Solving the inversion crisis: How the U.S. can keep companies at home

Big controversies often arise from big numbers, and on the surface the cost in U.S. tax revenue from the corporate tax avoidance scheme known as “inversion” looks like a big number: potentially $20 billion over 10 years, according to a congressional estimate last year.

But since the corporate income tax is projected to bring in some $4.5 trillion over the same period, inversions might cost less than half a percent of corporate tax receipts.

That suggests that the real issue for U.S. lawmakers shouldn’t be the particular method corporations use to avoid U.S. taxes, but why they would go to such great lengths to do so. The problem, tax experts say, is the enormous hoard of foreign earnings that American corporations don’t want to bring home.

Why not? The average tax rate paid by American corporations on foreign income is about 16.7%, according to a survey this year by two Dutch economists. In Ireland the rate is 5.6% and in Britain only 3.8%.

The stockpile of foreign earnings parked in low-tax countries out of the reach of U.S. tax authorities now exceeds $2 trillion, including as much as $1 trillion in cash, estimates Edward Kleinbard, an international tax expert at USC who labels it “stateless income.” That makes it urgent for Congress to restructure the U.S. corporate tax to eliminate the incentive for corporate tax gamesmanship.

The debate over corporate taxation has focused recently on inversions, in which a U.S. company merges with a smaller foreign firm and shifts its tax domicile to the smaller firm’s homeland. Drugmaker Pfizer has proposed the largest such transaction ever, via a merger with Ireland-based Allergan valued at more than $150 billion.

Pfizer has said the combination will cut its effective tax rate to as low as 17% from its declared rate of 25.5%. That’s a potential tax savings of more than $1 billion last year alone.

Inversions draw fire because they seem overtly to violate principles of corporate citizenship. Typically, nothing changes for inverted companies except their tax domicile; they keep their U.S. workforce and markets, and even continue to enjoy subsidies and other perks enjoyed by American corporations. That’s why President Obama last year labeled inversion an “unpatriotic tax loophole.”

Congress and the Treasury have been tightening inversion rules for years, but smart corporate lawyers invariably have found loopholes. The answer lies elsewhere.

“The only way to address it is by making the U.S. tax system resemble that of other countries,” says corporate tax expert Robert Willens. “If the rate differential were removed, it wouldn’t be worth the effort to invert.”

Yet inversions are just one way multinational corporations avoid U.S. tax on foreign earnings. Kleinbard tracked several for a 2011 paper. Among them was a “Double Irish Dutch Sandwich” structure launched by Google in 2003 to disconnect taxable income from the countries where it was generated, and relocate it to lower-tax lands.

The maneuver involved the creation of an Irish subsidiary that acquired overseas rights to Google’s search and advertising technologies and licensed them to a Dutch subsidiary of Google that relicensed them to another Irish subsidiary of Google. The subsidiaries were judged to be outside the reach of U.S. taxes. In this way, Kleinbard observed, “a company can disappear from view for purposes of U.S. tax law” in a way that allowed it virtually to choose which countries’ tax laws would apply.

Then there’s the suite of tax devices employed by Apple to avoid paying at least $15 billion in U.S. taxes on $44 billion in foreign income from 2009 to 2012, as laid out in a 2013 report by an investigative subcommittee headed by then-Sen. Carl Levin (D-Mich.). Its Irish subsidiary Apple Operations International recorded $30 billion in income but didn’t file a tax return in any country.

As the company acknowledged in testimony, as an Irish company, the unit was not judged taxable by the U.S., but because it didn’t meet the “residency requirements of Irish law,” it wasn’t taxable by Ireland either. Apple maintained that all its maneuvers were legal and justifiable and that “Apple does not use tax gimmicks.” The company asserted that it was responsible for 600,000 U.S. jobs and “likely the largest corporate income tax payer in the U.S.”

Apple still pursues many of the same stratagems. According to its most recent annual report, its foreign pretax earnings in the year that ended Sept. 26 came to $47.6 billion, or more than 65% of worldwide earnings. Almost all the foreign earnings were declared by the subsidiaries in Ireland. The annual report said Apple’s overseas pile of cash and securities had reached $187 billion and its “deferred” U.S. tax liability on foreign earnings kept overseas was $30 billion. It’s true that Apple’s maneuvers are largely legal and not unique. But they are on the verge of fomenting an international incident. The European Commission has been investigating allegedly sweetheart tax deals Ireland reached with the company and has hinted that it will rule them illegal. The EC could order Ireland to recover up to 10 years of past taxes from the company — which could amount to billions of dollars. Just Thursday, the EC opened a similar investigation of tax deals between Luxembourg and McDonald’s, which it said resulted in “McDonald’s paying no tax on their European royalties either in Luxembourg or in the U.S.” McDonald’s responded that it has paid billions of dollars in corporate taxes in the European Union over time.

Although one would expect such inquiries to be welcomed by U.S. tax officials, in fact they’re causing friction. Treasury official Robert B. Stack told the Senate Finance Committee last week that the EC “appears to be disproportionately targeting U.S. companies. (Starbucks and Amazon have also come under scrutiny, though the EC’s initial targets included Italian automaker Fiat.) The Treasury also fears that any settlements by the companies might have to be credited against their U.S. taxes, so that “U.S. taxpayers would wind up footing the bill.”

One hesitates to reward corporate tax shenanigans with lower tax rates, but the logic of restructuring U.S. corporate taxes to match our foreign rivals’ has become inescapable. Says Kleinbard, “The right solution is worldwide tax consolidation at a fair rate” to shut down corporations’ efforts to play one country’s tax regime off against another’s. The reform might reduce the U.S. corporate rate from 35% to somewhere in the mid-20s, he says, but the result will be a cleaner, fairer and perhaps even a more productive corporate tax.

Michael Hiltzik’s column appears every Sunday. His new book is “Big Science: Ernest Lawrence and the Invention That Launched the Military-Industrial Complex.” Read his blog every day at latimes.com/business/hiltzik, reach him at [email protected], check out facebook.com/hiltzik and follow @hiltzikm on Twitter.