Last year at this time, news about “tax inversions” was grabbing headlines – cases where large U.S. multinationals would buy a foreign company in a tax-friendly jurisdiction, and then relocate its headquarters to reap the tax arbitrage benefits. The Obama administration responded to the rash of high-profile inversions with new Treasury Department rules intended to reduce the tax benefits of such deals.
In the year since, six major inversion deals have been struck. We’re reminded of the old story of King Canute of Denmark. When his courtiers tried to flatter him by telling him that even the ocean would obey him, he had them bring his throne down to the seashore. Needless to say, his commands failed to stop the rising tide and they all soon had wet feet.
It’s a lesson highly relevant to contemporary politicians and to the market participants who are affected by their policy decisions. Human decrees can’t stop natural processes. Tax codes are indeed human creations – but the human motivations that are at work to minimize the effects of those codes, and maximize after-tax income, are more like forces of nature.
Tax Arbitrage and Gaming the System
Most member states of the OECD have acclimated themselves to an environment in which business is global. While the U.S. and a few other members maintain a worldwide taxation system – in which the profits of their domestic companies are subject to tax no matter where they are earned – most have gone to territorial systems where only domestic earnings are taxed.
On top of that, at 35 percent, the U.S. has the highest corporate tax rate in the OECD – at least on paper. Companies receive a credit from the IRS for foreign taxes paid, but in theory, will then be liable at least for the difference between that total and the 35 percent U.S. rate. The effective tax rate paid to foreign companies by U.S. multinationals is lower, varying widely by industry but averaging 27.2 percent. So incrementally, and depending on the industry, tax inversions make sense. U.S.-domiciled multinationals can avoid paying those incremental taxes by “deferring” the repatriation of their cash, and there are a variety of complex strategies for making use of that cash at home. Nevertheless, the assets held by U.S. companies overseas have reached such high levels – perhaps $2 trillion – that it’s beginning to become problematic.
Needless to say, the whole situation has become a rich field for investment bankers, financial engineers, and other technical specialists who can effectively create “stateless income” – that is, corporate income subject to the jurisdiction neither of the country where its parent company is domiciled, nor the country where that income was generated.
The strategy employed by Google (GOOG) in Europe – the so-called “Double Irish Dutch Sandwich” – is a case in point. It’s important to emphasize that there is absolutely nothing illegal about this structure; it is completely compliant with the tax systems of all the countries involved. Nor are we making a point that there is anything objectionable about GOOG’s strategy from an ethical standpoint. Further, GOOG is far from being the only company employing this particular strategy – it just gets more attention because of its size and significance. Thousands of companies do this: Apple (AAPL) in Ireland, Starbucks (SBUX) in the Netherlands, and Amazon (AMZN) in Luxembourg, among countless others, also use such structures to minimize their European tax burden.
GOOG’s European revenues flow into an Irish-domiciled subsidiary, Google Ireland Ltd. In turn, that company is itself a subsidiary of a Dutch shell called Google Netherlands BV, which is again a subsidiary of an Irish corporation, Google Ireland Holdings – recognized for tax purposes by Ireland as domiciled in Bermuda. Because of the way royalties and licenses are structured, GOOG ends up with a negligible tax rate – essentially a token fee paid to the Dutch government.
The complexity of GOOG’s tax strategy (and it’s a relatively simple one, as such strategies go) illustrates a simple point: human economic actors will respond to incentives, and will act rationally within a system to maximize the value of their assets. Where there is an opportunity for tax arbitrage – by effectively moving income from high-tax to low-tax jurisdictions – and economic actors have the capacity to take advantage of that arbitrage, they will.
Can rules or legislation stop the process? We doubt it. Incrementally, the effect will be to redouble the efforts of tax engineers to locate and exploit opportunities for arbitrage – the outlays a multinational incurs in creating such strategies are more than repaid by the benefits, obviously. In any complex system, this will be the case. Nor is this an evil; the impetus behind this strategy is written into the DNA of capitalism, and produces all the benefits we enjoy (and demand) as consumers. That is, less costly, higher quality products that fulfill our needs and desires – in short, ourmaximization of our own utility.
Therefore, there is no point in trying to deal with the symptoms of a poorly conceived corporate tax policy. Complaining about, and even legislating against, multinationals’ arbitrage of tax differentials is wasted breath. As long as the incentives are there, financial engineers will find a way to act on them.
Of course, there are serious negative consequences if the structures which encourage this system-gaming are left in place. One of the major ones is a phenomenon we warned about last year, and have now seen accelerating: if inversion deals are discouraged while the basic drivers that make them happen remain unaddressed, a simpler process will happen as U.S. companies are just bought by foreign companies. For individual firms such deals can make good sense under the current U.S. tax regime – even though on a macro level, they lead to the erosion of the U.S. tax base and the incremental migration of good, highly skilled jobs abroad.
The most obvious solution is for the U.S. to move in the direction of a properly managed territorial tax system, rather than a worldwide one; but even that will produce perverse incentives and distortions unless the effective U.S. corporate tax rate is transparently lowered to be more in line with OECD peers. Alternately, the worldwide system could be maintained, but with periodic tax holidays allowed for the repatriation of accumulated foreign earnings at a competitive and attractive rate. Neither of these would be a complete solution, but they would give us hope for significant improvement if we saw political momentum building behind them.
Whatever shape it takes, we believe corporate tax reform in the U.S. will be on the agenda in the debates leading up to next year’s Presidential election. We will be watching closely, because the tax environment is a key influence on the long-term pattern of capital formation and the vitality of the U.S. economy, and thus its ability to grow and produce jobs.
Investment implications: Current U.S. corporate tax policy, existing as it does in the framework of other national tax policies, creates perverse incentives and distortions for investment. To avoid those distortions, it’s not sufficient to try to discourage tax arbitrage strategies such as inversions; the underlying problems of the U.S. tax code must be addressed. Even so, as long as humans are involved, and ingeniously figuring out how to minimize their taxes, no system will be perfect, and periodic tax holidays may be necessary to encourage the repatriation of foreign earnings. As the election year gets closer, we have already started hearing tax rhetoric – and we will be very attentive to reform efforts, because they will have a significant long-term effect on capital formation in the U.S. and the vitality of the U.S. economy.
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