Brief of Tax Law Professors as \u3ci\u3eAmici Curiae\u3c/i\u3e in Support of Petitioner in \u3ci\u3eLoudoun County, Virginia v. Dulles Duty Free, LLC\u3c/i\u3e

Amici are professors of tax law at universities across the United States. As scholars and teachers, they have considered the doctrinal roots and practical consequences of judicial limits on state and local taxation. Amici join this brief solely on their own behalf and not as representatives of their universities. A full list of amici appears in the Appendix to this brief

Expectations and expatriations: Tracing the causes and consequences of corporate inversions.

ABSTRACT This paper investigates the determinants of corporate expatriations. American corporations that seek to avoid U.S. taxes on their foreign incomes can do so by becoming foreign corporations, typically by "inverting" the corporate structure, so that the foreign subsidiary becomes the parent company and U.S. parent company becomes a subsidiary. Three types of evidence are considered in order to understand this rapidly growing practice. First, an analysis of the market reacton to Stanley Works's expatriation decision implies that market participants expect its foreign inversion to be accompanied by a reduction in tax liabilities on U.S. source income, since savings associated with the taxation of foreign income alone cannot account for the changed valuations. Second, statistical evidence indicates that the large firms, those with extensive foreign assets, and those with considerable debt are the most likely to expatriate -suggesting that U.S. taxation of foreign income, including the interest expense allocation rules, significantly affect inversions. Third, share prices rise by an average of 1.7 percent in response to expatriation announcements. Ten percent higher leverage ratios are associated with 0.7 percent market reactions to expatriations, reflecting the benefit of avoiding the U.S. rules concerning interest expense allocation. Shares of inverting companies typically stand only at 88 percent of their average values of the previous year, and every ten percent of prior share price appreciation is associated with 1.1 percent greater market reaction to an inversion announcement. Taken together, these patterns suggest that managers maximize shareholder wealth rather than share prices, avoiding expatriations unless future tax savins -including reduced costs of repatriation taxes and expense allocation, and the benefits of enhanced worldwide tax planning opportunities -more than compensate for current capital gains tax liabilities. Introduction There is considerable confusion over the attributes necessary for a corporation located in the United States to be considered an "American" company, particularly insofar as nationality is thought to carry with it any entitlement to special treatment. Manufacturing production is typically integrated internationally, so multinational firms headquartered in the United States are likely to purchase large fractions of their inputs from foreign suppliers, sell much of their output to foreign buyers, and in the process often employ more labor and capital in foreign countries than they do in America. 1 This observation prompts some observers to question the wisdom of government policies directed at assisting those American companies with extensive global operations, 2 while others take exactly the opposite view, arguing that international business mobility makes it essential for governments to do everything they reasonably can in order to make their locations attractive to multinational businesses. 3 Taxation is one arena in which nationality has clear consequences. Home governments are entitled to tax the foreign incomes of their resident companies, and they do so to differing degrees. One consequence of the U.S. tax system is that a corporation considered to be American for tax purposes will typically face greater tax obligations on its foreign income than would the same company if it were considered to be, say, German for tax purposes. Tax authorities are keenly interested in the nationality of their companies for the simple reason that, if a multinational corporation is Japanese for tax purposes, then its foreign profits are subject to taxation by Japan, while if the same corporation were American, then the United States would receive any taxes due on foreign profits. From a legal standpoint, the definition of American tax residence is reasonably straightforward: a corporation is "American" for tax purposes if it is incorporated in the United States. Firms choose their sites of incorporation, and, under current U.S. law, a company need not produce or sell anything in the country that serves as its tax home. As a result, there can be strong incentives to select incorporation sites that offer the most attractive tax benefits. Individual shareholders, who previously owned shares of the American parent company, will then own shares of the foreign (parent) company, which owns the American company. These transactions are commonly referred to as "inversions," since their impact is to invert the corporate structure: the erstwhile subsidiary becomes the parent, and the erstwhile parent becomes the subsidiary. American corporations have undertaken several well-publicized inversions in recent years, and the rate at which they do so continues to rise. Indeed, seven members of the Standard & Poor's 500 index have expatriated, or have announced plans to do so, and there are reportedly several others considering such inversions. The purpose of this paper is to analyze the economic factors associated with corporate expatriations that take the form of