The Negative Consequences of Corporate Inversion

Presented to

Dr. Loewy

BUAD 501-02

Prepared byStephanie YangStephanie RiveraSzu Tung Chen

Fall 2014

Table of Contents

Executive Summary.....................................................................................................................

I. Introduction......................................................................................................................

II. Corporate Negative Consequences Resulted from Corporate Inversion.........................

A. Credit Risk ..........................................................................................................B. Political Risk........................................................................................................C. Shareholder's Capital Loss...................................................................................

III. Government Drawbacks of Corporate Inversion.............................................................

A. Tax Revenue Loss................................................................................................B. Cash Flow Restraint.............................................................................................C. Job Loss...............................................................................................................

IV. Tax Reform Proposals on Eliminating Corporate Inversions..........................................

A. Proposals by Chairman Dave Camp ...................................................................B. Proposals by President Obama.............................................................................

V. Conclusion.......................................................................................................................

VI. References........................................................................................................................

Executive Summary

This research examines the disadvantages of corporate inversions, specifically the corporate drawbacks, economic drawbacks and political risks associated when businesses move their headquarters overseas and make the operations in the U.S. as foreign subsidiaries. .

The increasing number of corporate inversions is gaining attention in the news because of the negative consequences the business faces and the tax loophole the government struggles. This paper states that corporate inversions should be eliminated because the negative effects of corporate inversion on credit rating, corporate governance, labor laws, shareholder capital loss, tax revenue, cash flow restraint, and unemployment as a result of corporate inversion and discusses two tax reform proposals by President Obama and Chairman Dave Camp. As a result, the paper concludes with actions the government should take to avoid corporate inversions.

Often seen as a way to avoid paying the high U.S. corporate tax rate, companies seek relocation to foreign countries in which the corporate tax rate is much lower than the U.S. 35% tax rate. Ireland and Switzerland are just two of countries whose corporate tax rates are significantly lower at 12.5% and 17.92% respectively. Although the initial desire to lower the corporate tax and dodge worldwide income tax on earnings may seem highly advantageous at first, corporate inversions do not always turn work in the interest of the company.

For example, fruit of the Loom who moved offshore to the Cayman Islands in 1998 became bankrupt a short time later because the consequences. The Joint Committee on Taxation, a nonpartisan committee of United States Congress, estimates that the U.S. government would lose around $19.5 billion in tax revenues for the next decade if tax inversions are allowed to continue.

Shareholders of the corporations should also beware of inversions because they many end up with unwanted capital gains. The IRS will treat shareholders as if they are selling shares even though they are not. This could result in loss of majority shareholders, leaving the company in a worse position than before the inversion.

Labor laws of a foreign country could hinder the productive nature of a US company and changes in the structure of corporate governance could lead to misrepresentation on the board of directors. The requirement for European employers to abide by processes when letting go or firing employees is not something U.S. employers are accustom to and could result in wrongful termination if employer-employee relations are not treated properly.

The research that is presented in this paper examines the changes a company should consider before committing to a corporate inversion as well as suggests possible solutions to the complex nature of corporate inversions that lawmakers are facing. With suggestions of lowering the corporate tax rate, increasing the thresholds of acquisition, and exempting overseas income, corporate inversions may no longer be an option to U.S. corporations.

I. Introduction

Over the past ten years, 47 U.S. corporations have renounced their U.S. citizenship and reestablished their tax home in a country with a lower corporate tax rate. This practice, referred to as corporate inversion, has many U.S. politicians and President Obama on edge. From the year 1983 to 2004, there were 29 corporate inversions, that is 29 inversions in 20 years (Ways and Means Democrats). McDermott International, Tyco, and Fruit of the Loom are just a few corporations who have already performed corporate inversion. Currently, there is about $2 trillion dollars overseas instead of in the United States.

