The Treasury’s Inverted Logic

After weeks of promising to address the alleged scourge of those M&A deals known as corporate inversions, the Treasury took action Monday, announcing what Secretary Jack Lew called an "important first step" to closing "this unfair loophole." Politicians cheered and jeered, and businesses weren't amused, but in our view, this is all just noisy political theater. The small rule changes might bring some unintended consequences, as rule changes tend to do, but the negatives are nowhere near big enough to buck the bull.

As a quick refresher, an inversion is when a US company buys a much smaller foreign firm (whose shareholders can hold as little as a 20% interest in the newly combined firm under current law), then switches HQ to that foreign address-an easy way to redomicile in a country with a friendlier tax code, with current shareholders maintaining majority control. Contrary to popular myth, they don't do it to avoid paying all US taxes. They'll still pay US rates on all profits booked here. They just won't get taxed twice on foreign earnings. Foreign firms don't have to pay Uncle Sam when they shift foreign earnings to the US for investment purposes or other use. (And they don't get taxed shifting US-sourced profits to their new home country.)

But politicians dislike inversions, because they believe the practice robs America of very important tax dollars. This is also an election year-the time to convince voters these lost tax dollars deprive America of very important investment, and then let the heavens bathe them in holy light when they "do something" about it. The administration has spent months doing the convincing. Now they're doing the "doing something."

They didn't (and can't) ban inversions outright or change major aspects of the qualifications that would de facto prohibit them, since changing the tax code requires an act of Congress.^[i] But they did "reinterpret" certain provisions of the tax code to chip at inversions' benefits. We'll spare you the boring legalese, but in essence they banned a few creative transactions firms used to transfer earnings from the foreign parent company to the US subsidiary (e.g., structuring the move as a form of loan) without having to go the traditional route of paying a dividend-a taxable event. They also banned a few tricks companies would use to make themselves look smaller or their foreign targets look bigger so they could comply with the size restrictions on inverting-the smaller you are and the bigger the foreign company, the easier it is to meet the 20% foreign-owned requirement.

The Treasury's big gripe with inversions is that they "erode" the tax base and rob America of investment, yet these "fixes" make it even harder for companies to bring money back to the US and invest it. Those foreign dollars that could have been spent here aren't a huge economic negative-the current economic expansion isn't dependent on money inverted firms might bring over here to invest-but it's an ironic unintended consequence that the Treasury made an imagined investment shortfall into a small but real one.

Overall, though, as government crackdowns on business go, the specifics here seem fairly benign. Government checks and balances won't let the administration push through its initial proposal, which would have effectively ended inversions by requiring foreign shareholders to end up with a 50% ownership share in the resulting entity. That said, inversions are a political lightning rod, and this won't be the last attempt to address them. We'll likely hear lots of talk from both parties as candidates use inversions to rile up voters and stir up campaign contributions for that final push to November. Many in Congress have voiced the need for reform, whether it's amending the tax code or stiffening rules. One Senator is reportedly preparing a bill that would retroactively strip the tax benefits of inversions as far back as 1994. That would be a big change! And probably undermine confidence in America as a good place to do business, as foreign investors tend not to like putting money to work in places where the rules can change after the fact. We saw this back in 2012, when India's government faced a huge backlash after it tried implementing a retroactive tax on mergers going back to 1962. However, given just how gridlocked Congress is today, the likelihood any radical legislation-whether it's administration-approved or inspired by a lone senator-passes is low. Ditto for the next Congress, as midterms likely just bring more gridlock.

That leaves the Executive branch fiddling as the major option. Now, fiddling around the edges of the tax code does set a sort of weird precedent, which makes one wonder what else the Treasury might try to fiddle with-and that could give businesses the willies to some extent. But that's a discussion of what's possible and not necessarily what's probable. Based on what is known about these rules, the probable impact on real businesses is likely very small. The lack of an outright ban means the risk of protectionist backlash, which we highlighted in July, is next to nil from these measures. This doesn't prevent the inversion brand of M&A and thus doesn't embargo capital.

In the end, this is a purely political issue with small side effects. We aren't in the business of sugar-coating things, so we have no problem saying the Treasury is cutting off its nose to spite its face. In its zeal to make a political statement, it created a solution in search of a problem. If you want businesses to invest more in America (something with universal popularity), we're pretty sure discouraging the practice-whether by making it harder to bring foreign-sourced profits back for reinvestment or giving businesses reasons to question whether it's worth the risk-is sort of a bad way to get what you want. These are small negatives-nowhere near big enough to buck a bull market or economic expansion that have so much going for them (including the gridlock that thankfully prevents much more radical change). But they're nonetheless a lesson in the ever-important law of unintended consequences.

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^[i] Literally and metaphorically.