Discourse.net

Policy makers want to attract foreign capital and business to the US. The Reagan Administration gave us a shameless example. Most countries impose tax on interest earned within their borders (unless mutually relaxed by a bilateral income tax treaty). The US rate is 30%. In 1984, to help US corporations burdened with higher borrowing costs as a consequence of having to compete against the voracious borrowing of the Reagan Administration, the US repealed the US tax on interest earned in the US by foreign investors. (At the same time, Reagan cut back your interest deduction.) Instantaneously, Manhattan was turned into the largest tax haven in the world. The enforceable tax bases of every country in Latin America disappeared overnight. But US companies got — and continue to get — cheaper borrowing!

Which gets us back to stripping. There is an unspoken assumption among many policy makers that we have to allow Honda and Toyota to reduce their US taxes by stripping in order to get them to open plants in the US. Apparently, the US otherwise is a bum deal. But, we can take US companies for granted. Under this analysis, inversions just involve turning US multinationals into foreign multinationals, which is OK, as it just eliminates the unfair US discrimination against its own companies.

Give ‘em an inch…..

The inversion alone saves no taxes, as the old US company continues to be taxed as before. (A good Treasury report is here: Treasury Inversion Report.) But, the inversion sets the stage for parking money offshore with US tax advantages. Most obviously, the new Bermuda parent and its foreign subsidiaries (not owned through the old US company) can earn foreign income free of US tax (until paid to US public shareholders as dividends). This benefit from inversions really is not that important, however, since real foreign income pays little US tax today (being parked in low-tax foreign corporations).

What is important is that foreign subsidiaries of the group now can get some US income — that’s US income — at a reduced or zero US tax. As noted in an earlier post, to prevent artificially parking movable income, like interest and royalties, in tax havens, current US anti-abuse rules tax this movable income of foreign subsidiaries of US corporations as earned by the foreign subsidiaries. After an inversion, the group can have foreign corporations that are not owned by a US company. So, after an inversion, the US operating corporation can pay interest or royalties to a foreign member of the group and get a deduction that reduces the US corporation’s (and, thus, the group’s) US tax, while the payee corporation is subject to low or no US tax. (One popular technigue for securing a low US tax on the payee uses our income tax treaty with Barbados, as discussed in an earlier post.) Moving US income offshore in a deductible fashion is referred to as “stripping” US income.

Patriotic, huh? Note that business defends inversions by saying that inversions are a reasonable response to the US taxing foreign income of US persons. In fact, as just noted, the real juice in inversions is from stripping US income.The really interesting (pun?) issue here is why the US hasn’t attacked stripping more forcefully. Tomorrow.

Under current financial accounting rules, when a company pays an executive with a stock option, the company is not required to show any expense (cost), ever. The executive may exercise the option and get millions of dollars worth of stock for nothing (that she then may sell for even more) and the corporation’s books say that the executive got nothing. All of the other shareholders got their percentage ownership of the company diluted, with an associated loss in value of their shares. A portion of the company’s assets has been transferred to the executive. The company gets an income tax deduction. But financial accounting says that the executive’s compensation cost the company nothing.

Business, particularly high-tech business, views the current accounting as a deity: There is no real cost, they say. Proper accounting would discourage innovation. Bad statements help US companies compete with their honest offshore rivals. It is hard to value stock-based compensation. Shameless nonsense! There are difficult timing and measurement issues involved, but these concerns are no excuse for never showing any cost.

The Financial Accounting Standards Board (FASB), the glorified trade association that the SEC lets sort of police accounting principles, considered changing these rules in the early 1990s. Senator Lieberman pushed through a Sense of the Senate Resolution that FASB’s authority would be rescinded if they did anything about stock options. FASB caved.

Many blamed the recent corporate scandals, like Enron, in part on stock option accounting: The accounting rules encouraged companies to pay executives with stock options. But, when most of an executive’s compensation is stock-based, that gives the executive an unhealthy incentive to focus on manipulating the price of the stock rather than managing the company’s business.