Although corporate inversions offer very attractive tax benefits to American corporations, who are accustom to the highest corporate tax rate in the world, other major consequences should be considered as these consequences have the potential to negatively affect the corporations in both the short term and long term. All corporations looking into corporate inversion should be aware of the drawbacks such as impact on credit rating, corporate governance rules, labor law changes, shareholder capital loss, and economic drawbacks such as tax revenue loss, cash flow restraint and unemployment.

This paper will examine the negative consequences of corporate inversions, the credit risks, political risks, Chairman Dave Camp's and President Obama's proposals as well as suggest a possible solution to end the increasing popularity of corporate inversions.

II. Corporate Drawbacks

A. Credit Risk

The stability of corporations that decide to invert is at risk because of access to offshore funds that were not previously available as a U.S. corporation. This new access to money has the potential to change the corporation's credit risk if the corporation is not responsible with the funds and enters risky deals that increase leverage. A corporation with high leverage has less equity and more debt. A report by Standard&Poor's Rating Services discusses how credit ratings may be affected. The temptation to fund operations and equipment with more and more debt will damage profits if not controlled.

In addition, the concept of financing through the new, foreign source of debt has the potential for the corporation to increase dividend payments and buyback shares. Having access to finance through debt increases the likelihood of a corporation going under especially if there were no strict guidelines. If a corporation proceeds with aggressive debt financing, it may raise a red flag for the long term. Also, if future tax reform were to occur, U.S. corporations who decided to invert may want to later bring some money back home and will find it difficult given new tax laws.

Corporate inversions do not always turn out for the best. Fruit of the Loom who moved offshore to Cayman Islands in 1998 went bankrupt a short time later. Fruit of the Loom returned to the states and has since paid about $4 million in corporate taxes. The initial desire of lower corporate taxes became nonexistent upon the repayment of the estimated $4 million dollars.

B. Political Risks of Inversion

Although the corporate tax rate in some countries outside the United States is substantially lower, other laws and regulations should be considered before a corporation completes an inversion deal such as corporate governance rules, labor laws, and executive compensation. The U.S. corporations should also contemplate the consequences of the industry the business is in for additional rules and regulations. Aerospace, pharmaceutical, and energy and utilities tend to be heavily regulated by governments.

Corporate governance, the technique of aligning stakeholder's interests, is important to consider before inverting abroad. In the United States, it is the shareholders who have the power to vote on corporate issues and decide who sits on the board of directors while the board of directors and management actually run the corporation and conduct business in such a manner as to comply with the shareholder's desires. European and Japanese corporate governance holds interests of shareholders almost equal to that of management, employees, customers, suppliers, and community members. This difference in balance of power could potentially result in prolonging processes.

A number of corporations in the United Kingdom follow the guidelines set forth by the Code of Best Practice established by the Committee on Corporate Governance in England. In the United Kingdom, the CEO position should not be held by the same individual as the board chairman. The U.S., in contrast, allows the position to be held by the same person. Corporate governance in Europe is less focused on shareholder rights than the United States and the United Kingdom. This is important to shareholders of corporations who invert to places such as Switzerland and Ireland because the shift in shareholder authority dissipates and may cause differences in how the company operates.

Another factor to consider is labor laws. Labor laws play a significant role, especially if the business is considering bringing foreign executives and employees on board in the new tax home. One major difference in labor laws in Europe is the contract between employers and employees while employment in the United States is on an at-will basis. The requirement for the European employer to abide by a process when letting or firing employees is not something U.S. employers are accustom to and could result in wrongful termination if employer-employee relations are not treated properly. Both the employer and the employee should be aware of the labor laws in their respective country.

Working hours are especially important given how hard the U.S. works. If the business carrying out the inversion were to hire a new segment in, say Ireland, the Irish employees would be limited to the amount of hours they can work per week. The EU sets a working week limit at 45 hours per week. The average American works about 40 hours a week full-time. It is not unusual for Americans to work a great amount of overtime as well. Irish employees may not only dislike working so much but certainly will not be able to meet the needs of the employer which has the potential for the business's needs to snowball and develop into further issues.

