The following post comes to us from Eric L. Talley, The Rosalinde and Arthur Gilbert Foundation Professor of Law at the University of California, Berkeley, School of Law. It is based on a recent working paper, “Corporate Inversions and the Unbundling of Regulatory Competition,” which is available here.

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

Most regulators and politicians have reacted to the inversion invasion with indignation, no doubt fearing that the trend is but a harbinger of an immense offshore exodus by US multinationals.  President Obama has reacted to the inversion trend as follows:

[W]hen some companies cherry-pick their taxes, it damages the country’s finances. It adds to the deficit. It makes it harder to invest in the things that will keep America strong, and it sticks you with the tab for what they stash offshore. Right now, a loophole in our tax laws makes this totally legal – and I think that’s totally wrong. You don’t get to pick which rules you play by, or which tax rate you pay, and neither should these companies.  [S]topping companies from renouncing their citizenship just to get out of paying their fair share of taxes is something that cannot wait. (Weekly Presidential Address: Closing Corporate Tax Loopholes, July 26, 2014)

This reaction, in turn, has catalyzed myriad calls for tax reform from a variety of quarters, ranging from targeted tightening of the tax eligibility criteria,  to moving the US to a territorial tax system, to significant reduction (if not complete elimination) of American corporate tax rates.  The US Treasury itself has recently released Guidance that would make tax inversions more difficult to pull off.  Like many debates in tax policy, however, there remains little consensus about what to do (or whether to do anything at all).

In a recent working paper titled, “Corporate Inversions and the Unbundling of Regulatory Competition,” I analyze the current inversion wave (and reactions to it) from both practical and theoretical perspectives. From a practical perspective, I 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, tax inversions are invariably dilutive and they are usually taxable transactions to the inverter’s US shareholders, which can augur 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 typically involve the merging of differing accounting protocols, which can prove extremely cumbersome. They involve potential regulatory risk from competition authorities, foreign-direct-investment boards and takeover panels (not to mention from tax authorities themselves, who have altered the rules on inversions in ways that impair pending deals). They frequently provide only partial relief from extra-territorial application of US taxes, especially for well-established US multinationals. And finally, inversions arguably introduce potential legal risk downstream, since they move the locus of corporate internal affairs out of familiar jurisprudential terrain and into the domain of a foreign jurisdiction whose law is, by comparison, recondite and unfamiliar.

Moving beyond these practical considerations, I also consider the inversion wave through a theoretical lens, drawing on regulatory competition theories in public finance.  Specifically, I advance the notion that regulatory competition among jurisdictions can play out not only out through tax policies, but also through other important non-tax channels, such as corporate law and governance rules.  Applying this framework, I show that strong domestic corporate governance regulations can provide a plausible buffer against a mass incorporation exodus: although US multinationals clearly dislike high tax rates, they have traditionally valued the strength of US corporate governance protocols, particularly those in Delaware.  And, since US tax policy explicitly ties tax residence to the state of incorporation, domestic tax authorities have enjoyed market power in keeping rates high while attracting and retaining domestic incorporations.  In other words, the US has for a long time remained somewhat insulated from ruinous tax competition because tax rules were “bundled” with corporate law in a unitary regulatory package. Viewed from this perspective, most forms of radical tax reform currently being championed seem both unnecessary and even destructive.

At the same time, the recent inversion trend plausibly suggests that America’s traditional market power in regulatory competition has perhaps begun to slip. I argue that there is an unlikely culprit: Securities Law. During the last fifteen years, a series of significant regulatory reforms – such as Sarbanes-Oxley (2002) and Dodd-Frank (2010) – have suffused US securities regulations with unprecedented corporate governance mandates, ranging from independence requirements to executive compensation reforms to internal financial controls to proxy access to many others. Historically, state law has played that role.  This displacement has consequently “unbundled” domestic tax law from domestic corporate governance regulation, since US securities regulations apply to all listed companies, regardless of their tax residence. Regardless of whether one believes recent federal governance mandates have been value enhancing or value destroying, I argue that this has effectively (albeit unwittingly) compromised the US’s ability to withstand regulatory competition from abroad.

If securities law helped dig this hole, then securities law may provide the needed reform tools to refill it.  My analysis suggests that it does, and that we should consider altering the securities law landscape in one of two (mutually exclusive) ways: either (a) US exchanges should charge listed issuers (regardless of residence) for their consumption of federal corporate governance law, granting exemptions to US-incorporated issuers; or (b) federal law should cede corporate governance back to the states by rolling back the governance mandates in securities laws. Which of these routes is wisest may turn on practical implementation constraints, as well as an assessment of whether the federal governance mandates have succeeded in bolstering firm values and market integrity.

Moreover, to the extent this unbundling hypothesis is valid, it suggests that tax law changes are likely to play only a supporting role in the reform process. Although some modest tax reforms may be warranted, the most radical tax reform proposals currently on the table (such as moving to a territorial tax system or eliminating US corporate income taxes altogether) are unlikely to help, and could well prove counterproductive.  Not only are such radical reforms almost certain to cost the US Treasury sizable tax revenues, but they respond to the unbundling phenomenon not by re-bundling tax and governance, but instead 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 US.