Jack Lew Tilts at Windmills

October 6, 2014 10:00 AM

While not as endearing as Don Quixote, Treasury Secretary Jacob Lew is every bit as ineffective. Where Don Quixote imagined that windmill blades were the arms of a giant, Jack Lew imagines that US corporations seeking to invert—i.e., sell themselves to a foreign parent firm to escape US taxes—are economic malefactors.

The US Congress can bid Quixote a fond adieu, but it should not ignore the secretary's misguided attack. Like a thermometer that reads 109°, inversions are screaming that much is wrong in the US system of taxing corporations. The US federal corporate tax, at 35 percent, is the highest among advanced countries, and unlike all its peers, the United States attempts to tax the foreign subsidiaries of US-based multinational corporations on their foreign earnings.

No wonder several US firms seek to avoid these burdens by relocating abroad and turning the erstwhile US parent firm into a subsidiary of the new foreign parent—in other words, invert.

To discourage such transactions, Lew instructed his assistant secretary for tax policy, Mark Mazur, to scour the thousands of pages of regulations that underpin the Internal Revenue Code and craft remedies that arguably interpret existing statutes and thereby make inversions more difficult or costly. Mazur came up with four small wooden swords, all of them ineffective:

  • "Hopscotch" loans—for example a loan from foreign subsidiary S to new foreign parent F—will be treated as if they were loans to the former US parent firm and will be taxed as US income.
  • When the new foreign parent buys a controlling interest in a foreign subsidiary owned by the US parent, the accumulated earnings of the subsidiary will be treated as US income and taxed accordingly.
  • The new foreign parent will not be able to sell its stock in the former US parent to one of its foreign subsidiaries in exchange for cash and thereby bypass the US tax on the subsidiary's accumulated earnings.
  • The new regulations will tighten the requirement that the former US parent must own less than 80 percent of the new foreign parent in order to escape US taxation of its foreign subsidiaries.

While ineffective in their announced purpose, the proposed new regulations will have two certain results. They will drive corporate clients to K Street law firms that will gladly design "work around" solutions, and they will spawn protracted litigation in the years ahead.

But the regulations will do nothing to redress the massive gap between US and foreign taxation of MNCs—a gap that will relentlessly drive American firms to establish headquarters abroad and to relocate managerial, finance, and R&D jobs on foreign soil.

Serious work awaits the 114th Congress in January 2015.

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Gary Clyde Hufbauer Senior Research Staff

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