Exit tax on U.S. firms with deferred earnings could slow inversions
Pfizer鈥檚 recent decision to merge with Irish drugmaker Allergan generated headlines as the latest, and biggest, example of an inversion鈥攚here 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).听 Sometimes, the U.S. firm will move聽operations abroad, but often it will not.听 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. 聽But our tax rules allow U.S. firms to defer taxes on their foreign subsidiaries鈥� earnings, often indefinitely.听 The tax is levied only when the income is brought home to the U.S. 聽Pfizer and many other U.S. multinationals now have large stockpiles of deferred earnings in their subsidiaries abroad.
How can Pfizer,聽in foreign subsidiaries?聽 Like many other drug companies, and other companies with valuable intellectual property, it聽聽in low-tax jurisdictions, such as Ireland.听 Pfizer then makes large payments to its subsidiaries to sell the drugs in the U.S., which is a very lucrative market.听 Multinationals use different variations of 鈥渢ransfer pricing鈥� 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 鈥渙ne-time鈥� tax holiday for U.S. companies to repatriate off-shore earnings (provided the earnings were invested in the U.S.).听 Pfizer took advantage of the holiday, and reaped a聽.聽 The firm brought home $37 billion at a 5.25 percent tax rate, less than a sixth of the usual 35 percent corporate rate.听 But as soon as Pfizer cashed in, it started stockpiling earnings offshore again.听 Those earnings now amount to $74 billion,聽.听聽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聽聽unsuccessfully for another repatriation holiday.听 But now the firm seeks a permanent holiday for its foreign earnings:聽 It plans to follow its profits abroad by combining with Allergan, an Irish drugmaker.听 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.听 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聽聽of people who relinquish their U.S. citizenship. 聽An exit tax would discourage tax-motivated departures.听聽聽Collecting the toll on both voluntary departures and hostile acquisitions would make U.S. companies less attractive takeover targets.听 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鈥檛 stop inversions or takeovers.听 Sometimes there are good business reasons for such combinations.听 But there鈥檚 no reason why the U.S. tax code should subsidize them.
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