How to Stop Corporate Inversions
/JUSTIN FOX: Welcome to the HBR IdeaCast from Harvard Business Review. I’m Justin Fox, and I’m talking today with Bill George, a professor of management practice at Harvard Business School and the former CEO of Medtronic and Mehir Dasai a finance professor at HBS and also a professor of law at Harvard Law School.
What we’re going to talk about is the currently very controversial, if maybe a little arcane, topic of corporate in versions. But first, Bill, welcome to IdeaCast.
BILL GEORGE: Pleased to be with you, Justin.
JUSTIN FOX: And Mihir, welcome to IdeaCast.
MIHIR DESAI: Great to be here, Justin.
JUSTIN FOX: I’m going to start with a very basic question for Mihir. What is a corporate inversion?
MIHIR DESAI: So the simplest way to think about an inversion is that the usual structure of a company is there’s a parent company on top usually, in this case, a US multinational. And then they have a foreign subsidiary often in, let’s say, a low tax jurisdiction. And that’s subsidiaries below apparent. And an inversion is an inversion about corporate structure. So you turn it upside down.
So that subsidiary in a low tax jurisdiction becomes the parent. And the US company is now the subsidiary of that foreign parent. So that’s the rough version of an inversion. They’re also known as expatriations, because in the process that companies no longer a US company but has now become, let’s say, an Irish or British or Caribbean company.
JUSTIN FOX: I assume this has been possible to do for a while. Why has it become a big deal lately?
MIHIR DESAI: That’s a great question. So these things have been going on for a long time, in a way. There’s a wave in the early 2000s. And we shut them down with legislation. That was called anti-inversion legislation.
But what’s happened recently is they now involve much more substantive transactions. To affect the same kinds of savings and particular tax savings, now firms are accomplishing this with a merger. So now, instead of just being able to do it by yourself, the rules are such that if you want to do this you really have to have a foreign partner and there has to be a merger.
So as a consequence of that, we now see these relatively high profile merger, which facilitate the departure of US companies. And the size has grown enormously. So we have some of our largest and most innovative companies doing this. So I think that’s the reason why it’s gotten much more note worthy.
JUSTIN FOX: So Bill, is the problem here– if there is a problem here– our corporate tax code or our corporate executives?
BILL GEORGE: Well, the problem is definitely with the tax code. We have a dysfunctional tax code in the United States. We have among the highest tax rates anywhere in the world. And what’s happened is companies are paying taxes on foreign earnings that they generate overseas, but they’re not bringing them back to the United States because they don’t want to pay the US corporate tax rate of 35%.
So you’ve got some $2 trillion of cash trapped overseas. So companies are looking for ways to use that cash effectively. It’s driven many US companies by foreign companies. But in many cases, they’d much rather deploy that cash in the United States. So we need to fix the tax code.
One very creative proposal came from Alfred [INAUDIBLE], who’s a liberal Democrat economist, who recommended that US go to the system that almost all of the industrial nations have, of just taxing people where they earned the money based on the revenues there. And personally, I think that would solve the problem. I don’t anticipate we’re gonna get there soon. But that’s one solution.
JUSTIN FOX: Well, Mihir, you wrote an article for HBR a couple years ago on how to fix the US corporate tax code. And I think that was one of the things you wanted to have happen. But what were some of the other key changes?
MIHIR DESAI: Well, I think Bill is exactly right. This is a manifestation of two big problems. One is a high rate and the second is this worldwide system. Both of which are highly distinctive relative to the rest of the world. And in particular, one of the things that’s happened recently is leading countries like the UK and Japan, which used to look more like us with relatively high rates and a worldwide system have left.
So now we’re really all alone. And that’s why these transactions are happening more. So meaningful reform would combine for sure two things. One, a considerably lower rate. And I think you need to get below 25 or 20 for it to be meaningful. And the second, as Bill mentioned, is a switch to a territorial regime.
I actually am optimistic that we can get there. There’s a fair amount of consensus about that. The tricky part is where does the money come from to fund all that. And there I think people divide up.
My proposal has two particular sources of revenue raising. One is we have now large numbers of pass through entities. And we have more business income in non-see corporate form than we do in see-corporate form.
JUSTIN FOX: Like what kind of entities?
