Reinterpreting corporate inversions: Non-tax competitions and frictions.

• Author: Mun, Inho Andrew

ABSTRACT. Corporate inversions have drawn outrage from all segments of society. In an inversion, a company reincorporates abroad to escape its U.S. tax burden. Regulators and academics have typically sought tax law solutions to curb tax inversions. However, the resulting tax regulations have been ineffective, while more radical tax reforms are not politically feasible. This Note argues that inversion is not a tax problem in isolation, but a problem of aligning tax paid with benefits conferred by a given country. By introducing non-tax dimensions into the equation, this Note refines the oft-ignored benefit tax theory. The benefit tax theory proposes that the U.S. corporate tax regime accounts for superior legal and nonlegal benefits that companies enjoy by incorporating or operating in the United States. While paying U.S. tax, corporations receive the benefits of corporate governance, securities regulation, intellectual property law, and other areas of law; furthermore, benefits include many nonlegal business factors such as access to a large consumption market, skilled labor pool, capital markets, and more.

This Note classifies the relevant benefits into three categories: Type I benefits, which corporations enjoy regardless of their place of incorporation or operation; Type II benefits, which corporations enjoy only if they are incorporated in the United States; and Type III benefits, which corporations enjoy by having operations in the United States. Using this classification, this Note builds a novel multi-dimensional regulatory competition model wherein countries compete across various legal and nonlegal dimensions, as opposed to the one-dimensional tax competition model on which inversion scholars have typically relied.

The benefit tax theory and the multi-dimensional competition model illustrate that the problem with inversions is that corporations continue to take advantage of Type III benefits offered by the United States while paying lower tax elsewhere to a non-U.S. country. Inversion is problematic precisely because of the unbundling of certain Type III benefits from the rest of U.S. tax law. Understanding the inversion problem in this way leads to a clear solution: a better bundling of the U.S. tax law with the Type III benefits provided by the United States.

NOTE CONTENTS INTRODUCTION 2156 1. HISTORY OF INVERSIONS: A CAT-AND-MOUSE CAME 2161 A. First Wave: McDermott and IRC [section][section] 1248(i), 163(j) 2162 B. Second Wave: Helen of Troy and 26 C.F.R. [section] 1.367(a)-3(c)(1) 2164 C. Third Wave: 1998-2002 Inversions and the Jobs Act of 2004 2164 D. Fourth Wave: Mergers, Notice 2014-52, Notice 2015-79, and April 4, 2016 Treasury Regulations 2166 E. Ad Hoc, Ex Post, and Piecemeal Approach Is Ineffective 2168 II. NORMATIVE EVALUATION OF INVERSIONS 2171 A. Insufficiency of the Traditional Lens of Efficiency and Externalities 2172 1. Effects on Inverting Companies 2172 2. Effects on Shareholders 2173 3. Effects on the U.S. Government and Public 2175 B. Befit Tax Theory 2177 1. Threshold Question: Why Benefit Tax Theory? 2178 2. Benefits Contributing Toward the Creation of Domestic Source Income 2182 3. Additional Benefits That Justify Tax on Foreign-Source Income 2183 4. Benefit Tax Theory and Inefficiently High U.S. Tax Rates 2185 III. MUI-DIMENSIONAL COMPETITION MODEL 2187 A. Idequacy of the Conventional Tax Competition Model 2187 B. Mti-Dimensional Regulatory Competition Model 2190 1. Setup: Formalizing the Benefit Tax Theory 2191 2. Type I Benefits: Not Reflected in Corporate Income Tax Rates 2194 3. Competition To Attract Incorporations and Operations 2195 4. Interpreting Inversion Through the Competition Model: A U.S.-Outbound Inverted Company Continues To Enjoy U.S. Type III Benefits 2199 IV. IMPLICATION OF THE MULTI-DIMENSIONAL COMPETITION MODEL: FRICTION 2202 A. Friction as a Way To Bundle 2203 B. Proposal 1: Reducing Type III Benefits to Inverting Companies 2204 1. Example 1.1: Reducing U.S. BIT/Treaty Protection 2205 2. Example 1.2: Reducing U.S. Business Benefit Factors by Denying Government Contract Privileges 2206 C. Proposal 2: Reducing Type I Benefits to Inverting Companies 2209 1. Example 2.1: Reducing Access to the U.S. Capital Market, Delisting 2209 D. Potential Collateral Consequences of the Proposals 2211 1. When To Pull the Trigger? Defining the Narrowly-Tailored Criteria 2212 2. Collateral Consequences to Entities Not Engaged in Foreign Mergers 2214 E. Drawing the Boundaries of the Proposals 2216 F. The Proposals in Relation to the IRS Approaches 2217 CONCLUSION 2218 INTRODUCTION

