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Are the new Corporate Inversion Rules Ethical?

Social Responsibility vs. Minimization of Worldwide Taxes

New Tax Inversion Rules

On April 4, the U.S. Treasury Department released a new set of rules that makes it more difficult for U.S. companies to conduct tax inversions. In an inversion, a U.S. company takes a foreign address, typically through a merger with a smaller firm. The combined company can then lower its tax rates through internal borrowing (thereby deducting interest expense) and can more easily move non-U.S. profits around the world and back to shareholders while avoiding U.S. taxes.

The Treasury rules have two primary components. The first part takes on “serial inverters,” which allows the government to ignore U.S. assets acquired by these companies over the last three years. The second component involves earnings stripping. The new rules make it more difficult for foreign-parented groups to quickly load up their U.S. subsidiaries with related-party debt following an inversion or foreign takeover, by treating as stock the instruments issued to a related corporation in a dividend or a limited class of economically similar transactions.

Pfizer-Allergan Deal

The first part, in particular, imperiled the Pfizer-Allergan deal because Allergan as it exists now is essentially the result of a series of high-profile mergers acquisitions since 2013. Allergan’s size and scope is the result of several cross-border deals, starting with the 2013 inversion of Actavis Inc., a small New Jersey-based drug maker, through a takeover of Ireland-based Warner Chilcott PLC. What followed was a string of ever-larger deals, culminating in Actavis’s $66 billion takeover of U.S.-based Allergan Inc. last year.

Under the Treasury regulations, those deals would be disregarded for the purposes of determining Allergan’s size under the tax law. The three-year window would cover the 2015 merger of Actavis and Allergan, Actavis’ $25 billion purchase of Forest Laboratories Inc. in 2014, and the original $5 billion Warner Chilcott deal. Stripping those deals out of Allergan’s closing market capitalization of about $96 billion as of March 31, 2016 could make it too small to serve as Pfizer’s inversion partner.

To reap the full benefits of inverting, the U.S. company’s shareholders should own between 50% and 60% of the merged entity, which requires a partner of carefully calibrated size. Above that, some restrictions apply, including rules making it harder for companies to access foreign profits. The Pfizer-Allergan deal is structured so that Pfizer’s shareholders will own 56% of the company. Under the new Treasury rules, the percentage in the Pfizer-Allergan deal would be at least 60% and could approach 80%, above which all benefits of the inversion are lost.

Motivation for Tax Inversions

Tax inversion deals are driven by a desire to avoid paying U.S. corporate income taxes that are the highest in the world (35%) by relocating to a tax-friendly country. The tax rate in Ireland is 12.5 percent, which is paid by the foreign entity. U.S. companies avoid paying any corporate income taxes by shifting profits overseas so that taxes are avoided until and unless those profits are repatriated from their low-taxed foreign earnings to the U.S. By simply keeping the profits overseas a U.S. company avoids paying U.S. corporate income taxes.

Ethics of Tax Inversion

Is it ethical for a U.S. corporation to engage in tax inversions merely to lower worldwide taxes? Another way of asking this is: Does a U.S. company have an ethical responsibility to keep its headquarters in the U.S. where the majority of its operations occur so that corporate income taxes are paid in the primary country of operations?

The problem is, as I see it, all too many deals have been made in the last ten years or so in the name of minimization of global taxes. There is no other explanation. It doesn’t make the company more efficient. It doesn’t create new jobs in the U.S. despite the statements to the contrary by U.S. companies. And, it doesn’t generate as much economic development in the U.S. as it would if the company was taxed not based on the foreign entity’s location but, instead, based on where the majority of its operations are conducted.

In tax inversions, the real headquarters are where executives work and this often doesn’t move after an inversion, because of the benefits of the U.S. workforce and legal protection. But, other countries have much more favorable tax systems because they don’t tax their companies’ worldwide earnings and because they have lower marginal tax rates. Inversions offer companies the best of both worlds—access to U.S. markets, customers and workers without all of the burdens of the U.S. tax code.

Social Responsibilities of U.S. Corporations

U.S. corporations contend that they operate in a global economy and must compete globally, and this is the driving force for the inversions. True enough but left out of the mix is any sense of social responsibility in the U.S.

In an ideal world, U.S. companies would understand and act on their ethical and social responsibilities, which include to support the community where they primarily operate. They need to be a good corporate citizen in that regard. The sad part is today that sense of obligation has been thrown out because inversions and other tax-driven policies save them a lot of money at the end of the day. The burden should be placed on the inverted corporation to prove, as they often contend, that their actions provide more benefits to U.S. workers and the U.S. economy than costs our country because of corporate inversions.

Blog posted by Steven Mintz, aka Ethics Sage, on April 14, 2016. Professor Mintz is on the faculty of the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at: