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Shooting For Tax Dollars, Hitting The Treasury

Treasury Secretary Jack Lew
Treasury Secretary Jack Lew. Photo courtesy the U.S. Embassy, Kyiv, Ukraine

President Obama has been openly gunning for tax inversions. Unfortunately, another target took the hit: the U.S. Treasury.

Don’t say I didn’t warn you, Mr. President.

The Wall Street Journal recently reported that a wave of foreign takeovers has followed the administration’s crackdown on American companies’ attempts to reincorporate abroad. Inversions, about which I have written before, spiked in 2014 as many American companies tried to flee to less hostile tax climates ahead of anticipated rule changes meant to make such reorganization strategies harder and less lucrative.

Last August, I observed that making inversions impractical for U.S.-based companies would only serve to turn those companies into takeover targets for foreign enterprises. Now that the president got his wish, this is exactly what is happening.

The Treasury Department announced a new set of rules last September, designed to slow inversions by removing some of the tax benefits. Since only Congress can change the actual tax code, and thus the burdensome system of corporate taxation motivating U.S.-based businesses to look elsewhere in the first place, the Treasury could only make it more difficult for them to go. The regulations mainly did this by narrowing the pool of potential merger partners and ending so-called “hopscotch loans” (in which inverted companies gain access to foreign earnings that had previously remained unrepatriated and thus untaxed), in an attempt to hold on to the ability to tax the U.S. company’s offshore earnings.

The Treasury also announced it might try to curb “earnings stripping,” a practice in which an inverted firm treats certain intra-company fund transfers as debt. So far, however, it has not done so.

The Treasury’s rule changes didn’t stop inversions entirely, but they did effectively slow them down. The regulatory changes also made it more difficult for American enterprises to spin off overseas subsidiaries to move assets out of the U.S. tax system.

So the rule changes succeeded, in that they did make inversions more difficult. Yet instead of keeping U.S. enterprises in the U.S., the administration has mainly transformed them into better acquisition targets.

The Journal cited the example of Salix Pharmaceuticals Ltd., which failed to complete an attempted inversion prior to the change in regulations. That inversion floundered as a result. Instead, a Canadian pharmaceutical company is in the process of acquiring Salix for $10 billion. Salix is still leaving; it is simply no longer doing so on its own steam or under the direction of American-based management.

Now that the administration has made inversions more difficult, U.S. companies are having a harder time competing for acquisitions. Foreign companies, with lower corporate taxes, have long had an edge when targeting American enterprises; taking inversions off the table has made this advantage bigger.

Even Treasury Secretary Jack Lew has been frank about the need for corporate tax reform. In a speech earlier this year, he called the anti-inversion policy a “short-term response to one symptom” of an “unfair, uncompetitive and overly complicated” tax system. Lew apparently had no objections, however, to making the American system even less fair and competitive while waiting for eventual legislation. Now, as we all wait along with Lew, foreign companies are scooping up U.S. targets. Many bankers and lawyers expect foreign acquisitions to speed up under the new conditions.

Trying to keep American companies here by force is an ineffective patch meant to cover the fact that our corporate tax system is uncompetitive in today’s global economy. Targeting inversions, rather than the conditions that motivated them, was always misguided. Now we are seeing the inevitable results of misguided regulatory targeting.

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