Unintentional Tax Humor on the Inversion Scam at Forbes

While you’ve all been busy being distracted by the strife in Gaza and Ukraine, or perhaps more sensibly decided to tune out and enjoy the summer, various not so pretty developments have been moving forward with alacrity in the US. One is a spate of so-called “inversion” deals, in which corporations use acquisitions to move their headquarters overseas, which allows them to arrange their affairs so as to greatly lower their tax bills. The latest group of companies to try this ruse are in the health care industry, brandishing the excuse that if they fail to follow this dodgy practice, they won’t be competitive.

Kenneth Thomas has been on this beat at Angry Bear. Here’s a short overview of how inversion deals work earlier this week:

Corporate “inversions” are back in the news again, as multinational corporations try every “creative” way they can to get out of paying their fair share of taxes for being located in the United States. With inversions, the idea is to pretend to be a foreign company even though it is physically located and the majority of its shareholders are in the U.S.

“What’s that?” you say. At its base, what happens with an inversion is that a U.S. corporation claims that its head office is really in Ireland, the Cayman Islands, Jersey, etc. Originally, all you had to do was say that your headquarters was abroad. Literally.

Now, the rules require you to have at least 20% foreign ownership to make this claim, but companies as diverse as Pfizer, AbbVie, and Walgreen’s are set to run rings around this low hurdle. The basic idea is that you take over a smaller foreign company and pay for it partly with your own company’s stock to give the shareholders of the foreign takeover target at least a 20% ownership stake in your company.

Thus, with pharmaceutical company AbbVie’s takeover of the Irish company Shire (legally incorporated in the even worse tax haven Jersey), Shire’s shareholders will own about 25% of the new company, thereby qualifying to take advantage of the inversion rules. It expects that its effective tax rate will decline from 22.6% in 2013 to 13% in 2016. Yet nothing will actually change in the new company: it will still be headquartered in Chicago, and the overwhelming majority of shareholders will be American.

As David Cay Johnston points out, even some staunch business advocates like Fortune magazine are calling this tax dodge “positively un-American.” Further, as he notes, Walgreen’s wants to still benefit from filling Medicare and Medicaid prescriptions even if it ceases to pay much in U.S. corporate income tax. In other words, it will get all the benefits of being in the U.S., including lucrative government contracts, without paying for the costs of government.

Yves again. Not surprisingly, the media is starting to feature some strained defenses of these inversion transactions, and Thomas gave one the dressing down it deserved.

By Kenneth Thomas. Originally published at Angry Bear

David Cay Johnston emailed me that there were errors in Forbes contributor Tim Worstall’s recent criticisms of the linked article. Indeed there are, but the biggest one (or at least the funniest one) isn’t the one Johnston pointed me to.

Worstall writes that AbbVie’s pending inversion will not, by itself, reduce the taxes the company owes on its U.S. operations, though it could be a preparatory move to drain profits from the United States. I’ll come back to that point, but Worstall then gives the example of how AbbVie might sell its patents to a foreign subsidiary and pay royalties to that unit, thereby draining U.S.-generated profits to a tax haven subsidiary, for instance Bermuda (though Ireland is more germane in the real world for intellectual property). But then comes the zinger:

However, do note something else that has to happen with that tactic. That Bermudan company must pay full market value for those patents when they are transferred. Meaning that the US part of the company would make a large profit of course: thus accelerating their payment of tax to Uncle Sam. This tax dodging stuff is rather harder than it sometimes looks: if you’re going to place IP offshore you can do that, certainly, but you’ve got to do it before it becomes valuable, not afterwards. [link in original]

“Must pay full market value”? I’m falling off my chair! It’s like Worstall doesn’t think transfer pricing abuse exists. If patent, copyright, and other intellectual property transfers had to be made at full market value, they would never happen. As I explain in the linked post, academic research has shown that transfer pricing abuses, in this case underpricing the intellectual property transferred from the United States to Bermuda (again, really Ireland), are quite common when no arm’s-length market exists for a good. Since companies aren’t going to sell their crown jewels to strangers, how can a tax authority know what will be a fair price for a Microsoft patent going from the U.S., where it was derived, to its Irish subsidiary?

