Reuven S. Avi-Yonah is the Irwin I. Cohn Professor of Law at the University of Michigan Law School. He would like to thank Steven Rosenthal, Mohanad Salaimi, and Bret Wells for helpful comments.
In this installment of Reflections With Reuven Avi-Yonah, Avi-Yonah explains the two waves of inversions, why there have been so few after the Tax Cuts and Jobs Act, and what might be down the road for them.
Inversions (transactions in which a U.S. parent corporation becomes a subsidiary of a foreign corporation, but the headquarters remain in the United States) were a major focus of tax policy before the Tax Cuts and Jobs Act.1 There have been no inversions since the TCJA, but that is more a result of the current rate structure. If the corporate tax rate is increased, inversions may come back, and the time to act to prevent that is now.
Inversion Waves
There were two waves of inversions. The first started with the Helen of Troy transaction in 1994.2 The IRS responded by changing the section 367(a) regulations to make inversions taxable at the shareholder level. But that did not stop the inversions, even though it probably prevented some (corporations controlled by their founders cannot invert because that will trigger tax for the founders on the unrealized appreciation in their stock).
The first wave continued until 2001, when Sen. Richard Blumenthal, D-Conn., led a successful campaign to stop Stanley Works from inverting after the September 11, 2001, attacks because doing so was “unpatriotic,” even though no U.S. jobs would be affected because inversions then involved only setting up a new shell corporation in Bermuda (New Parent) without assets or employees and having public shareholders of the inverting corporation (Old Parent) exchange Old Parent for New Parent shares.
Why did inversions continue? Because the tax advantages were large enough to overcome the one-time exit tax on the shareholders,3 as well as any corporate governance problems from incorporating the parent in Bermuda instead of Delaware.4 Those tax advantages were:
avoiding subpart F when it still had teeth (before check-the-box regs) because New Parent could form foreign subsidiaries that were not controlled foreign corporations;
the ability to load Old Parent with debt from New Parent and deduct the interest subject to the limits of old section 163(j), which could reduce the U.S. effective tax rate from 35 percent to 17.5 percent; and
the ability to repatriate foreign earnings eligible for deferral without triggering tax on a dividend by distributing them directly from the CFCs to New Parent, who could use them for stock buybacks (hopscotch transactions).
After 2001 inversions stopped while Congress mulled what to do, but once section 7874 was enacted in 2004, the second wave started. The problem with section 7874 is that it depends on the identity of the New Parent shareholders after the inversion, because an inversion has no adverse tax consequences if over 40 percent of the shares in New Parent are held by shareholders who were not shareholders of Old Parent.5 Second-wave inversions therefore involve a merger with a foreign corporation that is at least 40 percent as big as Old Parent. But unlike a true merger with a larger foreign corporation that does not trigger shareholder-level tax, in a second-wave inversion the headquarters invariably stayed in the United States.
Unfortunately, the Obama administration missed an opportunity to close that loophole in 2009 and 2010, when Democrats controlled both chambers of Congress. The fix would have involved reducing the section 7874 threshold to 50 percent, so that only true mergers are exempt, and adopting a managed and controlled standard for corporate residency, so that if the headquarters of New Parent are in the United States it would be treated as a U.S. corporation.
That was the proposal introduced in 2014 by the late Sen. Carl Levin and reintroduced recently by Senate Democratic Whip Richard Durbin of Illinois.6 Under the proposed Stop Corporate Inversions Act, New Parent would be treated as an inverted domestic corporation if it is a foreign corporation that has acquired substantially all of the assets of a domestic corporation or a domestic partnership after May 8, 2014, and, after the acquisition either more than 50 percent of the new entity stock is held by former shareholders or partners of the domestic corporation or partnership, or management or control of the new entity occurs primarily within the United States and the new entity has significant domestic business activities.