In February, FASB’s European competitor, the International Accounting Standards Board, required accounting for compensatory stock options. With this cover, in March, FASB again proposed more reasonable accounting rules here. And, this time, the House last month passed a bill that would reverse FASB. Hopefully, the Senate will resist the opportunity to once again put its imprimatur on misleading financial statements, but……

A few of President Bush’s tax cuts for the middle class phase down starting at the end of this year. (Yes, there is an over $11 billion a year tax increase, born mostly by the middle class, that takes effect in January. The politics leading to this are discussed in Michael Froomkin’s post, It’s Cynicism All the Way Down, on July 22, below.) All of Bush’s cuts in regular taxes expire at the end of 2010. The capital gains tax cuts expire at the end of 2008. (Dishonest budgeting is a topic for another day.) To extend all of these cuts from when they expire through the end of 2014 would cost at least $1.2 trillion. REALLY! $1.2 TRILLION! And breathtaking deficits are projected without an extension. This speaks for itself. (Or at least the silent political campaigns must so think.)

The second time bomb is the individual alternative minimum tax. This tax (in its current form) was enacted in 1986 to limit tax sheltering by the rich, but now is a misguided tax on the upper middle class, particularly those who live in states with high state and local taxes. For a good recent CBO report on this, go to CBO AMT Report . Bush’s tax cuts (although not the revenue numbers noted above) contained some minimum tax relief, but it sunsets at the end of this year. Historically, less than 1% of all individual taxpayers paid minimum tax. Next year, 11.6 million individual taxpayers (about 13% of all such taxpayers) will pay over $35 billion in minimum tax. These numbers will almost double in the following decade. Something must be done, but there is no money…

My numbers come from the CBO, the Joint Tax Committee Staff, and the Tax Policy Center.

His web site says a bit more:

Close Loopholes In International Tax Law That Encourage Outsourcing. Today’s tax law provides big breaks for companies that send American jobs overseas. Current “deferral” policies allow American companies to avoid paying American taxes on the income earned by their foreign subsidiaries and encourage them to keep their profits parked overseas, not reinvested in America. As president, John Kerry will end deferral that encourages outsourcing and will shut down other loopholes to make the tax code work for the American worker, not provide tax breaks for companies that ship jobs overseas.

Kerry is troubled by the ability of US corporations to defer a full US tax indefinitely by using foreign subsidiaries to do business in low-tax jurisdictions. Accordingly, he would look through these corporations and impose a current US tax as the subsidiaries earn money (reduced, of course, by a credit for any foreign taxes on those earnings). This is consistent with current financial accounting rules, as earnings of foreign subsidiaries are included immediately in the parent’s (consolidated) financial statements. (Although, as noted in a prior post, the US taxes on those earnings are not booked until the earnings are paid to the US parent as dividends.)

There is an important point in the Kerry website note: The US respecting foreign subsidiaries rewards outsourcing. By “outsourcing,” I mean a US business having an independent foreign business provide goods or services for the US business that, historically, the US business provided for itself. To the extent that (i) the independent foreign business is in a low-tax country and, this may be unlikely, (ii) those low taxes are reflected in lower prices from the foreign business, little can be done to reduce the US tax incentive to export. But, under current law, outsourcing makes it easier to move the extra profit in a multinational — which, in this context, most would view as profit attributable to non-asset intangible value, like know-how and non-patented technology — outside the reach of an immediate, full US tax. Kerry’s proposal to look through foreign subsidiaries would get at this incentive to outsource.

It is important to note that full look-through does not eliminate all incentives to move offshore. Most obviously, there still are problems from the averaging of foreign tax rates for purposes of the limit on the foreign tax credit. (This was discussed in an earlier post.) For example, a US business with operations primarily in high-tax countries still will be able to avoid all tax on some item of US income by moving the US income to a law-tax jurisdiction. Similarly, a US business with operations primarily in low-tax jurisdictions can move US income to a high-tax jurisdiction at no extra tax cost. These problems will be worse once the ETI bills become law, as they cut back on the 1986 restrictions on averaging.