Moving offshore

Posted: Aug 08, 2002 12:00 AM
When Congress returns from its August recess, the issue of corporate "inversions" will likely be close to the top of its agenda. Inversions result when U.S. corporations reincorporate in a foreign country in order to reduce their taxes. In recent years, several U.S. companies have taken this action. The issue of inversions has gotten a lot of attention because people, including many members of Congress, are under the false impression that jobs and factories are moving abroad. In fact, nothing real is affected. The only thing that is moving is legal residence for tax purposes -- a purely paper transaction. This goes on inside the United States all the time. According to the Federation of Tax Administrators, the top corporate tax rate is 12 percent in the state of Iowa. However, neighboring Kansas has a rate of just 4 percent. No doubt, over the years, there are any number Iowa companies that have reincorporated in Kansas in order to save 8 percent per year in taxes. Of course, individuals do the same thing. For example, FTA reports that North Dakota has the highest income tax rate at 12 percent. Yet South Dakota has no income tax at all. This may explain why the former's population has been falling, while the latter's has been rising. The point is that individuals and corporations move from one state to another and from one town to another every day, partially based on differences in the taxes they pay in one jurisdiction versus the other. This is not a matter of congressional interest, nor should it be. Competition helps ensure that citizens get the mix of services they want for the taxes they are willing to pay. However, it is much more difficult for individuals to move to foreign countries to take advantage of lower tax rates there. In part, this is because the IRS continues to tax U.S. citizens living in a foreign country as if they still lived here. It does not matter that they receive no services from the U.S. government, nor that they earn all of their income in a foreign country. The IRS still wants its pound of flesh. So, too, with corporations. A company that incorporates in Canada pays taxes only on its operations in Canada. If it has a U.S. subsidiary, it pays U.S. taxes on its profits here, but none to Canada. However, the exact same U.S. company with an identical Canadian subsidiary will pay Canadian taxes, plus U.S. taxes on its Canadian operations as well. Thus, the U.S. company will pay more total taxes even if the United States and Canada have the same tax rates. It is this anomaly in U.S. tax law that encourages inversions. In effect, a U.S.-based company establishes a foreign subsidiary, which then buys the U.S. company. In the process, it becomes a foreign-based company with a U.S. subsidiary, instead of the other way around. Nothing whatsoever has changed except the legal place of residence for tax purposes. While nothing more than a legal maneuver, it should be noted that it is not a costless one. In the process, shareholders of the original company must, in effect, sell their shares and realize capital gains, which may trigger a tax liability. They then receive new shares in the foreign corporation exactly equal to their old shares. Therefore, although ownership does not change, the inversion process imposes taxes on many shareholders. The tax cost of inversions is probably the major reason why more companies don't do it. The fact that some still do -- which requires a majority vote by shareholders -- tells us that the tax savings must be considerable. And indeed they are. A recent paper by economists Mihir Desai and James Hines found a significant increase in stock prices for companies announcing inversions. Investors recognize that after-tax earnings will be higher and bid up stock prices, thereby compensating shareholders for the taxes they incur in the process. Most attention on inversions has focused on so-called tax havens such as Bermuda, which has no corporate tax at all. However, many major countries have corporate tax rates well below the 40 percent rate here (including state taxes). These include such countries not noted for being low taxed as Finland (29 percent), Norway and Sweden (28 percent each). Ireland has a corporate tax rate of 16 percent, and Chile's rate is just 15 percent. Instead of writing new laws to prevent inversions, Congress would be better advised to cut corporate tax rates. The inversion phenomenon should be viewed as a warning that U.S. rates are too high. Additional laws may possibly prevent inversions by existing companies, but in the future, newly established corporations will find places like Ireland much more hospitable countries in which to incorporate in the first place.