The U.S. is notorious for hiring illegal immigrants to do work and pay them substantially less than American citizens. In contrast, the right to work requirements in the U.K. are more heavily

placed on the employer unlike the that in the U.S. A huge sum will be placed upon employers who do not keep evidence of employee's right to work. If similar laws were active in the United States, illegal immigration might not be that big of an issue and less U.S. employers would hire illegal workers

If the US employers want to conduct a background check on potential hires, they usually are not restricted. UK employers, on the other hand, can only perform a background check when closely related to the position that is to be fulfilled. Medical leave, sick leave and vacation time are also important factors for an American business who plans on inverting into another country and taking on foreign employees. After performing corporate inversion, U.S. employers simply cannot conduct business and maintain operations according to U.S. laws and regulations. The laws of the new country must be understood and adopted.

In addition to the differences in labor laws, say-on pay laws are also changing. Say-on-pay is a corporate rule that authorizes shareholders to vote on executive compensation. Say-on-pay will be in the European Union for the first time. The United States has always had say-on-pay, however; the new addition of say-on-pay in Europe comes with a few new regulations. Among the new additions to the say-on-pay is the installation of compensation policies and information regarding how policies were adopted and put into action. A maximum level of compensation pay also needs to be clearly stated.

The reason for the introduction of say-on-pay is the need for distinction between performance and pay, the two should be closely linked. In the United States, we use say on pay policies but in practice, some of the fortune 500 CEOs are still paid huge sums even if they are not performing at their best. In order to avoid that in European Union, new say-on-pay laws are to be adopted. CEOs who invert to the E.U. will have to clearly distinguish between performance and pay under the new laws.

C. Shareholder's Capital Loss

When a corporation inverts, the shareholder's who may end up with unwanted capital gains. In the case of Medtronic, a medical device corporation, who is hoping to move its tax home to Ireland, the IRS will treat shareholders of Medtronic as if they are selling the shares even though they are not. This is made possible courtesy of section 367 in the Internal Revenue Code.

The corporate inversion transaction triggers treatment of shareholder's as sellers. Although this beneficial to the corporation's executives, this will negatively affect shareholder's who own 50% or more in shares. However beneficial a corporate inversion may be in the long-term, shareholders will suffer in the short term meaning shareholders who cannot afford the increased capital gains are at risk of leaving as shareholders. It would be detrimental to see majority shareholders walk away from the corporation.

As stated above, when an American business wants to complete a corporate inversion several factors come into play. In order to make the best decision and not hurt the corporation, the business must consider how much debt they are willing to take on as it poses a potential hit to credit rating. Corporate governance can also be a huge drawback if the corporation wants to open

a new segment and hire new employees of the country to which they are inverting. Labor laws, employee compensation and short-term capital loss can all seriously damage the corporation's internal operations, reputation and purpose of inverting in the first place. Although corporate inversion may offer attractive tax breaks with a lower corporate tax rate, many other factors can hurt the business.

III.Government Drawbacks of Corporate Inversion

A. Tax Revenue Loss

The U.S. government could lose tax revenue when a corporation merges with a foreign company and moves headquarters out of the U.S. because its foreign profits are no longer subject to US corporate income tax. This is a very troubling issue specific to U.S. tax revenue. Taxes are what people pay for a civilized society and what government utilizes for people. Therefore, tax revenue loss could harm not only the society but also the economy, as government could not generate entitled taxes.

Taxes are compulsory charges levied by the government on citizens and other corporations’ profit. The government uses taxes on three major categories: discretionary spending, mandatory spending, and interest on federal debt. The loss of tax revenue could raise a variety of consequences because the government might not have enough money to improve the society and reimburse the federal debt.

When government’s expenditure cannot be covered by tax revenue, the burden of the public deficit has cumulated leading to the public debt, and further triggering a vicious cycle. In addition, people may lose their benefits of medical and health care and unemployed people may lose their federal aid.

