even Republican presidential front-runner Donald Trump has vowed to end the practice. His plan includes lowering corporate taxes.

Among the Democratic presidential candidates, both Sen. Bernie Sanders (I-Vt.) and the campaign of Hillary Clinton released statements on Tuesday praising the Obama administration’s measures.

The roots of corporate inversion are more complex than a stump speech can typically accommodate, however.

U.S. companies stash earnings overseas, they claim, because the top U.S. corporate tax rate of 39 percent is among the highest in the world. In practice, the vast majority of American corporations pay far less than that rate, thanks to loopholes and other aggressive avoidance methods.

But because the U.S. is one of the rare countries that taxes foreign profits at domestic rates if they are brought back to the U.S., companies also have an extra incentive to hoard cash overseas. Currently, U.S. companies are believed to be holding over $2 trillion in foreign tax havens.

That deprives the American public of much-needed revenue, and can also prevent companies from putting the profit to good use.

What distinguishes corporate inversions from other methods of overseas tax avoidance is that it gives the parent company freer use of the money being sheltered from the U.S. government.

In order to fix the problem over the long term, the Obama administration has proposed reforming the U.S. corporate tax laws to look more like a “territorial” tax system, in which companies pay taxes to the country in which they earned profits. The president also recommends lowering corporate tax rates, while closing tax loopholes, so the changes would be “revenue neutral.”