MIHIR DESAI: So those would be partnerships. Those would be REITs. Those would be Sub-chapter S corporations, LLCs, and they have mushroomed wildly in the last 25, 30, years. So as a result, the only people who pay the corporate tax, really, is large, public, multinationals. And that doesn’t make any sense. So a small tax on those pass through entities can help a lot.
And the second source revenue is trying to change the fact that corporations report large profits to capital markets and relatively small profits to tax authorities. That’s another source of revenue, which is, if we make it more the case that you have to base your taxes on profit reports to capital markets, that can raise a fair amount of revenue, as well. So I’m pretty optimistic that we can get something post election. But it’s going to take a lot of work.
BILL GEORGE: Mahir, I appreciate your optimism. One issue I hear is how much money’s going to be lost by the US Treasury. But in talking to corporate CEOs, CFOs, and board members, I don’t see any of the major multinationals planning to bring that cash back to the United States.
I was with the CFO of Apple the other day and was talking to him. They’ve got $140 billion of cash trapped overseas. They aren’t [? planning to do an ?] inversion. But on the other hand, after tax, they’re earning less than 1% on that money compared to well over 30% when they invested in new products, and R and D, and innovation.
MIHIR DESAI: Apple’s a great example, Bill. The amazing thing about Apple is they have 140, 160, billion in cash. They just decided to give back a lot of that cash in the form of dividends and share repurchases. But the irony, of course, as you point out is to fund it. They’re not bringing the money home from Ireland.
They’re borrowing a lot of money. They’re borrowing close to 40, 50, billion. And Tim Cook in his testimony to the Senate committee said, should I rather borrow money at 1% or should I pay 35% on my repatriated profits? And the answer obviously is borrow at one.
So this is just an example of the distortions you were talking about earlier, Bill. I guess the reason I’m optimistic is, both, the left and the right have conceded that the rate is out of whack and they’ve conceded that territorial is the way to go. So now it’s about political will, and it’s about finding the revenue to fund it.
And I think, Bill, we have to get a little bit more creative. But I guess I’m not a political prognosticator. I’m more of an optimist.
JUSTIN FOX: 1% versus 35%, that’s a really big difference. But at some level, is there a conflict here between you’re a CEO of a company and you were one bill. Your obligation to, I guess, your shareholders and others within the organization to minimize your taxes but then also your obligations as a citizen to not minimize them all the way to 0. I mean, what is the dividing line here? Is there one that we can identify?
BILL GEORGE: Well, that’s a great question, Justin, because I’ve spent many hours talking to Omar Ishrak, the CEO of Medtronic, who is involved in a major inversion– $43 billion dollar deal– to purchase Covidien. And I think the key question I asked him was why are you doing this? And if he’s doing it for tax inversion, he’s got trouble.
But he was very clear he’s doing it to expand the Medtronic mission of helping patients. The strategy is a perfect bid. It gives Medtronic five new number 1 positions. And it allows them to invest more money in innovation, ironically, because they can now use the $14 billion they have in cash trapped overseas to invest in the US.
So you have the great irony here of [? bringing ?] inversion and being able to invest it back in the US. In fact, they committed to the governor of Minnesota they’d invest $10 billion over their strategic plans in new ventures and innovation to try to expand the company’s growth rate. You see, these things are quite nuanced and quite complex. But certainly, that was not the primary motivation for leaving. You have to build the company.
JUSTIN FOX: Because you’ve been critical of some of the other inversions. I guess the Pfizer one, which isn’t going to go through, right?
BILL GEORGE: Well, I was quite critical of Pfizer because I thought they were doing it for the wrong reason. In fact, Ian Read, the CEO, in his testimony to British parliament said he was doing it basically for two reasons. One for tax savings through the inversion. And on the second reason, to all the savings he could by [INAUDIBLE] people and combining.
And that led to quite a bit of controversy because AstraZeneca had done a very good job in building its pipeline under his new CEO, Pascal Soriot, over the last two years. And everyone saw that pipeline going away and people losing their jobs that, beyond that, innovation that people needed– the lifesaving drugs– might not be there.
And Pfizer’s track record, since 1990, they’ve done a lot of major deals. And their stock is down about 30% while the Dow Jones Industrials are up better than 55%. So I saw that in a very different context that it was being done for the wrong reason.
