Is the US corporate tax system ripe for an overhaul?

A growing number of American companies are seeking to move their legal headquarters abroad by acquiring or merging with foreign companies. In the latest case, Medtronics plans to acquire Irish-based Covidien, a much smaller company spun off by US-based Tyco, and move its legal headquarters to low-tax Ireland, culminating in the largest ever “inversion” or “redomiciliation” of a US company. Walgreens is reportedly considering moving its headquarters to the United Kingdom by acquiring the remaining public shares of Alliance Boots, the Swiss-based pharmacy giant.

Such deals reflect the deep flaws in the American corporate tax system. The US has the highest statutory corporate tax rate among developed countries and is the only G7 country clinging to an outmoded worldwide tax system under which the foreign profits earned by US-headquartered companies incur additional domestic taxes when they are repatriated.

By contrast, all other G7 countries have adopted “territorial” systems that impose little or no domestic tax on the repatriated earnings of their global companies. This difference puts US-headquartered multinationals at a disadvantage relative to their foreign competitors in foreign locations. To offset this, US multinationals take advantage of a deferral option in US tax law.

Deferral allows them to postpone, potentially indefinitely, the payment of US corporate tax on their foreign earnings until they are repatriated. Not surprisingly, as their foreign earnings have grown as a share of total earnings, and as foreign corporate tax rates have plummeted, US companies’ stock of foreign earnings held abroad has soared, now topping $2 trillion.

The US system thus implies significant costs, as companies hold more cash abroad, borrow more to finance domestic cash requirements, and invest more in foreign locations. Deferred earnings are “locked out” of the US economy: the government receives no tax revenues from them, and they are not directly available for domestic use by US companies. This undermines their ability to compete with foreign companies in acquiring other US companies. It also makes investments by US shareholders in domestic companies less attractive relative to investments in foreign companies that can distribute their foreign profits in the US without an additional tax penalty.

Overall, deferral distorts corporate balance sheets, imposing efficiency costs on US companies that are estimated to be 5-7% of deferred earnings. As the stock of deferred earnings grows, these costs accumulate, and moving legal headquarters abroad through cross-border acquisitions becomes a logical step for US companies with a large stock of deferred earnings abroad. Companies like Medtronics can then use future foreign earnings in the US with little or no repatriation tax. Such companies have a strong incentive to relocate abroad, even to finance their US investments.

To be sure, strategic rather than tax considerations drive corporate mergers and acquisitions. The recent surge in cross-border M&As, to a seven-year high, is the result of ample cash, strong balance sheets, cheap financing and buoyant stock markets. But tax considerations play a major role in corporate decisions regarding how acquisitions are financed and where a merged entity is located. Large balances of foreign earnings are available to many US firms to finance their foreign acquisitions, and the competitive disadvantages of the US corporate tax system militate against locating the merged entities in the US.

Though American officials rail against “inversions” as unpatriotic, they are an efficiency-enhancing response to the flaws in the corporate tax system. As the prospects for corporate tax reform deteriorate, cross-border mergers with re-domicilation are becoming an attractive option for many of America’s most competitive global companies. And the pressure on other companies to follow suit intensifies as more inversion deals are done.

Under current law, US companies can move their legal headquarters abroad for tax purposes by buying a smaller foreign company, as long as the acquired company’s shareholders end up owning at least 20% of the combined company. To discourage inversions via cross-border M&A, President Barack Obama’s administration and several Democratic members of Congress have proposed legislation that would increase that percentage to at least 50%.

Moreover, a merged foreign company would be treated as a US company for tax purposes (regardless of share ownership) if its management, control functions and a substantial share of its economic activity (sales, employment, or assets) are located in the US. If enacted, the legislation would apply these new conditions retroactively to inversions occurring from May 2014.

Such policies will not address the underlying causes of inversions, will add to the widely acknowledged distortions in the corporate tax regime, and are likely to have negative unintended consequences. To meet the tougher new ownership requirements, US companies might respond by breaking up their business units into smaller pieces – reducing their market value and the returns to their shareholders and workers. Likewise, to meet the tougher new management and control conditions, US companies might respond by shifting more of these functions, and the jobs and investment associated with them (especially in research and development), to foreign locations.

The proposed anti-inversion measures would also make it more likely that US companies are the target, rather than the acquirer, in cross-border M&A deals. Corporate tax reform should make the US a more attractive place for business activity; threatening US corporations with tougher rules on cross-border M&A and retroactive tax increases will have the opposite effect.

The US should learn from the British example. In 2008, several large UK companies threatened to redomicile in Ireland because of its lower corporate tax rate. The British government responded by cutting its corporate tax rate from 28% to 20% by 2015; introducing a territorial tax system that exempts UK-based companies’ foreign earnings from domestic taxation; enacting a “patent box” that provides a 10% corporate rate on patent-related income; and adopting a new 10% non-incremental, refundable R&D tax credit. So far, these innovations appear to be attracting companies, investment, R&D and jobs to the UK.

Bold and prompt US action to reform the corporate tax system is essential. Sadly, that is not likely with a deeply divided Congress in an election year.

Author: Laura Tyson is an economic adviser to the Alliance for Competitive Taxation, an independent group of US companies committed to corporate tax reform.

Image: A picture illustration shows U.S. 100 dollar bank notes taken in Tokyo August 2, 2011. REUTERS/Yuriko Nakao