Scott Hodge (President, Tax Foundation), IRS Data Contradicts Kleinbard’s Warnings of Earnings Stripping from Inversions:
One of the loudest critics of the recent wave of corporate inversions is University of Southern California law professor Ed Kleinbard, who warns that these transactions will erode the U.S. corporate tax base because these newly relocated firms will use “intragroup interest payments” to “strip” income out of their U.S. subsidiary. ['Competitiveness' Has Nothing to Do With It, 144 Tax Notes 1055 (Sept. 1, 2014)]
While this is thought to be a common practice with multinational corporations, IRS data actually shows that the U.S. subsidiaries of foreign-based companies have smaller interest deductions relative to their total receipts than do American-headquartered firms and, interestingly, they have higher effective tax rates than their domestic counterparts. Thus, Kleinbard’s warnings would seem to be much ado about nothing. ...
Of course, the real threat to the U.S. corporate tax base is our corporate tax code itself, with the third-highest overall rate in the world and a worldwide system that requires American companies to pay a toll charge to bring their profits back home. Thus, the solution to the inversion “problem” is to dramatically cut the corporate rate and to move to a territorial tax system, not add even more unnecessary rules to an already complicated tax code.
Edward Kleinbard (USC):
Paul Caron has kindly given me an opportunity to respond to the Tax Foundation’s blog post, IRS Data Contradicts Kleinbard’s Warnings of Earnings Stripping from Inversion, authored by Scott Hodge. The data and relevant research in fact point in exactly the opposite direction as that suggested by the Tax Foundation in this post.
First, it should be obvious that inversions have been relatively rare transactions for the last decade, until the current wave of inversion mania infected Wall Street firms, and through that vector the larger corporate community. At the same time, genuinely foreign-controlled U.S. firms are a very large part of the U.S. domestic economy — holding roughly 20 percent of U.S. corporate assets, for example. This means that IRS Statistics of Information (SOI) data in general are insufficiently granular (to borrow a useful turn of phrase from the blog post) to shed much light on post-inversion tax planning. But we have a great deal of other information, in the form of Wall Street analyst reports, practice-oriented advisories, financial news reporting, and similar sources, all of which identify earnings stripping as one important objective in some current inversion trades. (Very generally, trades now or recently in the market lean primarily towards either the earnings stripping or the section 956 hopscotch strategies — one of the two dominates the other.) In short, the past is a poor predictor of future tax avoidance strategies in respect of the highly tax-motivated acquisition structures now in the marketplace.
But let’s persevere, as the blog post did not find this first observation disabling to its ability to mine for data to support its conclusion. The basic idea of the blog post was to take SOI data on all active U.S. corporations, and subtract out from those figures the corresponding numbers for foreign-controlled U.S. firms. The remainder was assumed to represent the results of domestic-controlled domestic corporations. I have no objections to that (other than to repeat that inversion transactions will not be visible in this data, where the numbers in some case are in the trillions of dollars). But the blog post then made two unstated modeling decisions that colored the results.
First, the blog post muddled data drawn from both financial and non-financial firms. Everyone who works with aggregate financial or tax data knows not to do that, because the two have radically different capital structures and regulatory environments. (In turn the insurance and non-insurance segments of the financial services industries have very different capital structures when compared to each other, because the liabilities on an insurance company’s balance sheet represented by current or future insurance claims against the company are non-interest bearing.) Financial services firms of course account for a very substantial percentage of corporate gross assets, liabilities, and interest expense. I am not aware of any financial services firm engaging in an inversion transaction. Following general practice in tax analysis, then, the blog post should have parsed its data one more level down, to compare foreign-controlled U.S. non-financial firms to domestic-controlled U.S. non-financial firms.
Second, the blog post compares interest expense to total receipts. But as anyone who has worked on foreign tax credit planning questions knows, interest expense does not support revenues, it supports assets. That is, you borrow money to buy stuff, not to buy free-floating revenues. So the relevant question is, how do the interest-to-assets ratios of foreign-controlled and domestic-controlled non-financial U.S. firms compare?
I do not run a tax think tank and so do not have a computer set up with the last 20 years or so of SOI data, but I did look at this question for 2011 (the most recent year for which data are available). Oddly enough, when you ask the right question, you discover that the 2011 interest-to-assets ratio for foreign-controlled non-financial U.S. firms is a bit higher, not lower, than the comparable ratio for domestic-controlled non-financial firms. Foreign-controlled firms are incurring a bit more interest cost per dollar of assets supported by the underlying borrowings.
And of course one can use the same approach to get a peek at larger earnings stripping and expense stuffing activities, by looking at the same SOI spreadsheets’ taxable income (formally, "income subject to tax”) entries. When you do, you discover that in 2011 domestic-controlled U.S. non-financial firms earned about 2.4 percent in “income subject to tax” on their gross assets. Foreign-controlled non-financial firms, by contrast, earned about 1.9 percent. You can claim that this is because all foreign investments are young and fresh, and therefore still in an expansionary mode, while domestic-controlled firms are old and tired, just collecting an annuity, but this excuse is belied by reality (e.g, Silicon Valley firms), and has grown tiresome after so many decades of use.
September 7, 2014 in Tax, Think Tank Reports | Permalink
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