If you thought there was a problem with inversions — deals that allow American companies to relocate their headquarters to lower their tax bills — wait until you hear about the real secret to avoiding corporate taxes. It’s called earnings stripping, and it is a technique that the Obama administration has so far failed to stop.
The public outcry over the use of inversions is now entering its third year. Pfizer is trying the biggest one yet, a $152 billion deal for Allergan, the maker of Botox, which is based in Dublin. The flight of American icons like Pfizer has led to complaints that corporations are gaming the system to lower the taxes they pay to Washington. At the same time, the companies stay in the United States, getting all the benefits of our country. But the tax games don’t stop with a relocation to Ireland, Britain or anywhere with a lower corporate tax rate than the United States.
The real gains from an inversion can come from earnings stripping, and here’s how it works:
A company completes an inversion deal and moves its headquarters for tax purposes outside the United States. The now-foreign company still has operations in the United States. These American operations are still taxed in the United States and pay taxes here.
The point of the inversion, of course, was to reduce taxes as much as possible. So, the company arranges for the United States parts of its operations to borrow large amounts of money from the now-foreign parent. The indebted American subsidiary will pay interest on that debt to the parent. Under the United States tax code, the interest payment can be used to offset the American earnings.
Voilà! The earnings of the company are now offset by these interest payments. What used to be a significant tax bill disappears.
To be fair, the earnings-stripping option is available to any foreign company with earnings in the United States.
But it does appear that American companies that have inverted are particularly poor expatriates, willing to take aggressive acts to exploit this tax loophole. A 2004 study of 12 corporate inversions [by James Seida] found evidence that after inversion, companies engaged in earnings stripping. The authors found that four of the companies had engaged in almost 100 percent earnings stripping, costing the United States Treasury roughly $700 million over two years. The authors also concluded that “most of the tax savings” found in corporate inversions was attributable to this earnings stripping.