Why the Treasury's New Tax Inversion Tactics Miss the Mark

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Until April 15 approaches every year, it's hard for many Americans to pay much attention to tax issues. But the recent surge in the number of U.S. companies using a popular tax-cutting strategy known as a tax inversion has led to extensive controversy, with proponents of the strategy arguing that it's entirely legal while opponents worry about the loss of U.S. corporate tax revenue. Moreover, political fallout from having well-known companies like Burger King Worldwide (BKW), AbbVie (ABBV) and Medtronic (MDT) flee for foreign countries almost guaranteed that the U.S. government would take action.

Earlier this week, the Treasury Department finally fought back, with new rules designed to limit some of the most common ways that companies structure tax inversions, but they fail to address the deeper issue that led to the use of tax inversions and similar tax-saving devices in the first place.

What Tax Inversions Are and Why They're a Big Deal

The reason that tax inversions have generated so much controversy is that they effectively take away U.S. tax revenue without having much meaningful impact on the way a company does business. A tax inversion involves a U.S. company buying out a foreign company, with the resulting combined business taking the tax home of the foreign company. Because most foreign tax systems have lower tax rates on businesses than the U.S. corporate tax rate of 35 percent, major corporations can save billions of dollars over the long run by moving abroad.

Until now, moreover, it was relatively easy for companies to do tax inversions. Despite rules designed to limit their use, tax inversions involved huge U.S. companies merging with much smaller foreign companies. For instance, AbbVie is almost twice as big as its target, Shire, even after Shire shares soared following the buyout announcement. Medtronic has a similar size advantage compared to target Covidien (COV).

What the Treasury Did

In its notice to the public, the Treasury took a hard stance on trying to eliminate tax inversions. Treasury Secretary Jacob Lew characterized the new rules as "meaningfully reducing the economic benefits of inversions after the fact, and when possible, stopping them altogether."

The rules themselves are complicated, but they seek to make tax inversions harder to structure. One rule change essentially doubles the required size of the foreign target company, with potential adverse consequences if shareholders of the U.S. company own as little as 60 percent of the combined company's stock. Another prevents a U.S. company from using tactics like paying special dividends to reduce its relative size or moving assets into a foreign subsidiary that it then spins off to its shareholders. Other rules go beyond the tax inversion strategy, limiting the ability of companies to access cash from their foreign subsidiaries through loans.

Why the Treasury's Moves Aren't Enough

Yet critics were quick to note that the new rules don't go far enough. CNBC commentator Josh Brown pointed out that the rules do nothing to stop U.S. companies from accumulating assets in overseas subsidiaries and keeping them outside the U.S. indefinitely. Under current tax law, such moves never require the U.S. parent company to pay taxes on the foreign income.

Even the Treasury admits that these measures won't solve the true problem involved in enforcing U.S. tax rules in a global economy. As Lew said, "comprehensive business tax reform that includes specific anti-inversion provisions is the best way to address the recent surge of inversions," but the Treasury felt that taking what action it could now would be better than doing nothing.

More broadly, the global economy makes it easier than ever for companies to shop for countries that offer the best tax incentives. Just as U.S. companies routinely get large tax breaks from state and local governments that want to lure new business prospects to their areas, so too have entire nations sought the business of the largest multinational corporations, touting their much-lower corporate tax rates and the availability of legal tax laws to help them minimize their worldwide tax liability.

The Treasury's efforts to control tax inversions are an important first step. But without full-blown tax reform to align the U.S. foreign tax system with the rest of the world, the Treasury's move won't solve the larger problem and will instead give companies an incentive to find other innovative methods to cut their tax bills.

You can follow Motley Fool contributorDan Caplingeron Twitter@DanCaplingeror onGoogle Plus.Hehas no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide and Covidien and owns shares of Medtronic.To read about our favorite high-yielding dividend stocks for any investor, check outour free report.

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