inversions. This task is complicated by the fact that inversions, while growing in popularity, are still quite uncommon, so it is possible to obtain reliable information on only two dozen or so inverting companies. Accordingly, the paper employs three distinct methodologies -an analysis of market reactions to one announced expatriation, a statistical analysis of the factors that lead to decisions to expatriate, and an event study analysis of reactions to expatriations -to understand the motivations behind expatriations. prevents a wholesale expatriation of corporate America is therefore either a reluctance to act on the basis of tax incentives, or else that costs of inverting exceed the potential benefits. A major cost of expatriation is that owners of inverting firms must recognize capital gains on stock appreciation since time of purchase; the magnitude of this cost depends, therefore, on a company's history of share price appreciation. For firms whose shares have appreciated significantly in value, it follows that expatriation is profitable only if the future gains from avoiding U.S. taxation of foreign income are so large that they more than offset the current capital gains tax liability for shareholders. The evidence that firms with significant prior share price appreciation exhibit the strongest positive price reactions to inversion implies that managers contemplating expatriation are generally sensitive to the tax burdens they impose on shareholders and these managers are maximizing shareholder wealth rather than share prices. If managers were maximizing share prices instead of shareholder wealth, there would be no taxbased counterweight to the perceived benefits of expatriation. These results suggest that a natural brake on the tide of inversions, and a corresponding selection mechanism, is operative with respect to expatriations. Section two of the paper reviews the U.S. system of taxing the international income of American companies. Section three identifies the incentives that companies face to expatriate, and the costs that they incur in doing so. Section four takes an in-depth look at the experience of Stanley Works, an American company that has announced plans to expatriate through an inversion. Section five evaluates the factors that lead companies to invert, analyzing a large sample of publicly traded firms. Section six analyzes stock price reactions to inversion announcements. Section seven is the conclusion. The taxation of foreign income 5 The taxation of international transactions differs from the taxation of domestic economic activity primarily due to the complications that stem from the taxation of the same income by multiple governments. In the absence of double tax relief, the implications of multiple taxation are potentially quite severe, since national tax rates are high enough to eliminate, or at least greatly discourage, most international business activity if applied two or more times to the same income. 5 Almost all countries tax income generated by economic activity that takes place within their borders. In addition, many countries -including the United States -tax the foreign incomes of their residents. In order to prevent double taxation of the foreign income of Americans, U.S. law permits taxpayers to claim foreign tax credits for income taxes (and related taxes) paid to foreign governments. 6 These foreign tax credits are used to offset U.S. tax liabilities that would otherwise be due on foreign-source income. The U.S. corporate tax rate is currently 35 percent, so an American corporation that earns $100 in a foreign country with a 10 percent tax rate pays taxes of$10 to the foreign government and $25 to the U.S. government, since its U.S. corporate tax liability of$35 (35 percent of $100) is reduced to$25 by the foreign tax credit of $10. Americans are permitted to defer any U.S. tax liabilities on certain unrepatriated foreign profits until they receive such profits in the form of dividends. 7 This deferral is available only on the active business profits of American-owned foreign affiliates that are separately incorporated as subsidiaries in foreign countries. The profits of unincorporated foreign businesses, such as those of American-owned branch banks in other countries, are taxed immediately by the United States. To illustrate deferral, consider the case of a subsidiary of an American company that earns$500 in a foreign country with a 20 percent tax rate. This subsidiary pays taxes of $100 to the foreign country (20 percent of$500), and might remit $100 in dividends to its parent U.S. company, using the remaining$300 ($500 -$100 of taxes -$100 of dividends) to reinvest in its own, foreign, operations. The American parent firm must then pay U.S. taxes on the$100 of dividends it receives (and is eligible to claim a foreign tax credit for the foreign income taxes its subsidiary paid on the $100). 8 But the American firm is not required to pay U.S. taxes on any part of the$300 that the subsidiary earns abroad and does not remit to its parent company. If, however, 5 Some parts of this brief description of international tax rules and evidence of behavioral responses to international taxation are excerpted from 6 the subsidiary were to pay a dividend of $300 the following year, the firm would then be required to pay U.S. tax (after proper allowance for foreign tax credits) on that amount. of foreign taxes, then it would be permitted to claim no more than$70 of foreign tax credits. Taxpayers whose foreign tax payments exceed the foreign tax credit limit are said to have "excess foreign tax credits;" the excess foreign tax credits represent the portion of their foreign tax payments that exceed the U.S. tax liabilities generated by their foreign incomes. Taxpayers whose foreign tax payments are smaller than their foreign tax credit limits are said to have "deficit foreign tax credits." American law permits taxpayers to use excess foreign tax credits in one year to reduce their U.S. tax obligations on foreign source income in either of the two previous years or in any of the following five years. 