Because anti-inversion legislation wasn’t possible from 2011 to 2019 with Republicans controlling one or both chambers of Congress, the Obama administration adopted regulations designed to stop inversions by eliminating hopscotch transactions and treating some intercorporate debt as equity.7
Those steps stopped some inversions (for example, AbbVie and Pfizer), but not others (Medtronic).
The TCJA reduced the appeal of inversions primarily by cutting the corporate tax rate (reducing the need to decrease the effective tax rate through interest deductions) and adopting a partial dividend exemption (eliminating the need for hopscotch transactions). It also put new limits on interest deductibility under section 163(j) and the base erosion antiabuse tax.
Inversion Comeback?
Inversions can make a comeback if the incentives are changed. Suppose, for example, that Democrats increase the corporate tax rate to 28 percent and raise the global intangible low-taxed income and corporate alternative minimum tax rates to 21 percent. Under those circumstances, the original motivation for inversions — avoiding CFC status — will apply again. Before the check-the-box regs, inversions enabled Old Parent to avoid subpart F by creating new foreign corporations under New Parent that were not CFCs even though they were ultimately owned by the U.S. public shareholders, because those shareholders did not individually own 10 percent of New Parent. Under current rules, after an inversion, New Parent and its foreign subsidiaries will not be subject to GILTI or the corporate AMT on foreign-source income.
The corporate AMT is groundbreaking because for the first time it includes in one corporate group the U.S. parent and all its foreign subsidiaries, which has been the goal of U.S. tax policy under Democratic administrations since 1961. Worldwide taxation of the corporate group is crucial, because any differential between the U.S. rate and the foreign rate leads to profit shifting. If the GILTI and corporate AMT rates are raised to 21 percent, inversions may be attractive again because it would be possible to incorporate New Parent in a jurisdiction with a tax rate of 15 percent under pillar 2 and avoid GILTI and the corporate AMT on foreign-source income. At that point, adopting the Stop Corporate Inversions Act becomes essential. Once it is adopted, one can imagine more drastic reforms such as raising the corporate AMT rate to at least 28 percent and abolishing the regular corporate tax, including GILTI and subpart F, because they are more prone to manipulation than the corporate AMT.8
Competitiveness — A Red Herring
Some may point to the need for U.S. multinational enterprises to remain competitive with foreign MNEs subject to a lower tax rate on their foreign-source income. That issue is, and has always been, a red herring.9
To begin with, competitiveness is an argument that can prove too much. One point made by its advocates is that U.S.-based MNEs face increasing competition from foreign-based MNEs in the United States. If so, and if the competitiveness of U.S.-based MNEs is as important to U.S. national welfare as its advocates maintain, why not exempt U.S.-based MNEs from tax on their domestic-source income as well? Surely this would improve their competitive position vis-à-vis the foreign-based MNEs. The answer, however, is that it would sit poorly with purely domestic businesses, and if the exemption were extended to them and the corporate tax were abolished altogether, that would offend individual taxpayers, and so on. In short, the competitiveness argument can be used to justify many types of tax exemptions, and it isn’t clear why U.S.-based MNEs should be first in line.
Second, if competitiveness is the issue, then presumably the rate differential can be eliminated in those situations in which U.S.-based MNEs don’t have much competition. Suppose in a given market, a U.S.-based MNE faces little competition (Alphabet, Amazon, Meta, and Netflix are quasi-monopolies in many markets), or that its main competition is another U.S.-based MNE (for example, Coca-Cola and Pepsi). In those cases, the argument for competitiveness would not apply, and the rate differential could be abolished.
Third, the competitiveness argument implicitly assumes that “what is good for GM is good for America.”10 It is true that U.S.-based MNEs have a higher percentage of employees, management, and research and development in the United States than foreign-based MNEs, although that gap may be shrinking. However, tax policies that favor U.S.-based MNEs presumably inure ultimately to the benefit of their shareholders in the form of a greater after-tax amount available for distribution. A key change in the international economy in the last 40 years is that the shareholder base of U.S.-based MNEs now includes many foreign as well as U.S. residents.11 If one assumes that U.S. tax policy should enhance the welfare of U.S. residents alone, a policy that favors U.S.-based MNEs does not pursue the right goal.
