When it comes to taxes, corporate America is getting a bit less corporate. And a bit less American.
Fueled by a wave of inversions, a record 54 companies in the Standard & Poor's 500 Index of leading U.S. firms are now at least partially exempt from the corporate income tax. That's more than twice the number four years ago.
The biggest factor is the recent wave of companies, such as Medtronic Plc and Mylan NV, that have completed what's known as an inversion, in which they move their tax address overseas. Other companies have declared themselves to be real estate investment trusts, or REITs, which the Internal Revenue Service doesn't treat as corporations. Just this year, Equinix Inc., a California company that operates data centers, became a REIT to lower its effective tax rate to as little as 10%. At 35%, the U.S. corporate rate is the highest in the developed world.
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The Congressional Budget Office predicted in January that these techniques, by eroding the tax base, would contribute to a drop in U.S. corporate receipts, from 2.3% of gross domestic product in 2016 to 1.8% in 2025. By then, receipts will be about 5%, or $27 billion a year, lower than they would be without the anticipated erosion, the CBO estimates.
“As capital gets increasingly mobile, it's harder to stop people from pursuing tax advantages around the world,” said William Gale, an economist at the Brookings Institution in Washington.
POPULAR ALTERNATIVE
The S&P; figures may understate the scale of the exodus, because the index doesn't include another investment vehicle that's become a popular alternative to the corporate form. Known as master limited partnerships, they, like REITS, don't pay the corporate income tax and instead pass on tax liability to their investors. Several S&P; companies have recently transferred assets to these vehicles.
“You can't ignore the fact that the U.S. has been sitting still with its tax code for a long time,” said Kyle Pomerleau, an economist at the Washington-based Tax Foundation, which favors a simpler system with lower rates. He said that other developed countries have reduced rates and made changes to favor domestic companies.
Many of the companies that undertook inversions or became REITS have argued that they have a duty to shareholders to legally minimize their tax bills. Some came to the decision after facing competition from rivals with more favorable tax arrangements.
“Unfortunately we have a tax structure in the United States that's putting companies in the U.S. at a disadvantage,” said the chairman of Actavis Plc, Paul Bisaro, shortly before it became Irish in 2013.
Last September, reacting to a series of high-profile inversions, the Treasury Department imposed new restrictions meant to make it less attractive for U.S. firms to claim tax residence in a lower-tax jurisdiction. The changes killed three planned transactions, and since then the pace of announcements has slowed.
In the seven months since the rules took effect, only four new inversion plans have been unveiled, compared with eight in the seven months beforehand. Still, the new pace of about one announcement every two months is similar to that seen in 2012 and 2013. S&P; 500 company Applied Materials Inc. plans to become Dutch by the end of June.
S&P; DEBATE
Other paths to a foreign address are still open. James River Group Holdings Ltd., an insurance company with North Carolina roots, went public on the Nasdaq Stock Market in December as a Bermuda company. James River, which is not in the S&P;, got the new address through its 2007 sale to a Bermuda entity set up by the New York hedge fund D.E. Shaw & Co., a type of transaction that's not affected by anti-inversion rules.
Since the S&P; 500 is supposed to be a list of the biggest American companies, the question of whether to include tax expatriates has in the past caused some debate within S&P;, the division of McGraw Hill Financial Inc. that oversees the index.
Thanks to an earlier wave of inversions, by 2008 there were 13 foreign-domiciled companies in the S&P; 500. After some investors complained these companies didn't belong, S&P; kicked most of them out in 2009, said David Blitzer, chairman of the S&P; index committee.
S&P; reversed course after talking with more investors, he said. Fund managers don't care what a company's legal address is, as long as it has substantial business in the U.S., is listed on a U.S. exchange, and reports financial results the way U.S. companies do, Mr. Blitzer said. Most companies that invert don't shift their top managers, factories or sales force out of the country. It's mostly a paperwork change.
REIT TREND
So in 2010, S&P; started letting them back in. Today there are 30 companies with foreign incorporations, representing about 5% of the index by market value.
Real estate companies have long organized themselves as REITs because they don't have to pay tax on income as long as most of it comes from real estate and is paid out promptly to stockholders. REITs have been allowed to join the S&P; 500 since 2001.
Recently, members of far-flung industries, from prisons to billboards, have sought to reap the tax benefits of being a REIT by declaring that they're essentially in the real-estate business. For the most part, the Internal Revenue Service has allowed them to do so.
Among those S&P; 500 components that have made the switch in recent years include Iron Mountain Inc., a document storage company; the Weyerhaeuser Co. timber producer, and two owners of cell-phone towers. Railroads and power lines may be among the next industries to try it, PricewaterhouseCoopers said last October.
REITs shouldn't be lumped in with inversions, said Ron Kuykendall, a spokesman for the National Association of Real Estate Investment Trusts. Unlike inversions, REITs were intentionally created by Congress in 1960 as a way to give small investors access to the same real-estate opportunities as large ones, he said. And he said part of the reason for their current popularity is that their regular cash payouts are attractive due to low interest rates.
“The inversion is strictly an attempt to reduce the tax liability -- that's all it is,” he said. “There's no structural benefit that accrues to a shareholder when a company moves its headquarters to Ireland.”
Virtually all of the foreign and REIT companies in the S&P; 500 still pay some U.S. corporate income taxes. The foreign companies still have to pay through their U.S. subsidiaries, and REITs have to pay through units that aren't in the real-estate business. Mylan, which got a Dutch incorporation in February, expects to lower its effective tax rate this year from 25% to 20%, its chief financial officer said at a conference last month.
“What you're seeing,” said the Tax Foundation's Mr. Pomerleau, “is what could be called self-help tax reform.”
