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Originally published Thursday, August 7, 2014 at 5:05 PM

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Guest: Tax inversions threaten U.S. economy

How the U.S. government can stop exit of U.S. companies choosing to relocate their headquarters to other countries to avoid having to pay taxes on income earned overseas, according to guest columnist Jerry Wegman.

Special to The Times

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@bluechip Actually, what happens is that companies with such inversions use various accounting techniques to shift... MORE
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CORPORATE America is in the grip of an epidemic of tax inversions, gimmicks used by some multinational corporations to avoid paying income tax. U.S. Sen. Ron Wyden, D-Ore., recently called inversions a “plague.”

These tax inversions have the potential to bring on the next financial crisis. Just as the U.S. is recovering from the Great Recession, another crisis looms.

What are tax inversions?

Tax inversions are a tactic being used by multinational companies based in the U.S. to avoid paying taxes on the more than $2 trillion they are holding overseas. (Redmond-based Microsoft is holding $76 billion overseas, second only to General Electric’s $110 billion.)

U.S. companies do not pay U.S. income tax on overseas earnings. But when they bring those earnings back to this country, they must pay the U.S. corporate income tax rate of 35 percent.

In order to avoid this, companies are renouncing their U.S. citizenship and moving abroad. They do this by merging with smaller companies in low-tax countries while keeping most of the corporate management and operations in the U.S.

First, a large U.S.-based multinational company acquires a small company in a low-tax foreign country. Then the merged company declares its legal residence to be the low-tax country. The company’s tax rate goes down.

The largest company to invert so far is Minneapolis-based medical-device maker Medtronic. It recently purchased Ireland-based Covidien. The merged company plans to renounce its U.S. citizenship and become a citizen of Ireland, where the income tax rate is 12.5 percent.

The drugstore chain Walgreens had considered a move to Switzerland by increasing its stake in the Swiss retailer Alliance Boots, but abandoned the moving plans Wednesday after political pressure.

Inversions remain an imminent threat because there is a great risk that they will snowball. As inversions become more common, the stigma of renouncing United States citizenship will fade, reinforcing the cycle. Eventually a reverse stigma could even develop, where companies that didn’t invert would be deemed to be inefficient. They could be sued by shareholders alleging a violation of management’s fiduciary duty to them by failing to maximize profits through inversion.

Meanwhile, as the tax base shrinks, the U.S. Treasury will take in less and less money. Congress would have to either raise taxes on everyone else, or cut spending. Is our quarrelsome and partisan Congress up to that task? If not, a financial crisis would result.

Most reform proposals deal with the problem on a piecemeal, stopgap basis. A bandage here, a tourniquet there.

There is a fundamental reform that would be an antidote to the plague of inversions and would also cure many other tax abuses. For years, U.S. states have successfully been using various forms of a system called “sales factor apportionment” to determine which state is entitled to tax the earnings of companies that do business in several states. This is exactly the same problem as determining which country is entitled to tax the earnings of companies that do business in several countries.

Sales factor apportionment is simple, efficient and transparent. If company A sells half of its products in the U.S. and half abroad, then the U.S. would be entitled to tax half of company A’s worldwide income. So if the company earned $100 million, the U.S. could tax $50 million.

Note this is an income tax, not a sales tax. Economists Michael Udell and Aditi Vashist recently demonstrated in a report for Tax Notes Today that sales factor apportionment would broaden the tax base and would help to close loopholes that allow U.S. multinationals to underreport their incomes. The increased revenue collected by eliminating underreporting would allow for a reduction of tax rates generally. The result would be that multinational corporations would finally pay more equitable taxes, and the rest of us would get some tax relief.

A sales factor apportionment would also help close one of the largest tax-avoidance loopholes: off-shored, untaxed profits.

Congress should act now to block the looming threat of financial crisis by passing the Stop Corporate Inversions Act of 2014. But it should not just kick the can down the road with another stopgap measure; Congress should get at the root of the problem by adopting fundamental reforms like sales factor apportionment.

Jerry Wegman is a retired professor of business law at the College of Business and Economics at University of Idaho. He is also a former prosecuting attorney and judge.

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