Back to the Medtronic example, ironically, Medtronic gets no tax savings. It already has an 18% tax rate. And that’s about what they’re going to pay with Covidien. So there’s really no savings to them at the present time. But it does free up cash.
MIHIR DESAI: I think Bill’s example is really interesting for two reasons. One is we’re in such a crazy place that doing something that seems like it’s actually going to remove activity from the US can actually help the US because of all this capital that’s trapped overseas. So that’s an example where the headline, which is some company leaving, is not representative of what the reality is.
At the same time, I do think, Justine, your question puts your finger on something deep, which is there’s a growing distrust of corporations. And when people see corporations doing this, they question their patriotism as, in fact, the administration has. So corporations have to be more sensitive to this issue that I think they’ve been, which is they’re viewed with suspicion.
And now when they undertake something like this, people question their motives almost automatically. So we’re in a place where the conversation’s pretty dysfunctional. And as a consequence, moves that are potentially legitimate business moves get questioned very seriously.
JUSTIN FOX: I mean, there’s been some talk that the president could do something unilaterally, even without Congress, about this. Could he?
MIHIR DESAI: There are people who disagree about this. But the short version is there are three outcomes here. One is we do something regulatory and that the president or the Treasury Department can do by themselves. The proposals that have been floated are of dubious constitutionality. And I don’t think most people think that those things are things that can be done by executive order.
So what’s more likely, believe it or not, is congressional action, which could happen in the lame duck session, which would be some form of anti inversion legislation. But you know, what’s sad about that is that we’re talking about patchwork solutions and Katy bar the door kind of solutions where we try to stop activity as opposed to using this as an opportunity for genuinely saying let’s think about what we need to do in a more dramatic way.
BILL GEORGE: Yeah, I agree with, Mihir. I think that that’s not really addressing the problem. I’m disappointed that the President has taken a more negative tone to this rather than recognizing the problem for what it is. It’s an opportunity to fix the tax code to attract more investment in this country.
In fact, I’ve even suggested five years ago when jobs were really hurting that we have a short term tax repatriation holiday if companies presented a plan for the Treasury Department to reinvest in hard assets like manufacturing R and D, job creation, and new venture and innovation. So I also agree with you, though. I think there’s a real problem, and I’ve seen this in Medtronic case and other cases, about how loyal are you to the United States.
And I think there has been a considerable amount of ill will over that. And I think companies are going to have to step up and show their commitment to invest in the United States because this is the greatest place anywhere in the world to invest in innovation and R and D, as well as investing in social programs through their own philanthropy, which I think that many companies start stepping those up, as well.
MIHIR DESAI: One problem with the rhetoric is that, you know, we think that when companies do things overseas it’s bad. Somehow, that foreign activity’s just bad for us as Americans. And I think many political folks have advanced that idea. And the problem is that’s wrong, which is, in fact, the evidence suggests that when companies flourish abroad, they flourish at home.
And that’s, I think, unsurprisingly once you think about it for more than a few seconds, which is, when organizations succeed abroad, they’re more likely to do things at home like R and D, like headquarters functions, like exporting, so we really need to change our minds about the way we think about global companies. You know, what happened in the UK is a couple of large companies left– WPP, Shire.
And then the politician said, you know, we don’t want to demonize these people. We just simply want to be home to great companies and let them succeed globally. And once you adopt that attitude and that rhetoric, as the British politicians did, I think things become a lot easier.
BILL GEORGE: Mihir, you and I worked together on the HBS US competitiveness study. And I think one of the things that came out of that was precisely the point you’re making. When a company like General Motors is successful globally and can compete with China, it strengthens their position back home. It strengthens their headquarters, their R and D, their engineering, their marketing, and they can get the worldwide car, which is where Mary Barra is trying to take the company. So I think American multinationals, which is really what we’re talking about, need to be very strong globally. And that does in fact, enhance the United States.
JUSTIN FOX: Bill and Mihir, thanks again for talking with us.
MIHIR DESAI: All right, great to talk.
BILL GEORGE: Yeah, it was great. Thank you, Justin.
JUSTIN FOX: That was Bill George and Mihir Desai. And this was the HBR IdeaCast. For more, go to HBR.org.