Corporate Inversions and the Unbundling Of Regulatory Competition

Several prominent public corporations have recently embraced a noteworthy (and newsworthy) type of transaction known as a “tax inversion.” In a typical inversion, a U.S. multinational corporation (“MNC”) merges with a foreign company. The entity that ultimately emerges from this transactional cocoon is invariably incorporated abroad, yet typically remains listed in U.S. securities markets under the erstwhile domestic issuer’s name. When structured to satisfy applicable tax requirements, corporate inversions permit domestic MNCs eventually to replace U.S. with foreign tax treatment of their extraterritorial earnings—ostensibly at far lower effective rates.

Most regulators and politicians have reacted to the inversion invasion with alarm and indignation, no doubt fearing the trend is but a harbinger of an immense offshore exodus by U.S. multinationals. This reaction, in turn, has catalyzed myriad calls for tax reform from a variety of quarters, ranging from the targeted tightening of tax eligibility criteria, to moving the United States to a territorial tax system, to declaring (yet another) tax “holiday” for corporate repatriations, to reducing significantly (if not entirely) American corporate tax rates. Like many debates in tax policy, there remains little consensus about what to do (or whether to do anything at all).

This Article analyzes the current inversion wave (and reactions to it) from both practical and theoretical perspectives. From a practical vantage point, I will argue that while the inversion invasion is certainly a cause for concern, aspiring inverters already face several constraints that may decelerate the trend naturally, without significant regulatory intervention. For example, inversions are but one of several alternative tax avoidance strategies available to MNCs—strategies whose relative merits differ widely by firm and by industry. Inversions, moreover, are invariably dilutive and usually taxable to the inverter’s U.S. shareholders, auguring potential resistance to the deals. They virtually require “strategic” (as opposed to financial) mergers between comparably sized companies, making for increasingly slim pickings when searching for a dancing partner, and a danger of overpaying simply to meet the comparable size requirements. They involve regulatory risk from competition authorities, foreign-direct-investment boards and takeover panels (not to mention from tax regulators themselves). They frequently provide only partial relief from extraterritorial application of U.S. taxes, especially for well-established U.S. multinationals. And finally, tax inversions can introduce material downstream legal risk, since they move the locus of corporate internal affairs out of conventional jurisprudential terrain and into the domain of a foreign jurisdiction whose law is—by comparison—recondite and unfamiliar.

Moving beyond these practical considerations, I will also consider the inversion wave through a theoretical lens, drawing insights from regulatory competition theories in public finance. Specifically, I will advance the notion that regulatory competition among jurisdictions can play out not only through tax policy, but also simultaneously through other nontax channels, such as corporate law and governance rules. Applying this framework, I will show that a strong domestic corporate governance regime can provide a plausible buffer against a tax-induced incorporation exodus: Although U.S. multinationals clearly dislike high tax rates, they have traditionally valued the strength of U.S. corporate law and governance, particularly within Delaware. And, since U.S. tax policy explicitly ties tax residence to the state of incorporation, domestic tax authorities have enjoyed market power in keeping rates comparatively high while attracting and retaining domestic incorporations. In other words, the United States has for a long time remained somewhat insulated from ruinous tax competition because tax residency was “bundled” with corporate law in a unitary regulatory package. Viewed from this perspective, the most radical tax reform proposals currently being championed seem overzealous at best, and may even prove counterproductive.

Nonetheless, the recent pace of inversion activity plausibly suggests that America’s traditional market power in regulatory competition has begun to slip. Although there are likely many contributing causes for this slippage, I will argue that a seemingly inconspicuous institution has played an under-acknowledged role: securities law. During the last fifteen years, a series of significant regulatory reforms—such as the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010—have suffused U.S. securities regulations with an unprecedented array of corporate governance mandates, ranging from board independence requirements to compensation reforms to internal financial controls to proxy access. Historically, state law served as the dominant (if not sole) arbiter of corporate governance. Federal law’s creeping displacement of state law has consequently “unbundled” domestic tax law from domestic corporate governance regulation, since most U.S. securities regulations apply to all listed companies, irrespective of their tax residence. Hence, regardless of whether recent securities law reforms have been prudent or misguided, I argue that federalization has effectively (if unwittingly) undermined the United States’ ability to withstand tax competition from abroad.

If securities market regulation helped dig this hole, then might it also provide the needed tools to refill it? My analysis will suggest that it does, and that we should consider altering the regulatory landscape in two possible ways: either (1) the United States should begin to tax listed companies (regardless of residence) for their consumption of federal corporate governance law, granting allowances for U.S. corporate income taxes paid; and/or (2) federal law should cede corporate governance back to the states by rolling back the federal governance mandates of the last fifteen years. Which of these alternatives (or combination of them) is most attractive turns on several factors, including practical implementation constraints, the value (if any) created by recent federal governance mandates, and the difficulty of coordinating governmental actors at the state and federal level.

Moreover, to the extent my unbundling hypothesis is valid, it suggests that tax reform responses to “inversionitis” must also anticipate downstream implications for corporate governance. Although some modest tax reforms may be warranted (for example, measured reductions in headline tax rates), the most radical tax reform proposals currently on the table (such as moving to a territorial system, or eliminating U.S. corporate income taxes altogether) are unlikely to help, and could well prove deleterious: Not only do such radical reforms seem likely to cost the U.S. Treasury sizable future tax revenues, but they respond to the unbundling phenomenon not by rebundling tax and governance, but rather by severing the link completely. A plausible long-term effect of such radical reform strategies is that the variety and quality of corporate governance regimes worldwide will atrophy—an outcome that is as undesirable for the global economy as it is for the United States.