Figure 1: A Spike in Corporate Inversion

Source: Congressional Research Service

Thirteen inversion deals have been announced since the start of 2013. The Joint Committee on Taxation, a nonpartisan committee of United States Congress, estimates that the U.S. government would lose around $19.5 billion in tax revenues for the next decade if tax inversions are allowed to continue. Tax revenue loss from corporate inversion could cause decreased welfare for the U.S. people and higher deficit and decreased economy growth for the U.S. government. Therefore, corporate inversion needs to be restricted because it not only tax results in revenue loss, but also induces other economic and social costs.

B. Cash Flow Restraint

When U.S. corporations are headquartered in a foreign country or merged with foreign companies, U. S. corporations are likely to retain huge cash overseas. Corporations are less willing to move cash back to the U.S. because the gains and losses from foreign exchanges and U.S. would need to be repaid. If corporations move cash back to the U.S., they need to pay not only the exchange fee, but also the higher taxes. If corporations keep holding lots of cash overseas, they will harm the U.S. economy by having less cash flow activities in the U.S.

Although the cash that corporations hold overseas has not often exceeded the revenue generated outside the U.S., corporations do not shift money back to the U.S. because of the U.S. tax system. The U.S. tax system not only encourages corporations to reduce their tax bill by transferring income offshore to lower-tax countries, but also discourages corporations from bringing the foreign profits back to the U.S.

The imbalance between domestic and overseas cash at many U.S. corporations indicates international expansion into new and tax-friendly markets. Corporations may tend to invest their foreign cash in global expansion, such as for new facilities abroad and more mergers and

acquisitions overseas. Corporations reinvest foreign companies and build facilities overseas would stimulate the economy in foreign countries and relatively slow down the economy growth in the U.S. by the investments and job opportunities they provide in foreign countries.

Figure 2: Foreign Commitments

Source: The Wall Street Journal

Apple, one of the giant American firms that move money around the globe to lower its tax bills, has the largest overseas cash trove by far at $121.3 billion. Also, Apple is one of the many corporations that rather to dip into its cash and take a tax hit took out debt instead of funding a big stock buyback and dividend program. The huge overseas cash would have a tremendous impact on the U.S. economy and society because that money should be taxable income that subject to taxes and use to reduce the government’s deficit, improve the federal budget, and invest to create more job opportunities in the U.S.

The U.S. government needs to figure out a way to effectively generate tax revenue from U.S. corporations’ foreign earnings and cash held overseas and thus stop corporations from using corporate inversion practice to avoid taxes. More important is that keeping liquidity assets abroad is unproductive and profitless for the U.S. and will not help the U.S. economy.

C. Job Loss

Tax inversion activities come at a significant cost for the rest of us. The federal government loses corporate income tax revenues when corporations move their headquarters overseas. Headquartering overseas by U.S. corporations means the loss of jobs in the U.S. As these companies become taxpayers and corporate citizens in foreign countries, the companies would have less incentive to grow in the U.S.

In general, unemployment is considered as a big issue. Unemployment imposes significant costs from the individual to the country. It affects people’s standard of living immediately when people lose their jobs and would consume far less than before. The economic consequences could go further not just less consumption by people. It would raise severe restriction on immigration and increased calls for protectionism when unemployment becomes a serious problem. Protectionism not only leads to destructive retaliation for countries, but also harms the economy of all trading partners because of the reduction of trading activities.

On the other hand, the unemployment could lead to other social costs because people change their behavior when they are unemployed. Studies have shown that unemployment would affect how people interact with each other because of less volunteerism and higher crime. The assumption of increased crime rate is reasonable because the lack of money could force unemployed people resort to criminality in order to meet their basic needs. Though the assumption of the less volunteerism might not have an explicit interpretation, it might relate to the negative psychological impacts of being jobless or even vexation at people who lost their job.

Unemployment costs more on economic costs than social costs because the government could pay more for unemployment benefits. Meanwhile, the government is no longer gathering the same levels of income tax as they pay for those unemployed people. Therefore, this expenditure could force governments to borrow money or cut down other spending which would affect the future unemployment benefits and deteriorate the economic situation.

