The declining allure of being 'American' and the proliferation of corporate tax inversions: a critical analysis of regulatory efforts to curtail the inversion trend.

• Author: Hamlett, John C.

1. INTRODUCTION

   In the realm of tax policy, within which there is rarely broad-based consensus, there are few topics as polarizing as corporate tax inversions. An inversion is a paper transaction in which a US corporation reincorporates abroad to realize strategic tax benefits, without actually transplanting its operations overseas. (1) These transactions necessarily reduce the US corporate income tax base, because although an inverted corporation is still taxed the same amount on income earned within the United States, it will no longer have to remit tax payments to the US Department of the Treasury ("Treasury") for income earned abroad. (2) This reduction in the tax base is especially troubling given that the national debt exceeds $19 trillion, (3) the US credit rating is experiencing unprecedented volatility, (4) and the annual US government deficit ranges from hundreds of billions to more than a trillion dollars per year. (5) Given the current state of the domestic economy, the notion of successful US corporations nominally moving their headquarters abroad to alleviate their tax burden is unpalatable for many. (6) Others do not fault inverters for acting in the interests of their shareholders, and simply see the trend as evidence of the need for substantial corporate tax reform so that the United States can become more globally competitive as a home for businesses. (7) However, those with opposing viewpoints may be closer together than they realize, and meaningful reform may be attainable if productive dialogue can be facilitated. (8)

   This Note provides an overview of trends in corporate taxation, (9) the thirty-year history of inversions and governmental attempts to contain them, (10) and an analysis of recent anti-inversion regulations proposed by Treasury in September 2014. (11) Finally, this Note critiques the legislative and regulatory framework that attempts to restrict the practice of inversions, and provides a suggestion for constructively responding to the trend. (12) Given the passion and diversity of viewpoints on the issue, arriving at a national consensus on how to respond to the recent proliferation of inversions presents an extraordinary challenge. There may, however, be enough common ground for lawmakers to craft a solution that removes the incentive for corporations to invert, thereby shoring up the tax base and making the US economy more competitive globally. (13) In light of the substantial--and rapidly growing--national debt, there is no better time to critically reevaluate the policies and priorities of corporate taxation.

2. ORIGINS OF THE INVERSION PHENOMENON

   1. Domestic and Global Taxation of Corporations

      The United States has consistently taxed corporations since the beginning of the twentieth century, when the Corporate Excise Tax Act of 1909 (14) was passed. (15) Under this law, all annual corporate income in excess of $5,000 was taxed at a rate of 1 percent. (16) Several years later, the Sixteenth Amendment to the Constitution (17) was ratified, permitting the federal government to levy direct income taxes on both citizens and corporations. (18) By 1918, corporations were being taxed at a rate of 12 percent of annual income earned in excess of $2,000. (19) The maximum corporate tax rate then fluctuated between 10 percent and 19 percent until 1940, when it leapt to 38.3 percent to support wartime spending. (20) While there continues to be a degree of annual fluctuation, the US corporate tax rate has not fallen much below 35 percent, (21) where it remains today. (22) In many ways, the decision to tax the income of corporations is a policy determination reflecting values of progressive taxation, (23) a system under which individuals and corporations with greater income bear a larger tax burden. (24) Arguably, much of the distinction between corporate and individual taxation is illusory because "corporations are owned, directly or indirectly, by individuals who (ultimately) receive a share of the corporations' incomes." (25)

      The United States utilizes a "worldwide" system of corporate taxation, under which US corporations are taxed by the United States on income earned both domestically and internationally. (26) Conversely, the vast majority of other countries utilize a "territorial" system of corporate taxation, whereby they only tax corporate income earned domestically. (27) While multinational corporations conduct business around the globe, treatment of multinationals under the United States' Internal Revenue Code (the "Code") turns primarily on whether a corporation is classified as "domestic" or "foreign," regardless of where it is formally incorporated. (28) At the most basic level, this is determined using a "place-of-incorporation test." (29) Justifications for the place-of-incorporation test include a theory of legal personhood, (30) administrative simplicity, (31) symbolic importance, (32) and a need for revenue. (33) While these explanations are intellectually satisfying to varying degrees, one might particularly question the validity of administrative simplicity as a justification (34) for a system that puts businesses incorporated in the United States at a disadvantage compared to their foreign competition. (35)

