Among the many issues Congress left unresolved when it left town last week was how to deal with companies that dodge U.S. taxes by turning themselves, at least technically, into foreign firms.
On Monday, the Obama administration took steps to make those so-called corporate inversion deals less attractive, but the Treasury Department’s move addressed only one of the two biggest drivers of such deals.
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The U.S. taxes domestic corporations on global earnings, meaning that a company with foreign operations owes Uncle Sam income taxes on earnings from those operations as well as on money earned here at home. However, that tax doesn’t apply until the earnings are brought back to the U.S. — “repatriated” in tax talk. Many companies hoard millions and even billions of dollars in “deferred” earnings overseas purely to avoid U.S. taxation.
Some corporations go even further to minimize their tax payments. Rather than eventually paying on those deferred earnings, they arrange a merger with a foreign firm that allows them to retain foreign earnings without paying U.S. taxes. Notable inversions of recent years include those by drug maker Actavis and offshore drilling firm Transocean. Pending deals include Burger King and medical device giant Medtronic.
The Treasury Department’s slew of new rules announced Monday are designed to limit the ability of U.S. companies to avoid taxation on deferred earnings by explicitly barring businesses from using some of the most common tools that facilitate the practice. So-called “hopscotch” loans — in which an inverted firm transfers deferred earnings to a newly minted foreign parent company — are blocked, as are a number of similar practices meant to turn previously taxable income into pure profit.
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Dealing with companies that invert in order to avoid the tax on repatriated income was the easy part, says Steven M. Rosenthal, a senior fellow with the Urban-Brookings Tax Policy Center in Washington. Rosenthal said he was pleased to see Treasury take some steps against abuse of the corporate inversion process, but pointed out that the new rules “did not tackle the full range of benefits U.S. companies get from a corporate inversion.”
The Treasury Department’s announcements failed to address a practice called “earnings stripping” — a different tax-avoidance practice by which U.S. firms are purchased by overseas companies which then “loan” them large amounts of money. Typically, the loans serve no practical purpose except to create a debt obligation for the U.S. firm, which allows it to deduct its interest payment from its taxable earnings.
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The effect is that money earned in the U.S., which would otherwise be taxable, is shipped overseas as interest payment on debts. U.S. affiliates of the foreign firms are thus able to subtract the payments from their taxable income — even, in theory, “zeroing out” U.S. tax liability.
Treasury on Monday asked for comments from the public on further efforts it might undertake to make corporate inversions less attractive, and earnings stripping was plainly on the agency’s radar screen.
However, Sen. Charles Schumer (D-NY), one of the most influential voices in Congress on the question, argued that the next steps are up to lawmakers. “The administration has made a good effort, but administrative action can only go so far,” Schumer said. “It’s clear that without legislation that stops earning stripping…this egregious abuse is likely to continue.”
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