Unemployment is dangerous for the U.S. economy. Personal consumption and unemployed workers occupy over 70% of what the U.S. produced. Even though those unemployed people who are getting government supports cannot spend at same levels for leaving as before. The absence of the production of unemployed workers would reduce the GDP and make the government to allocate its resource inefficiently.

Also, a high unemployment rate would harm corporations because they may need to pay more to the government. Unemployment benefits are financed largely by taxes assessed on individual income and corporate profits. However, when unemployment is high, the government will lose the tax revenue from individual income and the government would look to replenish their costs by increasing the taxation on businesses. Therefore, corporations face not only less demand for their products, but also more costs to maintain their business, which could intuitively discourage corporations from hiring more workers.

Corporate inversion could affect not only the individual but also the whole country. Corporate inversion affects individual because it could result in job loss, and it could affect the whole country because of the tax revenue loss and cash flow restraint on the U.S. government. To sum

up, corporate inversion could have a perpetuated negative impact among individual, business, and the health of the economic of the country.

IV. The Tax Reform Proposals on Eliminating Corporate Inversions

Joseph Stiglitz, a professor at Columbia University and a well-known American economist says the U.S. does not have a fair tax system for people to contribute and pay taxes, so he believes tax reform is necessary (Stiglitz, 2014). Two tax reform proposals from President Obama and Dave Camp provide insights of the possible alternatives to eliminate corporate inversion. However individually, the two proposals are not ideal to solve the problem.

President Obama has proposed to lower corporate tax rate to 28% in 2012 and continue to work on the tax reform proposal to include a higher threshold of acquisition, limit deferral for digital sector, and enforce foreign income tax. On the other hand, another proposal, “Tax Reform Act of 2014” that was released by Ways and Means Committee Chairman Dave Camp on February 26, 2014 proposes to move the current tax system towards to a more territorial tax system and to exempt taxes on foreign earnings. The better solution would be to use a combination of both proposals to make U.S. corporations more competitive and stop incentives to leave the U.S.

A. Proposals by Chairman Dave Camp

Most corporations merged and moved to other countries mainly to lower their tax burdens because the overall taxes they would have to pay under the U.S. tax law were higher than that of under other countries’ laws. The tax disadvantage also made corporations less competitive to their competitors. The reason why Dave Camp’s plan could eliminate corporate inversion is it simplifies the tax regulation of foreign income. It proposes to lower corporate tax rate from 35 percent to 25 percent, which is closer to the average tax rate of advanced countries. A lower tax rate is necessary to encourage corporations to stay in the U.S.

In addition, Dave Camp also proposes to exempt 95 percent of foreign earnings from active trade and business that make the U.S. tax system closer to a territorial tax system that most of other countries provide. The plan will keep headquarters of multinational corporations in the U.S. and save the cost and time that would be spent on processing acquisition and adopting a tax system overseas (McBride, 2014). The incentive of corporate inversion should be diminished, but what if some industries would stay in the U.S. no matter what the tax rate is. Therefore, a better solution might be to adopt different exemption rates to different industries not to every business.

B. Proposals by President Obama

The most compelling reason to have a territorial tax system is that U.S. corporations pay taxes on their worldwide earnings under worldwide tax system, while foreign competitors have foreign earnings exempt and only pay taxes on domestic earnings under territorial tax systems. Although President Obama proposes a lower corporate tax rate of 28 percent from 35 percent, he proposes to enforce immediate 35 percent tax rate on digital goods or service that are currently eligible for deferral under the tax system and apply U.S. domestic taxation on all foreign earnings even if those earnings already subject to taxes in other countries.

If digital items are no longer operated with deferred tax privileges and subject to a 35 percent tax rate, corporations like Amazon or Apple would be immediately be imposed large taxes due and

make it difficult to compete in the worldwide digital market and more likely to think of corporate inversion strategy if that could be a way to keep their market power. The proposal is closer to worldwide tax system with no exemption of foreign income. President Obama’s proposal would make the U.S. corporations more difficult to compete and place the U.S. economy in a worse situation (Gilleard, 2014).

