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The Lowdown on Inversions

August 18, 2015

We’ve been laying out the case for international tax reform lately, and no issue dramatizes the need for reform better than the recent spate of corporate inversions. Today, we’ll take a closer look at the “inversion perversion.”

What is an inversion?

An “inversion” is basically a fancy term for changing a company’s address to lower its taxes. For instance, an American company buys a foreign company and then designates its headquarters in that other country. That’s just what the American company Burger King did when it bought the Canadian company Tim Horton’s last year. The bigger U.S. company then moves to join with the smaller foreign company in the foreign company’s home country—that’s the “inversion.” Much of the old company still exists. (There are still Burger King restaurants in America.) But now the new company will shift income out of the U.S. and into the foreign country, where it will pay the other country’s lower corporate tax rate, instead of America’s.

Why is this a problem?

Because America is losing jobs and money. Once companies invert, they’re no longer U.S. taxpayers. As a result, the federal government is losing tax revenue.

And as the Economist points out, “Changes of corporate control will increasingly involve senior people upping sticks.” In other words, if your headquarters are going to be in another country, you’re probably going to put more of your top-level jobs there too.

Finally, inversions are indications of a bigger problem. American companies are keeping more than $2 trillion in capital outside our borders—because it costs too much in taxes to bring it back to the United States. So instead of bringing the money over here, they’re moving their headquarters over there. That means our tax code is punishing companies who invest in America and, as a result, chasing jobs overseas.

Why is this happening?

Because our tax code is a mess. Not only does America have the highest corporate tax rate in the developed world (35 percent at the federal level alone), it’s also one of the few countries that tax every dollar companies make—regardless of where they make it.

Most countries tax only the money made within their borders. But whenever American companies bring overseas profits back home, they have to pay Uncle Sam the difference between the other country’s and America’s much higher tax rate. So instead, they’re inverting. They’re keeping money they could invest in America in other countries and depriving the U.S. of needed capital and revenue.

America’s job-creators have been waiting for Washington to fix the tax code. But with global competition heating up—and with no tax reform in sight—they’ve decided to use inversions to lower their taxes, a form of what one commentator calls “legislative self-help.”

How can we stop it?

The real answer is to fix the tax code—all of it. But barring a complete overhaul, there are other steps we can take to stanch the bleeding. First, we need to move to an “exemption” tax system, which nearly every other country uses. In addition, creating an “innovation box” would encourage more companies to locate their research and development jobs right here in America.

So far, the administration has tried to stop inversions by twisting the screws on companies that attempt them. As the Economist says, “Making it hard for American firms to invert does precisely nothing to alter the comparative tax advantages of changing domicile; it just makes it more likely that foreign firms will acquire American ones.”

Instead of making sure there’s nowhere to hide, Washington should make sure there’s no reason to.