Pfizer, the large American pharmaceutical company, formally announced on Monday that it will buy Allergan, an Irish company with about one-tenth Pfizer's revenue. Except legally speaking, Allergan is going to be buying Pfizer. And legally speaking, the new company's headquarters is going to be in Dublin even though its "operational" headquarters will be in New York — right where Pfizer is located today.
The
reason? Tax avoidance. Having Pfizer become an Irish company will reduce its
tax bill a decent amount in practice and a huge amount in accounting terms,
making it easier for money to flow out of the corporate treasury and into the
pockets of shareholders.
Hillary
Clinton denounced the deal as a rip-off for US taxpayers, and in a statement
Bernie Sanders went even further and said, "The Obama administration has
the authority to stop this merger, and it should exercise this authority."
Hillary
Clinton blasts Pfizer-Allergan Merger: These kind of deals "will leave
U.S. taxpayers holding the bag."
Welcome
to the exciting world of what are known as "tax inversions" — an increasingly common practice
whereby American companies become foreign ones in order to evade the grasp of
the IRS.
How and why tax inversions work
One
key motivation for tax inversions is that the United States, unlike other
developed countries, attempts to tax US-based corporations on all
their profits regardless of where in the world the profits were earned.
Companies get to deduct the corporate income tax they pay to foreign
governments for their foreign profits, but since the US has a higher corporate
income tax rate than most foreign countries, that generally leaves a residual
tax bill.
So
if a US-based company can become a subsidiary of a company headquartered in a
low-tax jurisdiction like Ireland, then it can avoid paying a bunch of taxes on
sales made in foreign countries.
Pharmaceutical companies can do a lot of dodgy tax stuff
For
some companies, the inversion story is a pretty basic case of taxes paid on
foreign sales. But for companies in a handful of industries — most notably
pharmaceuticals and high tech — there are additional gains.
That's
because a huge share of the value of a pharmaceutical company is tied up with
its drug patents. By assigning ownership of the patent to a subsidiary located
in a low-tax jurisdiction and then having subsidiaries in higher-tax
jurisdictions license the patent from it, a pharmaceutical company can ensure
that profits accumulate in low-tax countries even if sales happen in high-tax
countries.
The US treats "offshore" profits in a weird way
In
theory, the US taxes all profits, whether they are earned at home or
abroad. But there's a catch: The tax is only due to the US Treasury Department
when the money is actually "brought home" from the foreign subsidiary
back into the US-based parent company. Before that, the cash is considered to
be offshore (note that the money may well actually be in a US bank account or
other financial institution — it's a question of ownership, not location), and
the taxes owed may be deferred.
Companies
generally hold money offshore because they are hoping some future Congress will
cut corporate income tax rates or pass some kind of repatriation amnesty that
will let them bring the money back onshore at a low tax rate.
But
as long as the taxes are being deferred, for accounting purposes the company has
to act as if it eventually plans to pay the full taxes due on its foreign
profits. By becoming an Irish company, Allergan can dispense with that pretext
and fully make its paper earnings look vastly larger. But it also makes a
difference in a practical sense. Before Pfizer can hand cash to its
shareholders in the form of dividends, it needs to bring it onshore and pay
taxes. An inversion will cut taxes on money used for that purpose, as well as
improve the company's paper profits in accounting terms.
The White House has a plan to curb inversions
The
White House actually wrote an inversion proposal into the budget it released in
March 2014. The original proposal would have made inversions more or less
impossible and would have retroactively penalized inversions completed earlier
in the year. But those proposals would have required legislation to pass
Congress, and the Republicans who run Congress have no interest in raising
taxes on American businesses.
Last
fall, Treasury instead released a broad suite of new rules and interpretations of
rules that make
inversions more difficult. These rules generally would make it harder for an
inverting entity to shift funds around various subsidiaries for tax purposes, and
would also strengthen enforcement of anti-inversion rules adopted in previous
decades.
But
as the Pfizer-Allergan deal makes clear, absent new legislation this sort of
thing is going to keep happening.
Corporate income tax reform is the dream that never dies
The
United States has more or less the highest official corporate income
tax rate in the world,
but it's so full of loopholes that very few companies pay anything close to the
official rate. This is widely regarded as a lamentable situation, and there is
overwhelming political consensus around the idea that the corporate income tax
code should be reformed. The broad idea is that the rate should be brought down
but loopholes should be closed. The resulting system would treat different
companies more similarly and should help US-based firms compete in global
markets.
Corporate
tax reform keeps not happening, however, for two reasons.
One
is that there's big-picture ideological disagreement between Republicans and
Democrats over whether the goal of reform should be to raise more tax revenue
or less. Everyone agrees that the current code is bad. But absent consensus
about revenue targets, it's hard to build a coalition for reform. The other is
that while it's easy for everyone to agree on the idea of "closing loopholes,"
it's very difficult to agree on exactly which loopholes should be closed.
Were
broad corporate tax reform to pass, it would likely reduce the incentive for
inversions somewhat. On the other hand, depending on exactly which loopholes
were closed, it might create more incentive for inversions in certain sectors.
Either way, inversions themselves are a huge loophole that companies will
almost certainly continue to exploit unless they are specifically restrained
from doing so.