Last month Milwaukee-based Johnson Controls became the latest American firm to move overseas in pursuit of tax savings. Politicians of all stripes decry these moves, but they have radically different ideas about what to do about them.

Johnson Controls is renouncing its US corporate citizenship by selling itself to Tyco International, domiciled in Ireland, in a deal valued at $14 billion. The move, called a corporate inversion, is the restructuring of an American company’s corporate form such that it becomes a foreign corporation based in a country with low corporate taxes. It is legal and has become a popular way for American companies to reduce their domestic tax payments.

By moving its headquarters to Ireland, Johnson Controls will pay a corporate tax rate of 12.5 percent and reduce its tax bill by at least $150 million annually. About 50 companies have inverted in the past decade and more are expected to vote with their feet.

These deals allegedly reflect the United States’ failure to change the corporate tax code to make it more attractive for American companies to stay that way. The statutory corporate tax rate of 35 percent (39.1 percent when combined with state rates) is unchanged since 1993 and is the highest among industrialized countries.

The federal government taxes all companies doing business in the U.S. on the income they earn here. It also taxes American firms on their foreign income. This is called a worldwide income tax system. Many countries only tax income generated inside their borders. Because they tax their residents (regardless of citizenship) only on domestic income, such countries are said to use a territorial income tax system.

America is now alone among developed countries in taxing the worldwide income of its corporations. This is in addition to the taxes they pay to foreign governments, but American firms are permitted to avoid double taxation by claiming credits for foreign tax payments.

American companies are also permitted to defer domestic tax liabilities on certain unrepatriated foreign profits until they actually receive such profits in the form of dividends. It is estimated that U.S. firms are keeping roughly $2 trillion in profits abroad to reduce their taxes. If an American citizen tried to play the same game of hide and seek, he or she would be in big trouble with the Internal Revenue Service.

When it comes to arguments in support of lowering the corporate rate, cheerleaders never tire of telling the public that American companies can’t compete in a global economy when they are handicapped by the highest corporate tax rate in the developed world. They argue that a significant reduction in the corporate tax rate would improve America’s competitive position, stem the tide of companies leaving the country and perhaps even reverse it by giving foreign corporations an incentive to locate and invest in the U.S.

Overlooked in these arguments is the fact that while on paper American companies are supposed to pay the 35 percent federal income tax rate, the country’s most successful companies pay at just a 19.4 percent rate after accounting for tax credits, deductions and exemptions, according to the Citizens for Tax Justice. If true, this certainly undermines the primary argument for reducing the corporate tax rate.

Neither Democrats nor Republicans like inversions, but they disagree on what to do about them. The former see the issue as one of corporate abuse and want strong rules to stop the exodus of tax dollars; the latter see it as the result of high corporate tax rates and argue for an overhaul of the corporate tax code.

As with so many issues today, you would be right to conclude that achieving consensus on how to halt corporate inversions is the equivalent of cleaning out the Augean stables with the horses still in them.

originally published: February 2, 2016

Every political season brings new issues and controversies. One of the big ones this time around is “corporate tax inversions.” Unfortunately, the trend is a symptom of a bigger problem that will require the kind of long-term solution that is rarely crafted in even-numbered years.

In business terms, inversion is the restructuring of a U.S. company’s corporate form such that it becomes a foreign corporation based in a country with low corporate taxes, basically turning the corporate structure on its head. American multinational corporations undertake these transactions because the top U.S. corporate tax rate of 35 percent is higher than in many other countries and the U.S. taxes worldwide income at a time when foreign income is increasing substantially.

One example is Medtronic Inc.’s recent agreement to buy Covidien for $43 billion. The move enables Medtronic to domicile to Ireland, take advantage of low corporate tax rates and access its overseas cash without having to pay high repatriation costs.

These inversion deals allow American corporations to reduce their average combined federal and state corporate tax rate of 40 percent. This rate is one of the world’s highest, double the European average more than triple the 12.5 percent rate in Ireland. Over the past 25 years, almost all countries in the Organization for Economic Cooperation and Development except the U.S. have lowered their top corporate tax rate.

The increased number of American firms that have incorporated abroad to reduce their tax burden has prompted a series of congressional hearings, where representatives can express their frustration and anger at maximum strength about firms reducing the U.S. corporate income tax base. The Joint Committee on Taxation estimates that future deals will cost the U.S. almost $20 billion in corporate tax revenue over the next 10 years.

The flurry of inversion deals has also angered President Obama, who has said the practice is “wrong” and urged Congress to close the loophole.

High corporate tax rates are not the only problem. What is frequently overlooked in these contentious discussions is that the United States, unlike many other countries, employs a worldwide taxation system, taxing corporate foreign income at the same rate as domestic income while permitting corporations to claim limited tax credits for income taxes paid to foreign governments to mitigate the possibility of double taxation.

By anyone’s standards the U.S. has a very complex tax code. Corporate tax reforms must recognize global economic changes and resolve the fundamental contradictions in the current corporate income tax structure.

All this strongly suggests that truly solving the problems created by the current corporate tax regime requires a long-term fix and cannot be solved unilaterally by the U.S. Some second-order benefits may be gained by plugging specific loopholes, but a real long-term solution requires better international coordination of tax rules to minimize tax avoidance activities by multinational corporations.

Not too long ago, a corporation could be successful by focusing on making and selling goods and services within its national boundaries. Profits earned from exporting products were considered frosting on the cake but not really essential to corporate success. That is no longer the case, and the U.S. needs to reform its corporate tax code to reflect this new reality.

originally published: August 2, 2014