The U.S. Tax Code and Its Impact on Global Competition

Corporate inversions bring up a range of emotion among those in the public policy world as they consider the state of our tax code. Inversions occur when a U.S. corporation acquires or merges with a foreign company, and restructures in a way to have that foreign entity become the parent of the U.S. company, which now becomes a subsidiary. One of the most noted examples of an inversion happened in 2014 when Burger King restructured to become a subsidiary of Tim Hortons Inc., a Canadian corporation. This allowed Burger King to access capital and remain competitive in light of the U.S.’s comparatively high corporate tax rates.

On one side of the debate, inversions are seen as the symptom of an unfair and broken corporate tax system that punishes U.S. corporations, rewards foreign multinationals over domestic multinationals, and prevents U.S. multinational corporations (MNCs) from competing on a level playing field with their foreign-based MNC counterparts. Under this view, MNCs are seeking to level the playing field with foreign businesses by operating under friendlier tax laws.

On the other side of the debate, inversions are viewed as an “unpatriotic” way for corporations to cheat the tax system and avoid paying their “fair share.” The proposed solution is to enact anti-inversion rules and create stricter tax laws and regulations in order to prevent inverted companies from avoiding taxation (and moving jobs and investments overseas). One leading proponent of this view, the Ivadelle and Theodore Johnson Professor of Law and Business at the University of Southern California, Edward Klienbard, dismisses the idea that the current tax code places U.S. MNCs at a disadvantage relative to their foreign competitors. He argues that U.S. MNC do not increase their global competitiveness by inversions and thus only erode the corporate tax base.

Klienbard detailed his reasoning and research in a 2014 article, which continues to serves as a guidepost for many left-of-center experts and politicians. Klienbard argues, “U.S. companies are not at a disadvantage from either a financial accounting perspective or a cash flow perspective.” This line of argument appears in numerous research papers, and was even hinted at in a Ways and Means Hearing last week on corporate tax based erosion.

However, this line of thinking and the claims made by Klienbard are difficult to fortify with empirical, proven evidence. Klienbard cites a number of studies in his article, but as noted by Michael Knoll, the Theodore K. Warner Professor of Law at the University of Pennsylvania Law School, “the inversion situation is more nuanced, complex, and ambiguous than Edward Klienbard acknowledges.”

In Knoll’s new study entitled Taxation, Competitiveness, and Inversions: A Response to Klienbard , Knoll outlines Klienbard’s arguments and challenges his claim that U.S. MNCs are not disadvantaged when compared to foreign rivals. Knoll shows in his study that the current tax system encourages inversions and that they allow U.S. corporations to be more competitive in the global market, and even in the domestic market in several different ways.

First, since when a corporation that is based abroad shifts income out of the U.S., that income permanently escapes obligation to pay U.S. taxes. But, when a U.S. corporation shifts income from the U.S., taxes on that income are essentially deferred until it is repatriated. Thus, a U.S. corporation can opt to become a subsidiary of a foreign corporation, move funding out of the U.S. without taxes, and reinvest in the U.S. without facing taxes on repatriated funds.

Second, Klienbard insists that the overall effective tax rate (ETR) of U.S.-based MNCs are as low as those faced by non-U.S. based MNCs. Knoll notes studies by Markle-Shackelford and PricewaterhouseCoopers (PwC) showing that U.S. based MNCs face either the “second highest (Markle-Shackelford - 25.9 percent) or the third highest (PwC - 27.7) average global ETRs.” Knoll finds that U.S. MNCs do generally face a higher ETR than non-U.S. when comparing the average global effective tax rate of U.S. based MNCs with their foreign counterparts in each one of several market-oriented countries. This way of comparing their taxes, as opposed to just looking at global averages, provides a more accurate measurement of the tax environment faced by businesses that operate internationally. Thus, U.S. MNCs could stand to benefit from inversions. Moreover, Knoll cites a number of case studies that conclude there were tax savings for a number U.S. based MNCs that inverted and lowered their global ETR.

Finally, Knoll refutes Klienbard’s argument that non-U.S. based MNCs are under stricter anti-abuse rules than U.S. based MNCs, and thus might face higher taxes. Knoll suggests that this observation is not supported by data or research and that the qualifying language used by Klienbard fails to prove that non-U.S. MNCs face stricter anti-abuse rules. He concludes that “Klienbard’s strong claim that competitiveness arguments for inversion are baseless is itself only conjecture and is inconsistent with the weight of evidence.”

Knoll’s detailed study shows that inversions are not simply an attempt to avoid paying taxes, but are the symptom of a punitive tax code that hinders U.S. based MNCs from competing globally. The current tax code drives U.S. based MNCs to seek shelter through inversions. The tax code should not grant preferential treatment to non-U.S. based MNCs over U.S. MNCs, or cause U.S. business to have to compete globally on an unlevel playing field. Tax reform must address these issues by lowering the tax rate, moving to a territorial tax system, simplifying the code, and encouraging U.S. business to stay and invest in the United States.