Treasury Department Fights Tax Inversions, But They Are Not The Only Issue

Tax reform has been a hot topic among politicians and corporate executives with a headline focus on corporate inversions as a method of tax avoidance. On Sept. 22, the U.S. Treasury Department announced new rules intended to prevent the use of this tactic from making economic sense. These new rules were effective immediately and to be applied to all deals closed on or beyond Sept. 22, 2014.

One of the core issues is that the U.S. has the highest corporate income tax rate — 35% — and many corporations and politicians argue that this puts U.S. companies at a competitive disadvantage. Recent announcements, such as Burger King Worldwide’s (BKW.N) plan to purchase Tim Hortons (THI.TO) and relocate to Canada, have brought tax inversions into the political spotlight.

However, as demonstrated in our previous story, “What if Tim Hortons had purchased Burger King?”, the issue wasn’t only about corporations seeking tax avoidance, but also a tax code that effectively penalized corporations that clearly earned their income abroad. The former tax code not only encouraged existing U.S. companies to use tax inversions, but discouraged foreign companies from moving to the U.S. Therefore, tax inversions in and of themselves were not the only issue.

EXHIBIT 1: NUMBER OF S&P 500 COMPANIES WITHIN GIVEN EFFECTIVE TAX RATE RANGES

Source: Eikon

Mind the gap

There is a clear gap between the 35% U.S. corporate income tax rate and the aggregated effective tax rate for the S&P 500, which is 27%; this is based on filings for the last fiscal year of the S&P 500’s current constituents and excludes REITs and companies with negative net income before taxes excluding extraordinary items (NIBT). Given this large difference, and the fact that 72% of these companies have an effective tax rate below 35%, it is no wonder tax reform has created a flurry of controversy.

Of the companies included in this study, 47% have effective tax rates between 30% and 40%. However, 47% have effective tax rates that fall below 30%. Straightforward tax inversions aren’t the only issue. Of the 465 S&P 500 companies included in these figures, the 5% with foreign headquarters have an aggregated effective tax rate of 16%. While this shows a clear advantage for those based outside the U.S., they only account for 2.4% of the total NIBT. Therefore, they are not the sole reason that the aggregated effective corporate tax rate is below the U.S. federal corporate income tax rate of 35%.

EXHIBIT 2: S&P 500 EFFECTIVE TAX RATES BY SECTOR AND INCOME TAX SCENARIOS

Source: Eikon

* Scenario 1: Aggregated increase (decrease) in effective income tax revenue if flat tax of 35% were used on all companies included in this study
** Scenario 2: Aggregated provisions for income tax for companies with an effective income tax rate below 35%

Where will the chips fall?

In a hypothetical scenario, if all 465 of the companies included in this study were to have paid a flat tax of 35% on their NIBT, annual income tax revenue for the U.S. would have increased by $104.9 billion. Conversely, the aggregated total annual fiscal year income tax provisions for the companies with an effective tax rate below 35% was $251.8 billion. While it remains to be seen if the Treasury Department’s new rules will hold and meet their intended purpose, or if companies will find ways to permanently exit the U.S., roughly $350 billion from the S&P 500 alone hangs in the balance.

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