On November 23, 2015, two pharmaceutical giants--the U.S. company Pfizer and the Irish company Allergan--announced that they had signed a $160 billion merger agreement. (1) The combined company would manufacture many popular pharmaceutical products, including Botox, Viagra, Prevnar pneumonia vaccines, and treatments for Alzheimer's and arthritis, with total annual sales of over $65 billion. (2) The size of this deal alone was noteworthy: in the history of mergers, there have been only six deals larger than $100 billion in size. (3) The deal drew considerable criticism, earning the label of "the biggest ever tax inversion." (4)

A tax inversion is the re-incorporation of a company overseas for the purpose of reducing the tax burden on foreign-source and domestic-source income. (5) Typically, a U.S. multinational corporation--in this case, Pfizer--acts as an "inverting company" and acquires a smaller foreign company--here, Allergan --from a lower tax jurisdiction such as Ireland, Luxembourg, the Netherlands, or the United Kingdom. (6) The combined entity is then incorporated abroad in the target's foreign jurisdiction with a lower tax rate, but almost nothing else changes; the inverting company's operations and management remain largely identical. (7) While the inverted company de facto continues to operate like an American company, it is formally an Irish company that pays tax according to Irish law.

The tax savings can be enormous. Through inversion, Allergan reportedly would have been able to avoid $21.1 billion to $35 billion in U.S. tax with respect to its accumulated retained earnings from foreign operations. (8) Commentators estimate that inversions generally cost the U.S. government billions of dollars of annual tax revenue. (9) For that reason, tax inversions often draw heavy criticism. President Barack Obama described inversions as damaging to the country's finances. (10) He stated, "[S]topping companies from renouncing their citizenship just to get out of paying their fair share of taxes is something that cannot wait." (11) Senator Bernie Sanders called inversions "nothing less than a tax scam," (12) and then-presidential candidate Donald Trump denounced the Pfizer-Allergan deal as "disgusting." (13) Senator John McCain has labeled Ireland a tax haven, criticizing inversion practices. (14)

In response to the inversion problem, Congress has proposed numerous bills--only one of which became law (15)--and the Department of Treasury and the Internal Revenue Service (IRS) have implemented several regulations that attempt to fight inversion practices. Some of these have had narrow success, but for the most part, this approach has been piecemeal and ineffective. (16) For instance, Treasury and the IRS promulgated joint regulations on April 4, 2016 (17) that directly targeted the Allergen-Pfizer merger--without mentioning the parties' names--which broke up the deal on April 6, 2016. However, these regulations are hardly solutions to the inversion problem because they are ad hoc, ex post, and narrowly targeted at individual deals.

The bottom line is that there has been a surge of inversions in the past decade, (18) the deals have grown in size, (19) and the tactics have become cleverer. In 2014, several U.S. firms with a combined worth of more than $500 billion announced their intention to invert. (20) And every time a new bill is passed or a new regulation is promulgated to curb inversions, corporations have circumvented the new obstacles by exploiting loopholes and utilizing ingenious inversion strategies. 21 This history of a cat-and-mouse game has led to wider reform proposals by politicians, regulators, and academics to fix the fundamental problems of the U.S. tax system by tightening eligibility criteria for reaping the tax benefits of inversion, (22) moving the country's tax regime to a territorial tax system from a worldwide income tax system, (23) declaring another tax holiday for corporate repatriations, (24) or reducing American corporate tax rates. (25)

There are indeed fundamental problems with the U.S. international tax system, as it is distortionary and inefficient. And some of the proposals to our tax system have merits and deserve attention. However, focusing solely on the tax dimension and tax proposal is problematic for at least two reasons.

First, it is unlikely that we can radically fix the corporate tax system in the current U.S. context. Democrats and Republicans agree that inversions need to be curbed but disagree on what needs to be done. (26) Republicans typically think the only solution is a full overhaul of the tax system, such as lowering the U.S. corporate tax rate. In contrast, Democrats tend to believe that the focus should be on anti-inversion legislation. (27) Meanwhile, changing the U.S. worldwide income tax regime to a territorial tax regime is a radical idea that is somewhat unrealistic in our current political setting. Facing congressional deadlock and an inability to enact sweeping reforms, the Obama Administration relied on administrative regulations and notices to stymie inversion deals in an ad hoc manner, but these efforts proved too piecemeal and ad hoc to provide a comprehensive solution to the general phenomenon of inversions.

Second, even conceding that tax solutions could be feasible due to the recent change in administration, this...