Exit tax on U.S. firms with deferred earnings could slow inversions

Pfizer’s recent decision to merge with Irish drugmaker Allergan generated headlines as the latest, and biggest, example of an inversion—where a U.S.-based firm combines with a foreign firm in order to save U.S. taxes (by sidestepping deferred U.S. tax liabilities and shifting income to the lower-tax jurisdiction in the future).  Sometimes, the U.S. firm will move operations abroad, but often it will not.  Congress could slow these tax-motivated departures, and preserve our tax base, by imposing an exit tax on U.S. companies with deferred earnings.

Unlike many other countries, the U.S. taxes its residents (both firms and individuals) on their worldwide income, not just their U.S. income.  But our tax rules allow U.S. firms to defer taxes on their foreign subsidiaries’ earnings, often indefinitely.  The tax is levied only when the income is brought home to the U.S.  Pfizer and many other U.S. multinationals now have large stockpiles of deferred earnings in their subsidiaries abroad.

How can Pfizer, with much of its sales in the U.S., have almost all of its profits in foreign subsidiaries?  Like many other drug companies, and other companies with valuable intellectual property, it transfers rights to its patents to foreign subsidiaries in low-tax jurisdictions, such as Ireland.  Pfizer then makes large payments to its subsidiaries to sell the drugs in the U.S., which is a very lucrative market.  Multinationals use different variations of “transfer pricing” to increase costs in a high tax jurisdiction, and revenue in a low-tax jurisdiction, which shifts profits to the low-tax jurisdiction.

In 2004, Congress offered a “one-time” tax holiday for U.S. companies to repatriate off-shore earnings (provided the earnings were invested in the U.S.).  Pfizer took advantage of the holiday, and reaped a bigger benefit than any other U.S. multinational.  The firm brought home $37 billion at a 5.25 percent tax rate, less than a sixth of the usual 35 percent corporate rate.  But as soon as Pfizer cashed in, it started stockpiling earnings offshore again.  Those earnings now amount to $74 billion, according to its public financial statements. Some analysts think it could be twice as much, if Pfizer counted its off-shore earnings for which it took a tax reserve.

For many years, multinationals such as Pfizer have lobbied unsuccessfully for another repatriation holiday.  But now the firm seeks a permanent holiday for its foreign earnings:  It plans to follow its profits abroad by combining with Allergan, an Irish drugmaker.  If successful, Pfizer would permanently sidestep any future U.S. taxes on its offshore earnings.

But Congress can ensure the tax on offshore earnings of U.S. companies is deferred, not forgiven.  If a U.S. company voluntarily departs (or is acquired by a foreign company in a hostile takeover), we could charge the U.S. company the tax due on its deferred earnings, just as we collect the deferred tax on IRAs of people who relinquish their U.S. citizenship.  An exit tax would discourage tax-motivated departures.   Collecting the toll on both voluntary departures and hostile acquisitions would make U.S. companies less attractive takeover targets.  And the potential of an exit charge would deter U.S. companies from accumulating earnings off-shore, with a hope of avoiding tax permanently.

The exit tax wouldn’t stop inversions or takeovers.  Sometimes there are good business reasons for such combinations.  But there’s no reason why the U.S. tax code should subsidize them.

This article first appeared at TaxVox.