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Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Friday, June 2, 2017

Weekly SSRN Tax Article Review And Roundup

This week, Daniel Hemel (Chicago) reviews a new article by Michael Knoll (Penn), Taxation, Competitiveness, and Inversions: A Response to Kleinbard, 155 Tax Notes 619 (May 1, 2017) 

HemelDo U.S. tax laws place U.S.-domiciled companies at a competitive disadvantage vis-à-vis foreign firms? In an influential 2014 article, Edward Kleinbard (Southern California) argued that the answer is no: “there is no credible evidence,” Kleinbard concluded, “that U.S. firms are at a fundamental international business competitive disadvantage under current law.” Now, Michael Knoll responds to Kleinbard’s article and arrives at a contrasting conclusion: while acknowledging the limits of existing empirical work, Knoll says that “the stronger case would seem to be that U.S.-domiciled corporations are often tax-disadvantaged relative to their non-U.S. rivals.”

Both authors agree that the competitiveness question has important implications for the debate over corporate inversions. Inversion defenders often argue that U.S.-headquartered multinationals must be allowed to shed their U.S. domicile so that they can compete on even terms with foreign firms. In Kleinbard’s view, this narrative is a “fable”: competitiveness concerns cannot justify inversions. Consequently, Kleinbard concludes that the U.S. Treasury and Congress should crack down on inversion transactions. In Knoll’s view, “improving competitiveness remains a strong reason for U.S.-domiciled companies to invert,” and “policies intended to curb inversions that ignore this state of affairs are likely to . . . produce adverse consequences.”

My own view, to lay my cards on the table at the outset, is that Kleinbard and Knoll are both right. 

U.S.-domiciled corporations probably are, as Knoll says, tax-disadvantaged relative to their non-U.S. rivals. Yet Treasury and Congress should, as Kleinbard contends, continue their efforts to deter inversions. Before explaining why arrive at that view, I’ll describe the empirical disagreement between Kleinbard and Knoll that leads to their normative divergence.

By “competitiveness,” I understand both authors to have in mind something like the following: Tax law puts a U.S.-domiciled corporation at a competitive disadvantage vis-à-vis a foreign firm if it causes the U.S. company not to pursue business opportunities that the foreign firm would pursue. This competitiveness question can be assessed along several dimensions. Imagine two corporations—one domiciled in the United States, the other in Ireland. We might ask:

  1. Will tax law cause the U.S. corporation not to pursue a business opportunity in the United States that the Irish corporation would pursue?
  2. Will tax law cause the U.S. corporation not to pursue a business opportunity in Ireland that the Irish corporation would pursue?
  3. Will tax law cause the U.S. corporation not to pursue a business opportunity in a third country (say, Britain) that the Irish corporation would pursue?

Knoll devotes several pages to showing that multinational corporations domiciled in the United States face some of the highest overall effective tax rates (ETRs) in the world, behind only Japan and (possibly) Germany. Yet as Knoll also acknowledges, a corporation’s overall ETR—its effective tax rate on worldwide income—is not necessarily the best way to answer the competitiveness question. Let’s say a U.S. and Irish corporation both face a 35% tax rate on income earned in the United States, a 12.5% tax rate on income earned in Ireland, and a 19% tax rate on income earned in Britain. The U.S. corporation might face a higher overall ETR than the Irish corporation, because more of its activities are in the United States. However, the U.S. corporation would not be at a tax disadvantage vis-à-vis the Irish firm along any of the three dimensions outlined above.

Still, we might expect U.S. multinationals to face a disadvantage on all three dimensions of competitiveness because the United States taxes U.S.-domiciled corporations on a worldwide income, while most other countries tax on a territorial basis. U.S. and foreign multinationals both have opportunities to shift income earned in the United States and other high-tax jurisdictions to lower-tax jurisdictions like Ireland and Bermuda, but the tax benefits of international income shifting are greater for foreign firms than for U.S. domiciliaries. This is because U.S. multinationals must pay a 35% toll when they ultimately repatriate those earnings and distribute them to shareholders, whereas most foreign multinationals can repatriate tax-free.

