Can the OECD Invert the Tax Inversion?

By Derek Hunter

The phrase “tax inversion” probably could not sound drier. But this esoteric tax maneuver is garnering considerable press, and not just in the finance pages, but in the mainstream news as well.

A tax inversion is a transaction in which a U.S.-based multinational enterprise (MNE) re-domiciles abroad by merging with a foreign corporation. The goal is to swap the relatively high U.S. corporate tax rate (39%) with the lower tax rate of the foreign corporation’s jurisdiction, frequently Ireland (12.5%) or the United Kingdom (21%). Besides the billions of dollars saved (or lost, from Treasury’s perspective) in U.S. taxes, nothing else changes about the corporation.

So what’s all the fuss? First, it smacks of unfairness – big corporations, with the help of their well-paid lawyers, avoid taxes while the little guys make up the difference. It is also a great political issue: President Obama can call an inversion “unpatriotic,” while Republicans can use it as an example of why we need to lower tax rates to be more competitive.

But what does being competitive mean? In the globalized economy of the 21st century an MNE has an extensive menu of jurisdictions to establish its tax home. And while calling a corporation unpatriotic, or lambasting one in a Senate hearing, makes for good political theater, it doesn’t help get to a solution.

To avoid a race to the bottom – a common byproduct of globalization – the taxation regime that Apple, Burger King, Endo, and other MNE’s face should match their scale. It should be international.

OECD Base Erosion and Profit Shifting Action Plan

The Organisation for Economic Cooperation and Development (OECD) has a plan to combat some of these tax avoidance techniques. In the summer of 2013, the OECD launched an Action Plan on Base Erosion and Profit Shifting (BEPS). The project aims to create a single set of international tax rules to end the erosion of tax bases and the purposeful shifting of profits to low-tax jurisdictions through various complicated loopholes. It recognizes that this isn’t your grandfather’s economy anymore. Its borderless, digital, and powerful MNE’s can bypass the force of domestic tax rules.

The BEPS Action Plan’s first concrete steps were released following the September 20-21, 2014 meeting of OECD member finance ministers. These steps are a good start and they approach the problem from several angles. Some of the highlights include:

Action 1: Addressing the Tax Challenges of the Digital Economy. This action explicitly recognizes the transformation of the global economy since the mid-20th century. For tax rules to be effective and fair, they must keep up with an innovative and dynamic economy that is increasingly based on digital interaction.

Action 2: Neutralising the Effects of Hybrid Mismatch Arrangements. A hybrid mismatch arrangement takes advantage of different tax treatment of an entity or instrument under the laws of two or more jurisdictions. A common example is “earning stripping,” which is often times an added benefit of inverting.

Action 6: Preventing the Granting of Treaty Benefits in Inappropriate Circumstances. By providing specific recommended amendments to current and future tax treaties, this action points out some of the biggest holes in international tax law. 

Action 13: Guidance on Transfer Pricing Documentation and Country-by-Country Reporting. Action 13 furthers tax regulation on a global level, and coordination among different domestic tax authorities by requiring MNE’s to provide comprehensive reports on their global business activities.

Action 15: Developing a Multilateral Instrument to Modify Bilateral Tax Treaties. Instead of piecemeal modifications of individual bilateral treaties, this action proposes a multilateral treaty to modify the bilateral treaties of the signatories. These amendments, in line with OECD recommendations, would be an aggressive advancement of the outdated international tax rules governing member state interaction.

Like any effort to strengthen and modernize international rules, the success of the OECD BEPS Action Plan will depend on how seriously member states take its recommendations. Of course, the U.S. will be most important, and will likely be the least receptive. But as the recent spate of tax inversions show, even the U.S. corporate tax base can, and will, defect.