Let’s be a bit more precise. What would it take for Apple to buy all of Microsoft’s patents? In return for whatever lump sum Apple paid, it would need the equivalent back in terms of the present value of all Microsoft’s future royalty payments. But if Microsoft sold its patents to its Irish subsidiary at that price, Worstall would be right that there would be no tax benefit. And it’s not like it’s cost-free to organize such a transaction. Not only would Microsoft incur the costs of drawing up the contract and so forth, but nowadays companies are taking reputational hits as a result of their tax shenanigans: Ask Starbucks, Google, and Amazon. So if the transaction created no true savings, yet hurt a company’s reputation, we know that it wouldn’t make the transaction. The fact that multinationals are flocking to sell their intellectual property to Irish subsidiaries where the royalties are tax free tells us that the transfer price is not the “full market value” Worstall claims.

Moreover, contra Worstall, it isn’t a question of transferring the intellectual property before it’s valuable. If you’re a multinational drug company, you can make estimates of FDA approval, how much you think a drug will earn, and so forth. And you’ve got inside information! To take the simplest possible example, let’s say AbbVie has two drugs it thinks are each 50% likely to generate revenues with a present value of $500 million each. If you believe Worstall, it will sell one of the patents to its Bermudan subsidiary for only $250 million. But it will sell its other patent for another $250 million, so the supposed cost will still be $500 million and the subsidiary will expect to earn revenues equal to a present value of $500 million off whichever drug turns out to be successful. It’s inescapable that there is no point for a multinational company to sell the patent to its subsidiary at a fair price. There would be no tax benefit, and we wouldn’t be seeing Microsoft with $76.4 billion offshore or Apple with $54.4 billion offshore in 2013. Or a total of $1.95 trillion for 307 companies. Heck, even AbbVie has $21 billion permanently reinvested offshore, according to its 2013 Annual Report (downloadable here), p. 93. “Full market value,” indeed.

Finally, a note on Johnston’s and Worstall’s main dispute. Worstall argued that an inversion does not reduce the tax that a U.S. subsidiary would owe to the United States, noting that you can drain profits (except, as we saw, he doesn’t really believe you can drain profits) from the American subsidiary as long as you have a tax haven subsidiary, i.e., you don’t need inversion for that.

From a very narrow point of view, this is correct. But what Worstall overlooks is that, for the U.S., worldwide taxation substitutes for a general anti-avoidance rule making avoidance itself illegal, which is the approach most other industrialized countries take. Inversions make it impossible to police avoidance, so they indeed threaten tax collections from U.S. subsidiaries. But one might argue that deferral has almost completely neutered the benefit from worldwide taxation already. The bottom line is that the United States needs an end to deferrals at least until it adopts strong anti-avoidance rules, at which point it would only then be possible to discuss ending worldwide taxation.

But all of that will be for naught if we allow ourselves to be seduced by silly claims about how transfer prices have to be the same as “full market value.”

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  1. pebird

    Since we have a few tax experts around (I assume), I was wondering …

    Are professional sports teams’ player trades taxable transactions?

    I mean, I am supposed to pay tax on a barter transaction – especially if the IRS finds out. Was wondering how/if that applies to, say, a baseball trade?

    1. John Glover

      I’m not an expert on this, but I know the basic rules. Section 1031 of the internal revenue code provides that if parties exchange property of “like-kind,” gain or loss is not recognized on the exchange. If money or other property is involved, gain has to be recognized to the extent of the value of the other property. The IRS has ruled that a trade of player contacts qualifies as a like kind exchange.

      Of course, gain is recognized only if the contract has value. If the player is being paid his full market value (or more because his skills have declined) presumably there is little or no gain to be recognized. The big issue in any exchange of property for property is what is the value of the items being exchanged. If you swap a player contract for a player contract, the issue is moot. But throw in some cash or draft picks and things start to get hairy.

      I assume draft picks are not of like kind with player contracts, so they would have to be valued and gain or loss recognized.

  2. Linda / Chicago

    …then those newly-relocated pharmaceutical companies will continue to sell their wares to American markets at a higher price than they would be able to receive in the ROW (rest of world). Incredible!

