The Treasury Creeps on Corporate Inversions

So on Monday, the Treasury closed "one of the most insidious loopholes out there": corporate inversions, by which US firms merge their way into friendlier tax jurisdictions. President Obama, lawmakers and presidential candidates for both parties have clamored for action to end this alleged scourge and ensure multinational companies pay their "fair share" of taxes. Politically, it's an easy sell, but reality is much more nuanced. We wholeheartedly agree America's tax code is ripe for reform, and the spate of inversions is evidence of that. Yet the Treasury's latest measures strike us as a solution in search of a problem. Not only are inversions not the black hole most presume, but there is a creeping trend of the government "reinterpreting" existing law to select specific winners and losers-often without much warning-which can raise uncertainty. While this isn't enough to wallop the bull market and the new rules' unintended consequences shouldn't much knock the economy, investors should be aware all the same.

A corporate inversion is when a US company merges with a smaller foreign firm and adopts its address to avoid paying domestic taxes on foreign earnings. Many do this instead of upping sticks and redomiciling abroad, which is usually a long, costly and painful process-mergers are a handy short-cut. Inversions aren't illegal, but politicians hate them since they love maximizing tax revenue. Hence the White House has been chipping away at inversions, in the name of "economic patriotism." In 2014, the Treasury started targeting several inversion tactics, like tinkering with how companies calculate their size, e.g., making their foreign targets look bigger. This made it more difficult for foreign companies to "stuff" their balance sheet so their shareholders own at least 20% of the new company, the minimum for an inversion (though tax benefits don't really kick in unless the foreign firm's shareholders own at least 40% of the new company). This crackdown continued in late 2015 as the Treasury posed several more obstacles to inversions. They made it more difficult for US companies to buy a firm in Country B and subsequently move to Country C, and they restricted inverted companies from shielding pre-existing foreign operations from American taxes. Yet these were mostly symbolic and barely curbed the practice.

The Treasury's latest proposal has more teeth. For one, in measuring foreign firms' market cap to determine whether a merger qualifies the US firm for a foreign address, the rule will exclude stock foreign firms issued within the last three years to merge with American firms-making it a clampdown on so-called serial inverters. Unlike the prior tweaks, which didn't retroactively change the math, pretending firms are the same size they were three years ago limits the pool of inversion candidates-and killed a certain ginormous inversion deal between Pharmaceutical giants Pfizer and Allergan. The Treasury also put constraints on the practice known as "earnings stripping," which companies use to help lower their tax rates. Currently, all foreign-based multinationals (inverted or not) can make loans to their US subsidiaries. The interest payments on these loans can be deducted from taxable income, thereby allowing these companies to reduce their overall tax liability, like income subject to America's 35% corporate tax rate. This announcement elicited a much larger outcry, as its reach extends far beyond those pesky inverters. (More on this momentarily.)

Contrary to what many politicians argue, corporate inversions aren't economic bogeymen bleeding Uncle Sam dry. Companies don't invert to avoid paying all taxes-they still pay US rates on profits booked domestically, just as they always did. Inverting simply lets them avoid US taxes on profits earned abroad-an atypical practice, with the US only one of three^[i] developed countries to tax foreign earnings. While individual companies stand to reap significant tax windfalls through inversions, the aggregate impact on government coffers isn't terribly large. Though it is tough to estimate just how much inversions are costing the country, as there is no counterfactual, one group in 2014 put the number at about $20 billion over the next 10 years. That's $2 billion a year-sounds like a lot! But consider: in the current fiscal year through February 29, 2016, a period of four months, the US took in almost $600 billion in individual income taxes alone. Plus, foreign earnings are taxed only if brought back to the US. As a result, many US-based multinational firms never repatriate them, instead investing and saving abroad. To the extent they do so, inverting avoids a tax they weren't going to pay anyway. The evidence the country is missing out on huge sums of shielded taxes just isn't there.

While some deride these firms for wanting to bring foreign earnings home tax-free, there is a pretty huge silver lining: Those earnings get invested here, when they otherwise wouldn't. In that way, inversions help raise business investment, despite widely held fear to the contrary. Killing inversions thus discourages businesses from investing here. The new "earnings stripping" rule does the same. For all the furor over the tax advantages of multinationals' loans to US subsidiaries, those lent funds are invested here-in equipment, facilities, software systems, R&D, you name it. And they just became more expensive for all multinational companies, while closer regulatory scrutiny adds to compliance costs. This is the very definition of cutting off your nose to spite your face, and some suggest curtailing this practice could also hit outright foreign-owned, non-inverted businesses, too.

More broadly, the Treasury's moves discourage risk-taking. They are an example of what we call "government creep"-the rising trend of government agencies changing more and more rules, often without much oversight or public input. When Congress makes rules, it's a lengthy public process. Politicians debate, folks comment on the pros and cons, and actual implementation rolls out at a future date-all of which reduce the surprise power. When Congress delegates rule-writing to the Fed or Executive agencies, it's shadowier, but there is often a public comment period between the proposed and final rules-much as there was with the DoL's new standards for investment professionals working with retirement accounts. But the Treasury's move was different: an Executive agency making decisions behind closed doors, with no public comment and immediate implementation. Oh, and they're retroactive. If you're a business owner, and government agencies do this a lot, how can you plan? The merger that died this week was announced five months ago. Seeing rules change suddenly and retroactively raises uncertainty and makes firms less apt to take risk, as it becomes all but impossible to measure future reward. We aren't yet at a point where this kills business investment, but the Treasury's moves do set a precedent. If more agencies follow their lead and change the rules on a whim, uncertainty and risk-aversion could snowball. It's an if, but an if worth considering.

Again, the Treasury's recent action doesn't pack a wallop that could threaten this economic expansion or bull market. Discouraging multinationals from investing here is a negative, but a minor one, and America has more than enough going for it to offset the tax headwinds. Dynamite human capital, free markets, strong property rights and geography make investing here worthwhile whether or not Uncle Sam reaches a bit deeper into businesses' pockets. But it could be sowing the seeds for something bigger down the line, and that's something we'd suggest investors bear in mind.