Under the current law, a U.S. corporation could be treated as a foreign corporation if less than 80 percent of its ownership will be held by former U.S. shareholders after merging. Because the threshold is considerably low, many corporations use the corporate inversion strategy to change their headquarters to other countries and claim to be new corporations in the U.S while the majority of their operations and shareholders have not changed. Therefore the threshold should be more restricted and make it more difficult for corporations to claim as a foreign corporation.

President Obama proposes to lower the threshold from 80 percent to 50 percent to make corporations who want to invert more difficult to leave because the risk of losing the ownership in the U.S. This proposal could prevent corporations from leaving and eliminate the incentive to operate as a foreign corporation for tax benefits in the U.S. (McBride & Hodge, 2014). However, the proposal would not solve the problem in the long run because if corporation thinks that tax benefit of inversion outweighs the cost or risk of merging to other countries, it could still leave the U.S.

The President also proposes a 20 percent income tax credit to make incentives for U.S. corporations who have headquarters overseas to move back to the United States. The tax credit would be applied to expenses that are raised by moving back to the U.S. Lowering the overall corporate tax rate and providing tax exemption not only could make corporations keep headquarters in the U.S., but also could increase employment and stimulate the economy.

Joseph Stiglitz also agrees that the better solution to encourage corporations to produce and operate in the U.S. would be to give corporations who pay taxes on their sales, production, and research activities in the U.S. lower corporate tax rates than others who stayed outside the U.S. This reform would further prevent corporations from leaving and, instead, stay in the U.S. to have the privilege of a lower tax rate.

V. Conclusion

Corporate inversion might not be a good strategy to improve the overall financial condition of a corporation even with an attractive tax break because the potential risks it could cause to the corporation itself and the United States economy. Corporate inversion not only causes the inverted corporations with credit disadvantages or uncertainties, foreign regulations or restrictions, and shareholders’ capital losses, but also hurts the U.S. economy with tax revenue loss, less cash flow available in the U.S., and job loss.

Instead of leaving the United States through corporate inversion, U.S. corporations should take actions to address the problem and loopholes of the current tax system and pressure the government for a better tax reform that can well-governed the tax system and make the U.S. corporations more competitive in the market. To alleviate corporate inversion, the government should reform the current tax system that cause the corporations to invert in the first place and have fair tax regulations that would make corporations to stay in the United States and contribute to the government.

There are several improvements the current tax system should do to make corporations contribute tax at home and end the run away or rush toward inversions, but still be competitive in the global market. First, the U.S. should not holdout the current worldwide tax system but instead adopt territorial system that all major developed and advanced countries enforce. The worldwide tax system will only increase incentive for corporations to leave and invert to other countries that do not impose tax on foreign incomes.

The second improvement is to reduce the corporate tax rate. Although the effective rates of most corporations are not higher than the top corporate tax rate or the average of other advanced countries, a lower tax rate hierarchy with a lower top rate from 35 percent to 28 percent or 25 percent would potential lower the income taxes that corporations need to pay and would lower the corporation’s incentive to invert.

Finally, the government should definitely encourage U.S. corporations to bring back operations to the U.S. by adopting a lower privileged rate for those corporations with headquarters in the U.S. and providing a 20 percent tax credit for expenses of moving business and money earned oversea back to the U.S. Such changes would make corporations stop engage in tax avoidance and would eventually increase employment and investment in the United States.

After improvements, corporations would not worry about the potential risks they might encounter through corporate inversion practices. The U.S. economy would be better off and the government would not need concern about economic impacts because if the reform eliminates loopholes and makes corporations pay corporate income taxes in the U.S., tax revenue would be raised and cash flow would be stimulated. Combination of a territorial tax system, lower corporate tax rate, and incentive for corporate operates in the U.S. should be enforced to end the practice and encourage corporations to stay home and contribute what they are supposed to pay.

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