"Character is the one thing we make in this world and take with us into the next."
- - Ezra Taft Benson
August 12, 2014
The Danger of Inversions
by Adam Smith

When I was very young (President Kennedy young) my family lived in Germany. While living there we had a man visit from Rhodesia who was a member of the church.

Rhodesia was getting pressure because the white minority was ruling the country and many of the residents were trying to leave because they (correctly) saw that arrangement would not last and there was great uncertainty about what would happen in a new government.

We saw this gentleman years later (I was still young) and his parents were then trying to leave Rhodesia. I remember absolutely nothing from this conversation except that his parents were not able to take their money with them out of the country. They could leave but the money had to stay. This struck me as being completely unfair which is why, I suppose, I remember the statement.

Thus has it always been, and will always be, that corrupt dictating central governments that create poor business environments restrict the outflow of capital from their countries.

I was reminded of this story with the news the past few weeks that companies are using “inversions” to avoid some tax liability to the U.S. Government.

An inversion is where a large U.S. company buys a company that is located in a country that has a lower tax rate for corporations and then moves their company headquarters to the foreign country. Why would a corporation do this? To reduce their tax liabilities and to make the operations of the company easier and more simple.

The company still has to pay taxes to the U.S. government for the profit earned in the U.S. However, now with headquarters out of the U.S., the company would be able to collect the profits from all over the world back to their headquarters.

The U.S. is one of the few countries that taxes the profits of foreign subsidiaries if the money is brought back into the U.S. (The amount of this tax is the U.S. rate less the foreign taxes already paid.) This policy has led to about $1,000,000,000,000 dollars of U.S. company dollars sitting in foreign banks. This is really adds a level of complexity to money management that is not needed and is inefficient.

For example, a company (U.S. based) I worked for financed many plants being built in Central America with money from Luxemburg. The Luxemburg money came from profits in Europe.

This rush to use inversions has many in the government extremely nervous. Looking at the above scenario it is not obvious, but once you know how companies operate in real life the government has every reason to be nervous.

Although it is true that the U.S. company will still pay taxes on profits earned in the U.S., it would now be easy to manipulate the amount of profit earned through the use of loans from the foreign company headquarters to the U.S. subsidiary and the use of dividends paid from the U.S. subsidiary to headquarters.

Basically, the profit made in the U.S. would be small on the U.S. books, with the income shifted to a country that has a lower tax rate.

This puts the $250 billion of annual corporate tax revenues in jeopardy. The call to write tax laws to restrict or stop inversions is now being heard from the Secretary of the Treasury to professors at universities.

Inversions are legal but that is not sufficient to make them ethical, so we need to think about the ethics. There are two competing ideologies to what is the civic responsibility of corporations.

One side sees the corporation as having its major responsibilities be to their country and employees. They believe that the country where they reside has provided them with the economic stability and infrastructure that has allowed them to grow and be successful.

According to this line of reasoning, the company should be willing to pay any amount of tax asked by the government, and the company trying to minimize their taxes is unpatriotic.

This ideology also thinks that corporations have a major responsibility to their employees. The employees are the ones that make the company work and so they are entitled to a greater portion of the profits of the company. (Remember Obama’s statement, “You did not build that by yourself.”)

The opposing view believes that corporations should maximize the profitability of the company and then let the shareholders (owners) decide what to do with the money they receive as dividends (this creates maximum utility for the owners).

The gulf between these two extremes is wide and deep, and to say there is animosity on both sides is an understatement. This is the question that is being proposed by the current administration who believe fervently on side one while those on the right, as expressed by some talk show hosts, believe in the other view.

I think I have expressed both sides well enough and will now give my views (which will be flagrantly moderate so disliked by both sides).

I believe corporations do have civic responsibilities. It is easy to think of some that we all can agree on like not polluting or not knowingly producing products that create a safety hazard for customers.

However, I believe it goes beyond these obvious examples, such as spending some of the money on the communities where they do business so an entire city, county, or state is blessed by the company being located there. I am not talking about extravagance, but it is amazing what a moderate amount of targeted spending can do.

They also have the responsibility to pay all the taxes that are lawfully required. But it would be completely irresponsible for them to pay enormous sums of money for taxes that could easily be avoided.

Imagine having someone prepare your taxes and having them telling you that they were not going to allow you to take the mortgage deduction because it dropped you below a tax rate they thought appropriate for your income and if you took the deduction it would be unpatriotic.

The U.S. Government has put corporations in a tough position. If you asked any of the CEOs that have moved their headquarters off-shore, it is likely that all or almost all would rather keep their headquarters in the U.S.

However, they would really be shirking their fiduciary responsibility to the owners of the company if they paid hundreds of millions of dollars every year to the U.S. government that they could legally avoid and give to the owners of the company.

The government put the corporations in the bad situation, and it could bail them out. I am always completely appalled when some powerful politician criticizes a company for following the laws the politician passed. You know you are hearing either a political hack or a moron talking. Nobody ever asks the politicians why they passed a bad law and what they are going to do to fix it.

Stopping companies from leaving the U.S. would be really easy. Just work to reform the corporate tax code so that the U.S. is competitive with the rest of the world. We do not have to have the lowest tax rate — just at least reasonably competitive.

This, of course, will not happen because of the dysfunction in Washington, even though there is wide bipartisan support for the reform. Let me say that again, there is wide bipartisan support for reform.

So why is the tax code not fixed? Politicians are getting money from special interests. Yup, it is time to start using the C-word when talking about our government.

Thus has it always been, and will always be, that corrupt dictating central governments that create poor business environments restrict the outflow of capital from their countries.

Bookmark and Share    

Why Economics Matter
- - October 20, 2015
- - December 30, 2014
The Chance
- - November 18, 2014
Changing Perceptions
- - October 7, 2014
The Threat
- - August 26, 2014
The Danger of Inversions
- - August 12, 2014
The Wait
- - July 15, 2014
East vs. West
- - June 3, 2014
Let Them Eat Cake
- - May 20, 2014
Ridiculous Averaging
- - May 6, 2014
More by Adam Smith

About Adam Smith

Adam Smith is obviously not the actual name of the author of this column. The real author has worked for two Fortune 500 companies, one privately held company, and a public accounting firm. His undergraduate degree was in accounting, and he earned an MBA for his graduate degree. He also has completed coursework for a PhD. in finance. He continues to be employed by one of the Fortune 500 companies.

The author grew up in the Washington D.C. area but also lived for several years in Arizona. He currently resides with his family on the East Coast.

The author has held various callings in The Church of Jesus Christ of Latter-day Saints.

Copyright © Hatrack River Enterprise Inc. All Rights Reserved. Web Site Hosted and Designed by WebBoulevard.com