The Inverted World of Mobile Capital

BERKELEY – A growing number of American companies are seeking to move their legal headquarters abroad by acquiring or merging with foreign companies. In the latest case, Medtronics plans to acquire Irish-based Covidien, a much smaller company spun off by US-based Tyco, and move its legal headquarters to low-tax Ireland, culminating in the largest ever inversion or redomiciliation of a US company. Walgreens is reportedly considering moving its headquarters to the United Kingdom by acquiring the remaining public shares of Alliance Boots, the Swiss-based pharmacy giant.

Such deals reflect the deep flaws in the United States’ corporate tax system. The US has the highest among developed countries and is the only G-7 country clinging to an outmoded worldwide tax system under which the foreign profits earned by US-headquartered companies incur additional domestic taxes when they are repatriated.

By contrast, all other G-7 countries have adopted territorial systems that impose little or no domestic tax on the repatriated earnings of their global companies. This difference puts US-headquartered multinationals at a relative to their foreign competitors in foreign locations. To offset this, US multinationals take advantage of a deferral option in US tax law.

Deferral allows them to postpone – potentially indefinitely – the payment of US corporate tax on their foreign earnings until they are repatriated. Not surprisingly, as their foreign earnings have grown as a share of total earnings, and as foreign corporate tax rates have plummeted, US companies’ stock of foreign earnings held abroad has soared, now topping $2 trillion.

The US system thus implies significant costs, as companies hold more cash abroad, borrow more to finance domestic cash requirements, and invest more in foreign locations. Deferred earnings are of the US economy: the government receives no tax revenues from them, and they are not directly available for domestic use by US companies. This undermines their ability to compete with foreign companies in acquiring other US companies. It also makes investments by US shareholders in domestic companies less attractive relative to investments in foreign companies that can distribute their foreign profits in the US without an additional tax penalty.

Overall, deferral distorts corporate balance sheets, imposing efficiency costs on US companies that are of deferred earnings. As the stock of deferred earnings grows, these costs accumulate, and through cross-border acquisitions becomes a logical step for US companies with a large stock of deferred earnings abroad. Companies like Medtronics can then use future foreign earnings in the US with little or no repatriation tax. Such companies have a strong incentive to redomicile abroad even to finance their US investments.