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Monthly Archives: April 2015

Do Corporate Managers Have a Duty to Avoid Taxes?

Reuven S. Avi-Yonah, Just Say No: Corporate Taxation and Corporate Social Responsibility __ NYU J. Law & Bus. __ (forthcoming), available at SSRN.

The recent wave of corporate inversion transactions, in which domestic companies essentially move their headquarters abroad to lower their U.S. tax bill, is just the latest in a decades-long trend of aggressive tax avoidance behavior by corporations. From the government’s perspective, inversions and other tax avoidance strategies erode the U.S. tax base and impose a costly enforcement challenge on Treasury and the IRS. But from the perspective of corporate managers, aggressive tax planning may simply be part of the corporation’s duty to maximize shareholder value. Reuven Avi-Yonah questions this latter proposition in Just Say No: Corporate Taxation and Corporation Social Responsibility. He offers a compelling argument that corporate managerial duties are not hopelessly at odds with the goal of promoting better corporate tax compliance.

Avi-Yonah frames the issue of corporate tax avoidance as one of corporate social responsibility (CSR). If it is legitimate for corporations to engage in activities that do not directly benefit shareholders—for example, involvement in philanthropic causes—then it should be legitimate for corporations to act as good tax citizens. On the other hand, if CSR is outside of the scope of legitimate corporate functions, then presumably corporations should seek to minimize their tax liability as much as possible.

Avi-Yonah argues that the legitimacy of CSR depends on our legal theory of the corporation. Under a “real entity” view of the corporation, under which a corporation has rights and duties similar to those of an individual, CSR is not required but is praiseworthy and should be encouraged. Under an “artificial entity” theory, which views the corporation as a creature of the state, CSR may fulfill the corporation’s obligations to the state and is required in at least some cases. However, the dominant view of the corporation in the United States is the “aggregate” theory, under which the corporation functions as an aggregate of its shareholders. To the extent that CSR involves activities that do not maximize shareholders profits in the long run, it is illegitimate under an aggregate theory.

The question, then, becomes how to square the theory that corporations exist to maximize shareholder profits with the goals of the U.S. tax system. One fascinating aspect of the article is the historical perspective that Avi-Yonah offers with respect to this question. Although, he notes, “the goal of shareholder profit maximization can naturally lead to corporations trying to minimize taxes and thus enhance earnings per share,” Avi-Yonah argues that this was not always a guiding principle among corporate managers. Rather, he asserts, this view has evolved over the past few decades due to several factors. First, the increasing use of equity-based compensation for managers (stock options, for example) has created more focus on earnings per share than in the past. Second, big accounting firms changed the landscape of corporate taxes in the early 1990s when they began marketing and selling tax shelters to corporate clients. Third, lower effective tax rates and increased earnings per share among some corporations has pressured others to adopt aggressive tax strategies in an effort to stay competitive.

Despite the proliferation of the modern view that aggressive tax avoidance is an inherent part of shareholder profit maximization, Avi-Yonah offers several reasons to be skeptical. First, from a theoretical standpoint, he argues that corporations have an affirmative duty to pay taxes, even under an aggregate view of the corporation. If CSR is not a legitimate corporate function, then social problems must instead be addressed by the government. However, if corporations are relieved of the obligation to pay taxes, then the government cannot collect adequate revenue. And without revenue, the government cannot resolve the social issues for which it is responsible. The result, Avi-Yonah argues, would be a theory under which neither the government nor corporations can adequately deal with social problems, which is an unacceptable outcome. Thus, aggregate theory must require corporations to pay taxes to enable the government to carry out the social functions that corporations themselves cannot legitimately perform.

Avi-Yonah moves beyond the theoretical and also offers some practical reasons to question the premise that shareholder profit maximization requires aggressive tax avoidance. For example, he points out that, historically, corporations were able to compete and maintain attractive share prices without resorting to abusive tax strategies. Further, he argues, there is not clear empirical evidence establishing a link between lower effective tax rates and higher share prices.

