New research claims benefits of inversions often outweigh costs.
American companies are increasingly moving to foreign countries to reduce their tax bills. This practice, called corporate inversion, involves moving a corporation’s headquarters to a country with corporate tax rates lower than those of the United States. Policymakers are worried that inversion allows companies to enjoy the benefits of doing business in America while avoiding the costs, eroding the U.S. tax base in the process. Despite policymakers’ concerns, a recent study suggests U.S. corporations will continue to look for opportunities to move overseas because the benefits of inversion often outweigh the costs.
A report from business professors Felipe Cortes of Northeastern University and Armando R. Gomes and Radhakrishnan Gopalan of Washington University in St. Louis identifies two crucial issues a firm must consider when deciding where to incorporate: the tax rate payable on the parent company’s profits, and the applicable corporate law. These factors may determine whether it makes good business sense to become an American Company with Foreign Incorporation (AFC) or to remain a U.S. firm.
The authors examined 240 AFCs and compared them to a control group of comparable U.S.-incorporated companies. They measured the effects of foreign incorporation by looking to the effective tax rates of the firms, the degree of leverage of the firms (the cash balance as a proportion of total assets), the amount of attention the firms attract from analysts, and the value investors place on cash held by the firms.
Cortes and his co-authors found that AFCs had a 7% lower effective tax rate than the control group of U.S.-incorporated firms. In some “tax havens,” such as Bermuda, the Cayman Islands, and Ireland, the effective rate can be as low as 0%. In addition, many foreign countries have territorial tax systems, where only income earned within their borders is taxed. The U.S., on the other hand, currently taxes the worldwide earnings of a company incorporated in the U.S. This is a major reason why a U.S. company might decide to invert.
Still, Cortes and his co-authors found inverting corporations may face significant costs because of the corporate laws in the country where they choose to relocate. This is because countries where AFCs are incorporated generally have weaker rule of law indexes compared to the United States. The authors note these indexes, promulgated by the World Bank, refer to “the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence.” Weaker rule of law means weaker protection for outside shareholders.
In addition, the authors found that AFCs exhibit significantly lower leverage rates than U.S. companies (22.7% higher cash balance as a proportion of total assets). AFCs further face a higher “bid-ask spread” for their stock (the difference in price between the highest price that the buyer is willing to pay and the lowest price at which a seller is willing to sell). According to the authors, AFCs also garner less analyst following, meaning investors perceive an “element of opaqueness” about AFCs and are reluctant to hold and trade in their stock. This results in AFCs’ cash being valued below U.S. companies’ cash. Further, AFCs generally have higher cash balances and pay fewer dividends than U.S. firms.
Despite calls from some members of Congress, including the Chairman and Ranking Member of the Senate Finance Committee, no legislation to address inversions has been passed, leaving the Obama Administration to rely on agency-level regulations. President Obama recently called for curbing corporate inversions in the name of “economic patriotism.” Treasury Secretary Jack Lew sent a letter to Congress expressing the same sentiment, urging them to take legislative action on inversions.
Currently, the U.S. tax code requires that an inversion can take place only if the owners of the American company seeking inversion will own less than 80% of the resulting firm. The U.S. Department of the Treasury recently announced plans to slow the growth of inversions. Among these steps are proposals that would make it harder for companies to find a suitable merger partner. This means that a U.S. corporation must find a foreign merger partner around one-quarter of its size, which is not an easy task.
Some policymakers, including Senator Charles Schumer (D-NY), have called for measures to stiffen the ownership requirement, which the U.S. Department of the Treasury announced it would do. Additionally, companies may have to pay an exit tax in order to invert. This could raise the cost of inversion, making it too expensive for some firms to reincorporate.
While new regulations may affect the calculation for some firms, Cortes and his co-authors conclude that corporate inversions are likely to become more common because they often make good business sense. Moreover, increasing competitive pressures drive many companies to consider moving overseas. Some countries that rank well in terms of rule of law, including the U.K., Canada, and Switzerland, recently adopted territorial taxations systems to entice prospective companies to reincorporate. Furthermore, many American start-ups are incorporating overseas to start, so laws designed to regulate existing companies may do little to slow the trend of U.S. corporations moving cash beyond the reach of the IRS.