Several caveats deserve explicit attention before proceeding. First, this is by no means the lone article to note the simultaneous operation of tax and corporate law within a setting of international regulatory competition. Although most prior contributions compare tax competition and corporate chartering competition in relative isolation, a handful also explicitly consider their mutual interaction. Notable among them is an article by Mitchell Kane and Edward Rock, who observe that the marriage of tax residency rules with corporate law in regulatory competition can have distortive effects, inducing corporations to make inferior jurisdictional choices when incorporating in order to reduce tax liability. Concluding that such distortions undermine a competitive chartering market, they propose “severing” tax residence rules from corporate law regimes, hinging the former on the locus of firms’ real economic activity and the latter on the place of incorporation. Although I commence from a similar motivation as do Kane and Rock, my analysis will depart from theirs in several ways. They do not, for example, consider how the steady encroachment of securities law has materially altered the tax/governance competitive landscape. More significantly, my analysis will suggest that regulatory competitive forces actually push in the opposite direction from the Kane/Rock proposal. In other words, even if differential tax levies “distort” incorporation choices, the bundling of corporate governance and tax regimes can make chartering competition more (not less) robust, affording jurisdictions a means by which to appropriate some of the social value created by their investments in legal/regulatory infrastructure—incentivizing them in the process to differentiate their governance/tax offerings, thereby enriching the portfolio of choices available to companies and adding to overall economic welfare.

Second, as noted above, this Article uses a regulatory competition framework to analyze how tax and corporate law may evolve simultaneously. That framework allows for the possibility that such competition can motivate at least some jurisdictions to “race to the top” by installing and maintaining governance regimes that increase firm value and attract incorporations. While some version of this view is common within the academic literature, others are more pessimistic about the merits of jurisdictional competition in corporate law, arguing, for instance, that because managers steer incorporation decisions, competition will tend to “race to the bottom,” catering to managerial preferences, not overall company value (or even share value). Still others have expressed ambivalence about whether either extreme account tends to prevail categorically. The analytical framework developed below is broad enough to allow for any of these possibilities, including settings where agency costs dominate incorporation choices for some firms, inducing some jurisdictions to use their bundled taxing authority to extract a portion of the managerial value they create. Indeed, at its most general level, my analysis presumes a type of hybrid setting where some companies are attracted to corporate governance regimes that maximize overall company value, while others prefer systems that cosset managerial interests.

Third, my analysis will generally presume that jurisdictions set policies noncooperatively, so as to serve their individual jurisdictional interests. While such an approach is a serviceable description of the status quo, it downplays the possibility of cooperative accords struck between otherwise competing jurisdictions that would effectively neutralize—or at least dampen—the oppositional landscape (for example, international accords among OECD countries setting uniform policies on tax rates or profit shifting). Such cooperative approaches could have desirable characteristics (at least in some circumstances), and they are certainly worth considering. It nevertheless remains an open question whether such accords are attainable in the short term and durable over the medium to long term. In any event, my analysis is perhaps better viewed as assessing an appropriate response for the United States in the absence of (or as a backstop to) such international accords.

Finally, it is important to note that the progressive federalization of corporate law chronicled here has not taken place in isolation. Rather, it is one of several pertinent changes to the strategic landscape surrounding comparative corporate governance and tax over the last decade and a half. Most conspicuously, several developed countries outside the United States have progressively walked down their own headline tax rates during this time, gradually enlarging the evident “gap” between American tax rates and those of its closest international comparators. Along with the stockpile of retained foreign earnings that American MNCs have steadily built up, this widening gap in headline rates has no doubt altered the economic calculus that underlies inversion decisions. My argument is not that the federalization of governance has been more important than these tax changes in driving inversions per se, but rather that it has greatly facilitated and simplified that calculus: Governance federalization has materially reduced the incremental costs of inverting, just as comparative tax changes have gradually enhanced the corresponding benefits. These simultaneous forces, I argue, have reinforced one another (perhaps unwittingly and unnecessarily). An appropriate regulatory response, therefore, should be mindful of both of them as well.

The remainder of this Article will proceed as follows: Part I will provide a high-level overview of how the corporate tax system in the United States interacts with the structuring of both foreign and domestic MNCs. Of particular interest here are the creative (yet fragile) ways that domestic MNCs utilize special ownership structures and intercompany transactions—short of an inversion—to minimize and/or defer tax liabilities. While such strategies can be effective, they can also impose risks and costs. In Part II, I will add inversion calculus to the mix, documenting the advantages such transactions can sometimes have over more traditional tax management techniques. At the same time, however, the relative advantages of inversions simply do not translate to all firms and all settings. The Part will close by describing how securities law has, over the last fifteen years, incrementally displaced and preempted state corporate law through a series of federal corporate governance mandates. Notably, these mandates apply to all public companies, whether incorporated/taxed in the United States or not. Part III will turn to my core conceptual arguments, presenting and analyzing a simple, game-theoretic framework for analyzing multi-attribute regulatory competition in tax and corporate governance offerings. Here I will demonstrate how a leader in providing strong corporate law and governance rules (such as the United States) may be able to withstand even substantial international tax competition without being drawn into a ruinous arms race in setting tax rates. Significantly, however, my analytic framework will expose a key necessary condition for the United States to enjoy such competitive insulation: It must be able to bundle tax and nontax regulatory attributes into a single, conjoined regulatory package. Troublingly, many of the most radical reform efforts recently proposed lose sight of this point, and they would ultimately have the effect of unbundling tax and governance even further. Myopic attention to tax competition, while eschewing its interaction with other regulatory dimensions, is both shortsighted and misguided. Part IV then applies the insights of this framework, considering two plausible reform approaches from a securities market perspective.