Accepting that corporations are not obligated to engage in aggressive tax behavior still leaves open the question of how to distinguish between legitimate tax planning and the abusive avoidance strategies that policymakers want to discourage. But while it may be difficult for the IRS and courts to make this distinction, corporate managers are usually well aware of whether a particular transaction is motivated by genuine business considerations or by tax avoidance. Thus, Avi-Yonah argues, “a corporation can be legitimately expected to police its own behavior in this regard, without worrying too much about where the line should be drawn.”

Avi-Yonah’s article doesn’t attempt to address how we might encourage corporate managers to police themselves with respect to aggressive tax planning. But he offers an important and unique perspective on how policymakers might address corporate tax avoidance more generally. Perhaps, as Avi-Yonah suggests, the lines between acceptable and unacceptable tax planning should be drawn by those armed with the relevant information—the corporate managers themselves. What’s still unclear, however, is how to make the leap from saying that paying more corporate tax is legally acceptable to convincing managers that paying more corporate tax is desirable. Avi-Yonah’s article raises the possibility that difficult questions such as this one may be better addressed by corporate law rather than by the tax law.

Cite as: Kathleen DeLaney Thomas, Do Corporate Managers Have a Duty to Avoid Taxes?, JOTWELL (April 29, 2015) (reviewing Reuven S. Avi-Yonah, Just Say No: Corporate Taxation and Corporate Social Responsibility __ NYU J. Law & Bus. __ (forthcoming), available at SSRN), https://tax.jotwell.com/do-corporate-managers-have-a-duty-to-avoid-taxes/.

Non-U.S. Acquirers: Clients for U.S. Targets’ “Locked-Out” Earnings?

Andrew Bird, Alexander Edwards, & Terry J. Shevlin, Does the U.S. System of Taxation on Multinationals Advantage Foreign Acquirers? (January 15, 2015), available at SSRN.

Did Burger King submit to acquisition by a Canadian donut chain for tax reasons? Or, at least, once Burger King and Tim Hortons decided to merge, did they choose to have a Canadian parent for tax reasons? A recent empirical study by Andrew Bird, Alexander Edwards and Terry Shevlin suggests that one tax factor—the existence of “locked out” offshore earnings—increases the likelihood that a non-U.S. acquirer will acquire a U.S. target. Bird, Edwards and Shevlin analyze thousands of merger transactions, without regard to whether the transactions might be labeled “inversions.” Their paper contributes to the considerable literature that tests the idea that accounting and tax disparities affect firm prices and transaction decisions.

Bird, Edwards and Shevlin examine several thousand public company firms with a parent corporation incorporated in the United States, for example under Delaware law. Each of the firms in the sample was acquired between 1995 and 2010. The paper considers the possibility that these target U.S. firms might have been acquired by U.S. or non-U.S. acquirers. Bird, Edwards and Shevlin find that when a U.S.-parented target corporation has more offshore “locked-out earnings,” the target firm is more likely to merge with a non-U.S. acquirer rather than a U.S. acquirer.

The concept of “locked-out earnings” has meaning in both tax law and tax accounting vocabularies. From a U.S. income tax law perspective, the presence of “locked-out earnings” generally means that a firm has achieved a low tax rate on non-U.S. earnings housed in non-U.S. subsidiaries of a U.S. parent. The earnings are “locked-out” because the U.S. parent would have to pay significant residual U.S. corporate income tax (as well as, perhaps, non-U.S. withholding tax) upon a dividend of the earnings to the U.S. parent. Such a residual U.S. tax would be reduced by credits for foreign income taxes paid, but a firm that has achieved a low tax rate on non-U.S. earnings will generally not have significant foreign tax credits available.

Financial accounting for taxes provides a required disclosure related to locked-out earnings. A firm can designate and report earnings that are indefinitely reinvested in a foreign jurisdiction as permanently reinvested, or PRE. A firm need not record any income tax expense with respect to PRE, on the theory that the designated earnings are earmarked for offshore investment and will never come home. Other work has shown that both tax and nontax incentives drive PRE designation. In other words, there is some overlap between PRE in accounting and the idea of locked-out earnings in tax, but the overlap is not complete.