Fourth, the competitiveness argument in its simplest form suffers from the “UBIT fallacy,” which refers to the argument for imposing tax on the unrelated business income of tax-exempt organizations, lest they be able to compete “unfairly” against taxable entities in the same line of business. As Boris Bittker and George Rahdert showed long ago, under normal competitive conditions, the tax-exempt has every incentive to charge the price that the market will bear.12 In that case, no competitive disadvantage to the taxable entity will ensue.
This is reflected by one of the case studies in a 1999 National Foreign Trade Council report, which is based entirely on the competitiveness argument.13 In one example, a U.S.-based MNE competes against a foreign-based MNE to build a pipeline in a foreign country. For both companies, an investment of $1,000 yields $250 in pipeline revenues. After interest and depreciation, this translates into $100 of net revenues. Foreign taxes are $15, so net earnings after foreign tax are $85. The foreign-based MNE is not subject to any tax on foreign income in its home country and can therefore keep the entire $85 as net earnings after foreign and home taxes. The U.S.-based MNE is subject to U.S. tax on the $100 of net revenues, yielding $35 in tentative U.S. taxes before foreign tax credits under the pre-TCJA tax rate of 35 percent. But because of the interest allocation rules, it has an overall foreign loss and is unable to credit the foreign tax, so that its net earnings after foreign and home taxes are only $50.
The council’s report points out that “to earn the same after-tax return as the foreign pipeline company, the U.S. company would have to charge 44 percent more than its foreign competitor (generating pipeline revenues of $359 as compared to $250 for the foreign competitor).” This, it says, results in a competitive disadvantage that is generally “too large to overcome.”
However, it is unclear why a competitive disadvantage should result here. If one assumes that the goal of the foreign pipeline company is to maximize its after-tax revenue, its rational response would be to charge $359, rather than $250 — that is, to charge the same as the U.S. company. In that case, neither the United States nor the foreign company would be under a competitive disadvantage — except that the U.S. company would have an after-tax profit of only $85, compared with $158 for the foreign company.14
Of course, if the goal of the foreign company is to drive the U.S. company out of the market rather than maximize its after-tax earnings, it may charge less than the U.S. company, which would then be forced to lower its own price in return (and accept a lower after-tax profit, as in the example). But the National Foreign Trade Council report does not show that such predatory behavior is the norm, and the theoretical case studies it includes are insufficient to prove the case. Concrete empirical studies, rather than theoretical demonstrations or anecdotes, are needed here.
Finally, the report pointed out that in 1962, when subpart F was adopted, U.S. MNEs dominated the global lists of the largest corporations, and that this was less true in the 1970s and 1980s. But by 1999, when the report was published, the lists were again dominated by U.S. MNEs, and that has continued ever since. In 2024 the 10 largest MNEs in the world by market capitalization are Microsoft, Apple, Saudi Aramco, Alphabet, Amazon, Nvidia, Meta, Berkshire Hathaway, Tesla, and Eli Lilly. Enough said.
FOOTNOTES
1 See, e.g., Reuven S. Avi-Yonah, “For Haven’s Sake: Reflections on Inversion Transactions,” Tax Notes Int’l, July 8, 2022, p. 225; Avi-Yonah, “Reflections on the ‘New Wave’ Inversions and Notice 2014-52,” Tax Notes Int’l, Oct. 6, 2014, p. 63; Avi-Yonah, “The Three Causes of Inversions: Reflections on Pfizer/Allergan and Notice 2015-79,” University of Michigan Law School (Nov. 20, 2015).
2 There was one earlier example, McDermott Corp., in 1982. See James Hines, “The Flight Paths of Migratory Corporations,” 6(4) J. Acct., Auditing, & Fin. (1991).