To be sure, U.S. multinationals can stash cash in offshore subsidiaries and hope for another repatriation holiday, like the one in 2004-2005 that reduced the effective tax rate on repatriated earnings to 5.25% for a single year. But as Knoll emphasizes, there are three problems with the wait-it-out approach. First, like Godot, the next repatriation holiday may never arrive. Second, in the meantime, the United States might impose a “deemed repatriation” tax (like the 14% tax proposed by President Obama or the 10% tax proposed by then-candidate Donald Trump), which would apply on a one-time basis to overseas earnings regardless of whether U.S. corporations bring that cash home. And third, interest on cash held offshore is potentially taxable at a 35% rate under subpart F. Thus, even when U.S. multinationals can shift income to low-tax jurisdictions, they still bear some burden on account of the United States’ worldwide taxation system.

Kleinbard’s response, I anticipate, would go something like the following: Even if U.S. multinationals do face real tax costs when they shift earnings to low-tax jurisdictions and hold cash there indefinitely, these are not the sorts of costs that drive corporate decisionmaking. According to Kleinbard, investors and corporate executives view the world through the lens of U.S. generally accepted accounting principles (GAAP). Under GAAP, a U.S. corporation can designate foreign earnings as “permanently reinvested,” meaning that the corporation never intends to bring those earnings home. That allows the corporation to avoid recognizing a deferred tax liability linked to future repatriations on its balance sheet.

Maybe this is a function of the fact that I teach at the University of Chicago, where rational-actor models reign supreme, but I find it hard to believe that managers of U.S. multinationals consistently ignore the very real tax costs of booking income overseas and “permanently” reinvesting the earnings. (Perhaps it is a function of the fact that Knoll is a product of the University of Chicago that he takes the same view too.) We know that share prices of publicly traded firms reflect the off-balance-sheet tax liabilities associated with permanently reinvested earnings, which suggests that investors do not view the world exclusively through the lens of GAAP. Corporate executives, who generally care about their companies’ share prices, would be ill-advised to ignore the tax costs of offshore earnings. And if U.S. corporations factor the tax costs of offshore earnings into their capital budgeting decisions, then we have strong reason to believe that U.S. multinationals will be deterred from seizing at least some business opportunities that foreign firms would pursue.

But even if one concedes that tax law puts U.S. multinationals at a competitive disadvantage on some dimensions, that does not necessarily mean we should allow U.S. multinationals to change their country of domicile through corporate inversions. First, we might be concerned about competitiveness along still another dimension: the United States as a site for the production of goods and services versus foreign countries as sites for the production of goods and services. If formerly U.S.-domiciled multinationals can earn income in lower-tax jurisdictions and then distribute those earnings to shareholders without paying a repatriation toll, then the incentive for those firms to shift production away from the United States will be stronger.

Second, we might be (indeed, probably should be) concerned about the revenue consequences of inversions. While Rita Gunn and Thomas Lys have suggested that the revenue gains from accelerated capital gains tax collections following an inversion might offset the corporate tax revenue losses, Gunn and Lys assume that U.S.-domiciled corporations face no U.S. tax cost from booking profits overseas and keeping the cash offshore. But as Knoll emphasizes, there is indeed a U.S. tax cost of keeping cash offshore—and, commensurately, a benefit from the Treasury’s perspective of keeping corporations with offshore cash from leaving the U.S. tax system.

Third, even if one does believe that the United States ought to shift to a territorial tax system, inversions are a decidedly suboptimal way of relieving the burden of worldwide taxation on U.S. multinationals. Inversions entail massive transaction costs: the Pfizer-Allergan deal alone would have generated up to $350 million in investment banking fees. Better, it would seem, to shut down inversions in the short term and then move toward a territorial tax system in a more orderly manner.

In sum, even if one agrees with Knoll about the competitive consequences of inversions, one might also agree with Kleinbard about the appropriate policy response. But whatever one’s view on the merits, we can at least agree that Knoll’s article—like Kleinbard’s before it—makes an important contribution to a debate on inversions that shows no signs of abating.

Here’s the rest of this week’s SSRN Tax Roundup:

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