Having a non-U.S. parent—rather than a U.S. parent—alleviates both the tax law and the accounting problems associated with locked-out earnings. From a tax law perspective, it may be possible for a firm to repatriate pre-transaction earnings without residual U.S. tax using a “hopscotch loan” or other “out-from-under” technique. (The Obama administration recently promised regs that would treat hopscotch loans as deemed dividends, but only for a firm that had engaged in a transaction treated as an inappropriate inversion.) Also, future non-U.S. earnings should not produce the tax-lockout problem.

A favorable accounting result follows from favorable tax results, to the extent available. In other words, if there is no residual tax upon the repatriation of earnings, a foreign parent need not report a tax expense upon a distribution of foreign earnings.

Bird, Edwards and Shevlin use three proxies for locked-out earnings. One is the PRE disclosed in a target firm’s financial statement footnotes. A second is a binary PRE indicator variable that equals 1 if there is any disclosure that PRE exists. A third is a repatriation cost measure derived from the difference between U.S. corporate tax that would be imposed on foreign income (at the U.S. statutory rate) and current foreign income tax expense already paid (to account for foreign tax credits).

They find that the more PRE a U.S. firm has, the greater the likelihood that the firm will be acquired by a non-U.S. firm. A one percentage point increase in PRE translates to a 0.58 percentage point increase in the likelihood of a foreign acquirer. A one percentage point increase in the repatriation cost measure proxy for locked-out earnings has a smaller effect—it translates to a 0.02 percentage point increase in the likelihood of a foreign acquirer. Both are highly significant, at the 1% level, meaning that there is a 99% probability that the relationship described in the sample of firms also applies for a larger population. When the authors control for the existence and proportion of foreign earnings at a firm, a one percentage point increase in PRE translates to a 0.36 percentage point increase in the likelihood of a foreign acquirer, with significance at the 5% level. These changes compare to 23% overall likelihood of a non-U.S. acquirer for a U.S. target with non-U.S. operations.

The authors also divide non-U.S. acquirers into two groups according to whether they operate under territorial systems, meaning that the jurisdiction of incorporation only taxes domestic income; or worldwide systems, meaning that the jurisdiction of incorporation taxes (at least in theory) both domestic and foreign income. They find that the observed correlation between locked-out earnings and the likelihood of non-U.S. acquisition is driven by non-U.S. firms incorporated in territorial jurisdictions. A one percentage point increase in PRE translates to a 0.32 percentage point increase in the likelihood of acquisition by a territorial non-U.S. firm, but lacks a statistically significant correlation with the likelihood of acquisition by a worldwide non-U.S. firm.

This work has relevance for international tax policy because it suggests a general reason why non-U.S. acquirers may have an advantage over U.S. acquirers for some U.S. target firms. Bird, Edwards and Shevlin do not claim that their results show that accounting and tax considerations cause firms to seek an acquirer; the paper’s sample does not include any control group of firms that did not merge at all. But their results may have relevance for proposals to adopt territoriality for the U.S. system.

More generally, their results emphasize the importance of working out how to tax non-U.S. parented firms with U.S. subsidiaries. This project has long been a sideshow in the U.S. The paradigm case in regulations, white papers and case law features the U.S. parent of a multinational group. Earnings stripping legislation has been stalled for years. This project needs to move forward in order to reach appropriate results for non-U.S. parented multinationals, including those that result from acquisitions described in the Bird, Edwards and Shevlin paper.

Cite as: Susan Morse, Non-U.S. Acquirers: Clients for U.S. Targets’ “Locked-Out” Earnings?, JOTWELL (April 3, 2015) (reviewing Andrew Bird, Alexander Edwards, & Terry J. Shevlin, Does the U.S. System of Taxation on Multinationals Advantage Foreign Acquirers? (January 15, 2015), available at SSRN), https://tax.jotwell.com/non-u-s-acquirers-clients-for-u-s-targets-locked-out-earnings/.