10 9 Subpart F income consists of income from passive investments (such as interest and dividends received from investments in securities), foreign base company income (that arises from using a foreign affiliate as a conduit for certain types of international transactions), income that is invested in United States property, money used offshore to insure risks in the United States, and money used to pay bribes to foreign government officials. American firms with foreign subsidiaries that earn profits through most types of active business operations, and that subsequently reinvest those profits in active lines of business, are not subject to the Subpart F rules, and are therefore able to defer U.S. tax liability on their foreign profits until they choose to remit dividends at a later date. 10 Foreign tax credits are not adjusted for inflation, so are generally the most valuable if claimed as soon as possible. Barring unusual circumstances, firms apply their foreign tax credits against future years only when unable to apply them against either of the previous two years. Firms paying the corporate alternative minimum tax (AMT) are 7 In practice, the calculation of the foreign tax credit limit entails certain additional complications, the first of which is that total worldwide foreign income is used to calculate the foreign tax credit limit. This method of calculating the foreign tax credit limit is known as "worldwide averaging." A taxpayer has excess foreign tax credits if the sum of worldwide foreign income tax payments exceeds this limit, subject to the requirement that income is segregated into functional "baskets" for the purpose of this calculation. 11 A second, and very important, aspect of the foreign tax credit calculation is the way in which it is affected by expenses incurred in the United States. Firms with certain types of taxdeductible expenses, particularly interest charges, expenditures on research and development, and general administrative and overhead expenses, are required to allocate fractions of these expenses between domestic and foreign source. The concept underlying this allocation process is that raising investment capital, producing innovations, and managing firm operations all contribute to the worldwide income of the firm. The intention of the U.S. allocation rules is to retain the tax benefits of the deductibility of such expenses against domestic income only for the portion of expenses that contribute to producing income that is taxable by the United States. U.S. tax rules attempt to implement this principle by assigning a certain fraction of general expense items to have domestic source, with the rest being assigned to foreign source, based on arcane and ever-changing formulas. Expenses that are assigned to foreign source reduce the magnitude of foreign income for the purpose of calculating the foreign tax credit limit, which is costly for firms with excess foreign tax credits, and not costly for firms with deficit foreign tax credits. Interest expenses are allocated between domestic and foreign source based on fractions of assets located inside and outside the United States, 12 while R&D and other expenses are allocated based partly on place of performance and partly on relative foreign and domestic sales. 13 Since subject to the same rules, with the added restriction that the combination of net operating loss deductions and foreign tax credits cannot reduce AMT liabilities by more than 90 percent. It is noteworthy that, since the AMT rate is only 20 percent, firms subject to the AMT are considerably more likely to have excess foreign tax credits than are firms that pay the regular corporate tax. 11 The "baskets" distinguish general active income from passive income, petroleum income, shipping income, and some other income categories, thereby, e.g., preventing taxpayers from using credits for taxes paid at high rates on petroleum income to reduce U.S. taxation of other active income. The United States imposes withholding taxes on cross-border dividend, interest, and royalty payments to recipients in other countries. These royalty tax rates are frequently reduced according to the terms of bilateral tax treaties. For example, the United States imposes a 30 percent tax on interest payments to related parties resident abroad, but this rate is reduced, typically to zero, when recipients reside in countries with whom the United States has tax treaties in force. Expatriation in practice This section reviews the U.S. tax treatment of expatriations, and the incentives for which the U.S. tax system is responsible. Expatriation mechanics An expatriation is accomplished by removing foreign assets and foreign business activity from ownership by an American corporation, thereby effectively eliminating U.S. taxes on any income they generate. While not an exhaustive list (due to the spotty coverage of historic inversion data, and the constant flow of current inversions), 15 The expatriations announced in the last twelve months that are listed in 10 -Accenture and Seagate -are listed separately at the bottom of Incentives to expatriate Firms that expatriate remain subject to U.S. taxation of their U.S. income, since the American subsidiary under the new corporate structure is taxed as a U.S. corporation. The tax incentives for an American firm to expatriate can therefore be organized around (i) the tax consequences that arise from no longer being subject to rules arising from the U.S. treatment of foreign source income, (ii) the tax consequences that arise from triggering capital gains at the firm level or shareholder level, and (iii) the tax consequences that arise from enhanced opportunities to relocate profits worldwide in a tax-advantaged way after an expatriation. 