  3. Robert Frances

    Wasting time trying to figure out a corporation’s “fair” income tax is a fool’s game for many reasons.

    1) Corporations (and other businesses) do not “pay” tax; only humans pay tax. Any tax imposed on a corporation (or other business entity) is paid by the customers (most often), its shareholders (most likely if the business can’t raise prices for competitive reasons), or is “paid” by its business executives, employees and/or suppliers in the form of reduced compensation.

    2) A tax on a corporation’s profits is the stupidest tax possible since any decent-sized company has operations in many states and/or many countries. Trying to allocate where the revenue should be sourced or where the expenses should be allocated, or trying to apportion income and expenses to a complex web of inter-connected subsidiaries is a silly game. Give 100 reasonably competent tax accountants and economists the same financial data for a medium-sized or larger-sized company and you’ll get 350 different answers for what the “true profit” is in any particular country or state. This is because there are innumerable assumptions needed on how to allocate and apportion income and expenses for cross-border transactions. If you add in the desire to minimize tax expense in high-taxed countries (and states) and maximize profit in low-tax countries (and states), and include some economists and tax lawyer advisers into the mix who can provide documentation and studies (paid for by the tax-minimizing corporation) to justify the income and expense allocations, then the financial results reported for the various taxing jurisdictions will be even more convoluted.

    3) The incentive to transfer profits to low-tax locations and transfer expenses to high-tax locations is greatly increased with higher corporate tax rates. If the combined state and federal tax rate is 40%, every dollar allocated outside the US to Netherlands, Cayman Islands, Hong Kong or Singapore could be a 40% ROI. The corporate tax system, ironically, has become a profit center for larger, complex businesses, especially those formed in the last 10 years as more sophisticated tax techniques have become widely known. Apple is subject to a 35% federal tax rate, but Google and Facebook are subject to a 5% federal tax rate since their ownership structure (Double-Dutch Irish sandwich) is very tax-efficient and because their very valuable technology was transferred overseas long before the companies had significant sales or profits, thus reducing the tax cost of the technology transfers.

    Corporations may not “pay” tax, but they are very efficient tax collectors, assuming it’s a tax that is not easily avoided by cross-border shenanigans such as the corporate income tax. In contrast, a tax on business gross receipts in a particular location (country or state) is not easily avoided. Anyone who would like to see corporations and large businesses pay more of the tax burden should be pushing for a tax based on gross receipts and shouldn’t waste one bit of energy trying to make the corporation profit tax more “fair.”

    1. jrs

      I’ve never personally seen why a corporate tax was preferable to say a tax on shareholders, maybe above 15% ha.

  4. different clue

    Could corporations which do this be de-chartered? Is there anything in their charters of permission to incorporate and exist and in corporate law which definitively says that they can NOT be de-chartered for this behavior? If not, is anyone looking at movements or cases to de-charter such corporate absconders? If the relevant legal authorities “could” decharter corporations for doing this but are not dechartering such corporations, can they be sued over their failure to decharter tax-runaway corporations?

    1. Carla

      Because corporations are persons with constitutional rights, and money equals the first amendment right to speech, corporations have bought every branch of government making corporate charters rather beside the point. But you could look into http://www.WeThePeopleAmendment.org to consider a solution to this problem.

      The amendment basically states that only human beings, not corporate entities of any kind (for-profit, non-profit, union, ETC.), are entitled to constitutional rights, and money does not equal speech.

      Does it solve everything? Definitely not. However, very few solutions, if any, are possible without it.

  5. ChrisPacific

    If they really are transferring IP at full market value, how about a regulated clearing period with a right of third party purchase? For example:

    – I want to transfer patent A offshore to a subsidiary for $20 million. I declare as much in a public filing based on certain disclosure requirements.
    – I now have 60 (or 30, or 90) days before the transfer becomes final. During this time, if anybody offers to buy patent A for, say, 25% over the transfer price ($25 million) then I must accept the offer.

    If the transfers are really occurring at full market value then this would not be an impediment, as the company would be receiving a premium over market value and would obviously be happy to make the deal.

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