3 Only 27 percent of U.S. equities are held in taxable accounts, and nontaxable shareholders are unaffected by an inversion. See Steven M. Rosenthal and Livia Mucciolo, “Who’s Left to Tax? Grappling With a Dwindling Shareholder Tax Base,” Tax Notes Federal, Apr. 1, 2024, p. 91.
4 That is why the stock prices typically rose when inversions were announced. See Mihir A. Desai and James Rodger Hines, “Expectations and Expatriations: Tracing the Causes and Consequences of Corporate Inversions,” National Bureau of Economic Research Working Paper No. w9057 (July 2002).
5 This problem was pointed out to Congress before section 7874 was enacted. See “Law Professor Testimony on Corporate Inversions,” Tax Notes Today Federal, Oct. 16, 2022; Avi-Yonah, “For Haven’s Sake: Reflections on Inversion Transactions,” supra note 1. Another problem is the exclusion of cases in which the post-inversion group has substantial business activities in the foreign country in which New Parent is incorporated. See Mohanad Salaimi, “Corporate Inversions: Evolutionary Process and Key Policy Considerations,” 41(2) Va. Tax Rev. (2021).
6 See “Senators Announce Bill to Reduce Corporate Inversion ‘Loophole,’” Tax Notes Today Federal (May 20, 2014); Stop Corporate Inversions Act of 2015, prepared by Ways and Means Committee Democratic staff and the offices of Sens. Richard Durbin, D-Ill., and Jack Reed, D-R.I.
7 See Notice 2014-52, 2014-42 IRB 712, and Notice 2015-79, 2015-49 IRB 775, and the proposed regulations under section 385.
8 On the advantages of the corporate AMT, see Avi-Yonah, “Taxing the Right Book: Arguments for the Corporate AMT,” Tax Notes Federal, Nov. 27, 2023, p. 1645.
9 The following is based on Avi-Yonah, “Tax Competition and Multinational Competitiveness: The New Balance of Subpart F,” Tax Notes Int’l, Apr. 19, 1999, p. 1575. See also Avi-Yonah and Nicola Sartori, “International Taxation and Competitiveness: Foreword,” 65 Tax L. Rev. 313 (2012); Avi-Yonah and Omri Marian, “Inversions and Competitiveness: Reflections in the Wake of Pfizer-Allergan,” 41 Int’l Tax J. 39 (2015).
10 Quote attributed to Charles Wilson, president of General Motors Co., during his 1953 confirmation hearings for defense secretary. Wilson was asked if he could make a decision while in office that was bad for GM. He responded that he saw no conflict, “because for years I thought what was good for our country was good for General Motors, and vice versa.”
11 Rosenthal and Mucciolo, supra note 3, estimate that in 2022 foreigners held about 42 percent of U.S. corporate stock.
12 Boris Bittker and George Rahdert, “The Exemption of Nonprofit Organizations From Federal Income Taxation,” 85 Yale L. J. 299 (1976).
13 National Foreign Trade Council, “The NFTC Foreign Income Project: International Tax Policy for the 21st Century, Part One: A Reconsideration of Subpart F” (1999).
14 This result is bad if one assumes that it affects the relative savings rate of U.S. versus foreign shareholders, which is the old argument for capital import neutrality. But there is little empirical evidence that tax rates affect saving decisions. Alternatively, it is bad if the U.S. MNE is more efficient (before tax) than the foreign MNE, which is the argument for capital ownership neutrality, but that too has little empirical evidence behind it. See Mihir Desai and James Hines, “Evaluating International Tax Reform,” 56(3) Nat. Tax J. (2003); but see Willard Taylor, “What’s ‘Neutral’ About This?” Tax Notes Int’l, May 30, 2011, p. 715 (arguing that capital ownership neutrality boils down to competitiveness).
END FOOTNOTES