      Proponents of the United States' worldwide corporate tax system invoke a "benefits theory" (36) to justify what may otherwise seem to be an uncompetitive scheme. This theory postulates that favorable and well-enforced property and contract laws, as well as more sophisticated public infrastructure, can be used to validate the US system, (37) even though it objectively results in greater tax liability for domestic corporations. Proponents also argue that worldwide taxation incentivizes domestic businesses to locate their active investments in the United States, rather than moving them abroad simply for tax reasons. (38)

      In addition to the United States' comparatively less desirable (39) worldwide theory of corporate taxation, the 35 percent maximum rate is no longer competitive from the perspective of multinational corporations. (40) The extent to which the United States' corporate tax scheme has fallen behind the systems used by other countries is evidenced by its tax competitiveness being ranked thirty-second out of thirty-four countries in the Organisation for Economic Co-operation and Development ("OECD") by Forbes magazine. (41) This decline in competitiveness has not escaped notice. Former President Bill Clinton recently told CNBC:

      America has to face the fact that we have not reformed our corporate tax laws.... We have the highest overall corporate tax rates in the world. And we are now the only OECD country that also taxes overseas earnings on the difference between what the companies pay overseas and what they pay in America. (42) Clinton, who was President when the current corporate tax structure was signed into law in 1993, (43) has acknowledged that the global economy was in a different place at that time and has accepted that reform is now necessary. (44) President Obama has also called for "revenue-neutral" reform of the corporate tax structure, but thus far he "has not put much political capital behind the proposal." (45)

      While the relatively heavy tax burden placed on United States corporations allows the government to collect more in corporate tax revenue, (46) there are major countervailing considerations that suggest significant reform is needed. (47) One issue created by the current corporate tax regime is that US corporations are incentivized to hold earnings overseas, rather than repatriating foreign-earned income to the United States, (48) at which point such earnings would be immediately subject to US corporate income taxes. (49) There may be $1-2 trillion held overseas by US corporations seeking to manage their tax burdens. (50) Congress addressed this issue in 1994 by granting a "tax holiday" for the repatriation of dividends at a reduced rate, (51) but that relief has not been offered since. (52) Despite the arguments made by those in favor of additional tax holidays, (53) others oppose their usage. (54) Critics point out that tax holidays incentivize corporations to leave their foreign earnings overseas and simply wait for Congress to grant relief. (55)

      Another consequence of the current US corporate tax system is that it slows domestic investment by US corporations, (56) while simultaneously making it more difficult for them to compete with multinationals incorporated abroad. (57) This is a major concern for the United States, given that a quarter of its economy is tied to exports. (58) In light of these problems, (59) many commentators fear that the Code is pushing investment overseas and minimizing US economic power. (60)

   2. CORPORATE TAX INVERSIONS: THE REACTION OF US BUSINESS

      Given the unfavorable treatment of US corporations (61) under an outdated corporate tax system that has had no significant overhaul since the mid-1990s, (62) many businesses are reincorporating abroad to take advantage of more favorable tax laws. (63) This is accomplished through a process that has come to be known as "inversion." (64) In an inversion, a US corporate parent utilizes one of several methods (65) to effectuate its reincorporation in either a low-tax or no-tax foreign jurisdiction. (66) This generally occurs when a US corporation acquires or merges with a foreign one. (67) The US company then becomes either a subsidiary of the foreign corporation or establishes a new overseas parent that is incorporated in a tax-friendly country, which holds both the US corporation and its foreign counterpart. (68) When an inversion transaction is successful, "U.S. tax can be avoided on foreign operations and on distributions to the foreign parent, and there are opportunities to reduce income from U.S. operations by payments of fees, interest, and royalties to the foreign entity." (69) Accordingly, the extent to which inversion transactions are...