The Wrong Way to Stop Corporate Inversions
The federal government has a bad habit of conjuring new regulatory powers seemingly out of nothing. Especially troubling is a new regulation proposed by the Treasury Department that gives the IRS the power to determine unilaterally whether parts of a company’s financial structure are considered equity or debt. The prospective regulation, known as the Section 385 debt/equity rules, could be finalized as early as Labor Day.
The regulation is meant to stop the practice of “corporate inversions,” whereby an American company merges with a foreign company and moves its headquarters oversees in order to escape American tax burdens. In fact, however, the regulation dramatically expands IRS control over businesses — even those that have no intention of engaging in inversions.
Inversions have become commonplace in recent years for a simple reason: While the rest of the world has dramatically cut corporate tax rates — currently averaging 25 percent in developed countries — the average American business pays 39.1 percent. Additionally, the U.S. uses a “worldwide” system of corporate taxation, meaning profits are taxed both in the country of origin and again when they are brought back to America.
It’s no wonder businesses are looking for the optimum corporate structure to reduce their tax bills. There has been an uptick in inversions, with 20 taking place since 2012 alone. And some $2.1 trillion is now kept overseas to avoid being sliced into ribbons by the American tax code.
But rather than reform the high corporate taxes and encourage businesses to return to the U.S., the Obama administration is proposing yet another complicated and convoluted rule. For instance, under the new Section 385 rules, the IRS could declare that a business’s debt — which usually has tax deductible interest payments — is equity. The result? What was once tax-deductible interest becomes taxable dividends, increasing the company’s overall tax liabilities.
Moreover, the proposed rule is overly broad and will surely have unintended consequences for businesses. In the first study of these potential regulations, the accounting firm PricewaterhouseCoopers found that the 385 rules could reduce the amount of investment foreign businesses make in the U.S., while simultaneously making it harder for U.S. businesses to invest abroad.
Multinational long-term cash flow management is already complex. Businesses shift money abroad in order to fund capital expenditures, invest in profitable foreign markets, or just to cover day-to-day operational expenses. The IRS’s new authority threatens to add a new level of complexity to all these processes, thanks to an added risk of increased taxes.
Businesses without overseas investments would be impacted as well. The IRS’s new authority would extend to all domestic businesses, allowing the bureau to enlarge tax burdens at will across the nation. It would also require costly and time-consuming new compliance requirements, further adding to the current burden of corporate tax compliance.
In its war against inversions, the Obama administration has chosen the least effective method of rooting them out. Discouraging tax avoidance by raising compliance costs and cutting into the profitability of businesses is like trying to cure a headache with a hammer to the head.
The best solution for the Obama administration — or the next administration — is not to make the tax code more arbitrary and punitive, but, rather, to simplify and reduce it. Our corporate taxes need to become more competitive with those in the rest of the developed world. Lower rates and a territorial system in which businesses are taxed according to their places of residence would make it more attractive for them to remain in the USA.
In the meantime, the Treasury Department should scrap the 385 rules before the IRS uses them to target more businesses. Treasury has a valuable opportunity to take a step back and rethink whether it’s worth hampering the American economy to collect a few more tax dollars.
Eric Peterson is a senior policy analyst at Americans for Prosperity.