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Since the Treasury Department announced new rules in early April designed to stop corporate inversions, some corporate lobbyists have protested loudly. This likely is an indicator the proposed rules would have a real effect on the ability of big multinational corporations to avoid corporate income taxes. The new rules are designed to prevent U.S. companies from merging with a foreign company and reincorporating as a foreign entity in order to escape paying U.S. taxes, a practice known as a corporate inversion.

In recent years, corporate inversions have emerged as a real threat to the U.S. tax base. In fact, the Joint Committee on Taxation (JCT) now estimates that inversions will cost the U.S. Treasury at least $34 billion over the next 10 years. The American people should not have to make up for the revenue hole created by inversions, and in the absence of legislation to curb this problem, the Treasury is right to take whatever actions it can within its legal authority to curb inversions on its own.

Citizens for Tax Justice (CTJ) submitted comments this week in support of two parts of the Treasury’s proposed rules, the Serial Inverter Rule and the Earnings Stripping Rule, while also urging Treasury to take additional action to curb corporate inversions.

The Serial Inverter Rule

Serial inverters are multinational corporations created by repeated inversions. The proposed rule on Inversions and Related Transactions, also known as the “serial inverter” rule, disregards newer inversions in determining whether anti-inversion rules apply to a company, meaning that companies will find it more difficult to circumvent these rules through a series of successive inversions.

We’ve already seen the positive impact of the proposed serial inverter rule in the case of Pfizer, which abandoned its planned $125 billion merger with foreign company Allergan, a serial inverter, shortly after this rule was proposed. This action alone may have already saved U.S. taxpayers as much as $40 billion in taxes on offshore profits that Pfizer could have avoided by inverting.

The Earnings Stripping Rule

Earnings stripping is an accounting gimmick used by multinational corporations to avoid taxes by shifting profits from higher- to lower-tax jurisdictions. Usually, this practice involves a multinational giving subsidiaries in higher-tax jurisdictions (like the United States) loans from subsidiaries in low- or zero-tax jurisdictions (like the Cayman Islands). Because interest payments on these loans are tax-deductible in the higher-tax country and are paid out to the subsidiary in the lower-tax company, the company is able to artificially shift much of its income to the lower-tax jurisdiction.

Treasury’s proposed rule on Treatment of Certain Interests in Corporations as Stock or Indebtedness, or the “earnings stripping” rule, will inhibit multinational corporations’ ability to use this trick to shift profits out of the U.S. by increasing the cost of excessive intercompany loans. This action will curb the incentive for companies to invert because it will lower the amount that companies can permanently shift out of the U.S. tax system if they invert.

A particular strength of this rule is that it applies not only to inverted companies, but to all multinationals doing business in the United States. Cracking down on all earnings-stripping activities will raise badly-needed revenue and will also help level the playing field between multinational corporations that can take advantage of this gimmick and the many smaller domestic businesses that cannot.

More Action Needed

Although these two rules will undoubtedly help to prevent tax-motivated corporate inversions, Treasury should take additional steps to curb this practice. A good starting point would be putting an end to “hopscotch loans,” which occur when inverted U.S. companies escape paying taxes on dividends by making a loan directly to a foreign parent and bypassing the U.S. parent.

Unfortunately, Treasury action can only go so far, and only legislative action can stop inversions cold. The good news is that Congress has available several promising legislative options to shut down inversions, including enacting an exit tax, further cracking down on earnings stripping and requiring that post-merger companies be owned by a majority of the foreign company’s shareholders in order to be considered foreign. The bad news is that lawmakers have not yet shown the political will to take these sensible steps. 

Kelsey Kober, an ITEP intern, contributed to this report.