On July 14, the Foreign Account Tax Compliance Act became effective, and instantly virtually all foreign banks were required to keep track of, and report on, all assets held by U.S. citizens. Individuals who don’t report income on those assets and pay taxes to Uncle Sam face draconian penalties in excess of the actual money in the account. The actions are part of the IRS led, government initiative, to narrow the estimated $300 billion a year in lost taxes that could be used to help finance our government.
Despite that initiative and the finding that $100 billion of that annual amount is related to large corporations not paying their fair share, the game of hiding income abroad is nothing more than business as usual for large American companies. There is a history of this action starting with McDermott (an oil and gas company) that moved to Panama in 1982. Dart Corporation followed suit quietly around 1994 so it did not make it to the media. However, that changed in 1997 when Tyco Corporation moved its tax headquarters to Bermuda, but maintained its original headquarters in New Hampshire. The CEO at that time, Dennis Kozlowski, bragged to the media that the move would save the corporation hundreds of millions of dollars without making any structural change. Since that date, many other companies are also doing the math and willing to dance through the hoops that the US government installs every so often.
Clearly, there is something completely wrong with our system if we create a tax law that encourages companies to develop sham moves overseas so that they can escape tax when worldwide income is supposed to be taxable only when those funds are brought home. As a result, Cisco has billions of dollars abroad but borrows money to run its US Company. The interest of 4% or less is a lower cost than paying a 35% tax. The simple answer would be to eliminate the loophole but the current administration and Congress are hell bent on doing something else.
As a result, many corporations are now ducking through a corporate tax loophole by relocating their tax base overseas. These so-called “inversions” hit the mainstream news media when medical device manufacturer Medtronic bought rival Covidien, which is domiciled in Ireland, and then began stripping income out of the U.S., where the top corporate rate is 35%. The merged firm is paying taxes on most of its net income in Ireland, at a 12.5% rate. This will save the company between $3.5 billion and $4.2 billion in overall taxes. The CEO of Medtronic will receive a bonus on that tax savings, a huge bonus for doing nothing.
Others are following the same strategy. Wallgreens Co. is purchasing a Swiss company it partially owns, and pharmaceutical giant Pfizer Inc. openly pursued an inversion this year when it sought to purchase British drug maker AstraZeneca. Chicago-based pharmaceutical company AbbVie is buying Irish drug maker Shire, and two U.S.-based pharmaceuticals, Muylan Laboratories and Abbot Laboratories are planning to merge and reincorporate in the Netherlands. Overall, nearly 50 U.S. companies have used this tactic over the past decade. The net effect is to reduce U.S. tax revenues by an estimated $17 billion over the next decade.
Still others are assigning their valuable patents to a subsidiary in a more tax-friendly locale. For example, Apple, Inc. now generates 30% of its total net profits through an affiliated firm based in Ireland, saving an estimated $7.7 billion in U.S. taxes in 2011 alone. When the Wall Street Journal examined the books of 60 big U.S. companies, it found that they had shielded more than 40% of their annual profits from Uncle Sam.
An inversion works like this: A U.S. company buys or merges with a smaller company in the same business that happens to be located in a country where the corporate tax rate is lower than the maximum 35% federal rate here in the U.S.–plus, of course, state taxes. This covers a lot of territory. According to the latest update in Wikipedia, only the United Arab Emirates, Guyana, Japan and Cameroon assess higher corporate tax rates than the U.S.; their rates top out at 55%, 40%, 38% and 38.5% respectively.)
Next, the company is reincorporated, and its global headquarters is shifted to the foreign country. Operations continue exactly as they were before, which may mean that most of the sales and profits are still coming from the U.S. market. But the taxes are now paid at the lower rates of the overseas location.
The net result is to shift tax revenue to Ireland, the Netherlands, Switzerland and Canada, which offer a combination of low corporate tax rates and a territorial tax system, whereby income from foreign sources (like, for instance, the U.S.) isn’t taxed at all.
How does this affect you? First of all, you will bear a slightly higher tax burden as the government seeks to recover lost revenues, currently the estimate is $100 billion in taxes or about $750 per individual taxpayer. The Journal report found that if just 19 of the 60 companies had to pay U.S. taxes on their earnings like you or me, the $98 billion in additional tax revenues would more than offset the $85 billion in automatic spending cuts that were triggered by the fiscal cliff negotiations. In addition, companies that are holding assets offshore for tax reasons have effectively made that money unavailable to invest in the U.S., which could lower economic growth and cost jobs for the U.S. economy.
More directly, that offshore money is no longer available to pay dividends to shareholders like you and me, or to buy back shares, which raises the value of our stock holdings instead companies borrow money which decreases dividends and buy back of shares
Finally, an inversion often triggers higher taxes for its shareholders.
How? When the company inverts or reincorporates abroad, all current shareholders are required to pay capital gains taxes on their holdings in that year, as they are issued new stock in the new company. So if you happen to own $100,000 worth of Medtronic, and your shares originally cost you $20,000, you would get a 1099 in the mail saying that you have $80,000 in realized gains, subject to capital gains taxes immediately. If you had planned to hold those assets until death, and get a step-up in basis for your heirs, well, that strategy is preempted by the company’s decision to invert. If you were holding the stock long-term to avoid annual taxation, or trying to shift tax obligations to next year, tough luck. You’re paying taxes now, whether you like it or not.
Is there a way bring these assets back into the U.S. tax system? One obvious possibility is to lower our corporate tax rates below the rates of other countries. But there is no guarantee that those nations wouldn’t lower their rates in turn, leading to a global race to the bottom, with the logical outcome that corporations would be essentially granted a 0% tax rate everywhere. And a lower corporate tax rate would, of course, mean higher individual tax rates, which is politically unlikely at the moment. Opponents would note that the share of federal revenues paid by corporations has already fallen from 32% in 1952 to just 8.9% today.
Another possibility is being explored in Congress. A recently proposed bill would require the foreign partner of any inversion tactic to be larger than the American merger partner; otherwise, the company is assumed, for tax purposes, to be domiciled in the U.S. The argument is a good one: these companies want to take advantage of U.S. laws and have full access to the U.S. consumer market, but not have to pay for it.
Of course, the simple method of eliminating the loophole and taxing all worldwide income without an exclusion or credit for foreign taxes is too simple. It will not be proposed by the Obama administration or be proposed by Congress! Instead, some method will be devised which will claim it eliminates the loophole as has happened since 2002 but will really have no effect!
Sources:
How to stop companies from moving overseas
Drug firms make hast to elude tax
Tax inversions allow firms to avoid state taxes
Obama takes aim at firms that shift profits overseas to avoid taxes
More U.S. profits parked abroad, saving on taxes
Corporate tax scam watch: the “inversion” craze