16 The tax benefits of expatriating that relate to the U.S. treatment of foreign source income can be construed to have two distinct components. First, repatriation taxes, and costly actions taken to avoid repatriation taxes, would be avoided upon expatriation. 17 These savings, and the restructuring of worldwide operations such that non-U.S. operations would avoid repatriation taxes and the encumbrances associated with Subpart F, are the most widely cited reasons for expatriating. Separately, and as highlighted above, expense allocation rules, including those related to the allocation of interest expense to foreign source income, can provide incentives to expatriate. By expatriating in a way that removes foreign assets from U.S. ownership, it is possible to receive the full benefits of tax shields associated with interest expenses that might not be as valuable currently due to a firm's excess foreign tax credit status. Many of the expatriations profiled in 11 determine the tax costs shareholders incur as a result of expatriating. A second potential tax cost associated with expatriating is withholding taxes on subsequent payments to the new foreign parent company, the avoidance of which requires careful choice of new corporate home. 18 Finally, an expatriating firm and its shareholders may perceive gains from increased flexibility with respect to the worldwide allocation of taxable profits. This increased flexibility pertains to the location of profits within foreign and domestic operations. Within their foreign operations, the foreign tax credit and the potential repatriation taxes a firm faces when bringing income home to the United States limits the returns to relocating profits from high-tax to low-tax jurisdictions. 19 Given that this barrier is removed, and an expatriating firm therefore no longer faces a residual repatriation tax, incentives to be more aggressive in their structuring of worldwide operations would also increase, possibly resulting in increased after-tax cash flows. Similarly, an expatriating firm may become more aggressive with respect to relocating its U.S. income to the tax haven to which they are expatriating. While limits on such activity exist in U.S. tax law, the structuring of debt contracts with the new parents in tax haven countries may allow for reduced domestic tax obligations -sometimes referred to as interest stripping. 20 Interest stripping entails financing a tax haven parent company's ownership of its American subsidiary largely with debt, thereby generating interest deductions against U.S. taxable income. The resulting interest income 18 Since many inversions involve reincorporating in countries with whom the United States does not have tax treaties, it has been common practice to obtain treaty benefits (a five percent withholding tax rate on dividend payments from the United States, and no withholding taxes on interest) by having the foreign parent company managed and controlled in Barbados, with whom the United States does have a tax treaty. Barbados, in turn, imposes a small tax (of between one and 2.5 percent) on the foreign incomes of such companies. 19 Profit location is affected by all aspects of a firm's foreign operations, including investment, financing, and the nature of intra-firm transactions. There is ample evidence that home-country taxation influences patterns of foreign investment 12 is untaxed (or taxed very lightly) by the tax haven, and is not taxed by the United States under Subpart F, since the interest recipient is no longer owned by the American company. Stanley's foreign operations remain the property of the American company, but would presumably be quickly sold to the Bermuda corporation, thereby removing them from American ownership. The Bermuda corporation would be managed and controlled in Barbados in order to benefit from reduced withholding tax rates provided in the U.S.-Barbados tax treaty. Chairman and Chief Executive John Trani cited both increased operational flexibility and improved tax efficiency as strategic motivations for implementing the restructuring. Specifically, Trani projected that Stanley's effective income tax rate would fall by 7 to 9 percentage points from its current level of 32 percent. He also clarified that new future foreign entity would continue to be managed out of Stanley's New Britain, CT headquarters and that its then current ownership structure would not change. The three full quotes attributed to Trani from the press release are: "This strategic initiative will strengthen our company over the long-term. An important portion of our revenues and earnings are derived from outside th

Brief of Tax Law Professors as \u3ci\u3eAmici Curiae\u3c/i\u3e in Support of Petitioner in \u3ci\u3eLoudoun County, Virginia v. Dulles Duty Free, LLC\u3c/i\u3e

Amici are professors of tax law at universities across the United States. As scholars and teachers, they have considered the doctrinal roots and practical consequences of judicial limits on state and local taxation. Amici join this brief solely on their own behalf and not as representatives of their universities. A full list of amici appears in the Appendix to this brief