The congressional response to corporate expatriations: the tension between symbols and...
During the past few years, several high-profile U.S.-based multinational corporations have changed their tax residence from the United States to Bermuda or some other tax haven. They have accomplished these expatriations, and the resulting millions of dollars of annual tax savings, merely by
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INTRODUCTION
In the past few years, (1) several well-known U.S.-based multinational corporations have engaged in restructurings known as "expatriations" or "inversions." (2) Pursuant to an inversion, a corporate group changes the parent corporation's place of incorporation from a U.S. state, such as Delaware, to a foreign country, such as Bermuda or the Cayman Islands.
It is important to distinguish these corporate expatriations from related phenomena such as "runaway plants" and "outsourcing." The runaway plant phenomenon involves corporations with U.S. manufacturing operations shutting down those operations and shifting production to a foreign location. Similarly, outsourcing involves a corporation eliminating service positions in the United States and instead hiring service workers in a foreign location. In contrast to these phenomena, a corporate expatriation does not involve any immediate change in the physical location of the corporate group's management headquarters, manufacturing operations, services, or other activities. (3) Instead, expatriation merely reflects a formal legal change in the country in which the parent corporation's articles of incorporation are filed. (4)
Recent corporate expatriations have been driven by a desire to reduce U.S. income tax liability. The Internal Revenue Code (Code) (5) imposes significant tax consequences based on a corporation's residence, (6) which is determined solely by its place of incorporation. (7) Accordingly, by changing the place of incorporation of the corporate parent, a multinational group might be able to save millions of dollars in U.S. taxes. (8) For example, Cooper Industries anticipated a $55 million annual tax savings from its expatriation, (9) while Ingersoll-Rand expected a $40 million savings in the first year and larger amounts thereafter. (10)
As might be expected, the prospect of large multinational corporations reincorporating abroad to escape U.S. tax liability has attracted significant media and political attention. In the past three years, more than three dozen bills were introduced in Congress to address corporate expatriations, (11) and numerous legislative hearings and debates occurred. (12)
The expatriation phenomenon has, in effect, become a Rorschach test of international tax policy. In interpreting the causes of and appropriate responses to corporate expatriations, legislators have projected their own tax policy belief systems onto the phenomenon. For example, some legislators view expatriations in a sympathetic light, as an understandable response to an overreaching tax code, and argue that the phenomenon reflects the need to curtail drastically the scope of U.S. international taxation. Others view the U.S. international tax system as fundamentally sound, or perhaps even too limited in its scope, and characterize expatriations as unpatriotic tax avoidance by greedy corporations. The legislative proposals and debates reflect these widely varying viewpoints.
Despite the significant legislative attention given to corporate expatriations over the past few years, Congress initially refrained from enacting legislation directly addressing the tax consequences of corporate expatriations. Instead, Congress initially targeted the phenomenon through non-tax legislation. (13) That non-tax legislation, part of the Homeland Security Act of 2002, (14) purports to prevent expatriated corporations from entering into government contracts with the Department of Homeland Security. (15) Thus, rather than directly addressing the tax provisions and underlying tax policies implicated by corporate expatriations, Congress initially relied on an "alternative sanction"--i.e., a mechanism outside of the traditional civil and criminal sanctions that is used to stop a perceived abuse of the tax law. (16)
For almost two years following the enactment of this alternative sanction, Congress periodically entertained proposals aimed at the tax consequences of corporate expatriations. The House and the Senate each developed, and passed, their own respective tax-focused bills, which adopted significantly different approaches to the phenomenon. (17) The House-favored bill would have limited certain tax benefits associated with expatriations, but in general would have continued to permit corporations to obtain significant tax benefits by expatriating. In contrast, the Senate-favored bill would have eliminated all tax benefits associated with expatriations by, in effect, disregarding the inversion transaction and continuing to treat the corporate group's parent as a domestic corporation. Ultimately, in late 2004, Congress enacted the American Jobs Creation Act of 2004 (AJCA), which contained a tax-focused expatriation provision based largely on the Senate's approach. (18)
This article addresses Congress's responses to corporate expatriations--in particular the initial alternative sanction contract ban and the more recent tax-focused legislation. Applying theories of symbolic legislation and social norms as well as an analysis of the normative tax policy arguments underlying the Congressional responses, the article concludes that these responses reflect an abdication of Congress's responsibility to create a coherent and consistent scheme for taxing multinational corporations in an increasingly globalized economy.
Part I of the article provides background information regarding the U.S. taxation of multinational corporations and the tax consequences of corporate expatriations. Part II then provides relevant details regarding Congress's response to the phenomenon.
Part III analyzes the Congressional response through the lens of symbolic legislation theory. The analysis focuses on the symbolic nature of the alternative sanction purporting to deny future government contracts to inverted corporations, concluding that, like most symbolic legislation, this provision has little instrumental effect. Instead, it is principally intended to allow legislators to claim public credit for having responded to a perceived problem while, at the same time, permitting them to avoid detrimental tax consequences to a politically powerful group of corporations. Part III reaches a similar conclusion with respect to the tax-focused proposal that was favored by the House of Representatives.
Part IV considers whether, despite the lengthy delay in enacting instrumentally effective legislation, the mere fact that Congress debated the issue may have had secondary instrumental effects. In particular, it extends the expressive theory of legislation into an expressive theory of legislative debate to determine whether Congress may have influenced social norms regarding corporate expatriations indirectly.
Finally, Part V focuses on the tax policy implications of Congress's response. In particular, it addresses the expatriation provision of the AJCA. It concludes that this tax provision, by disregarding the expatriated corporation's new foreign place of incorporation, raises fundamental questions as to the central role a corporation's place of incorporation plays under current tax law. It analyzes the tenuous normative justifications for the current place-of-incorporation rule, concluding that the United States should consider alternative rules for determining a corporation's place of residence and should adopt a uniform definition applicable regardless of expatriation status.
I. BACKGROUND--OVERVIEW OF RELEVANT U.S. TAX LAW
A. U.S. Taxation of Multinational Corporations
Two fundamental principles underlie the U.S. taxation of corporations in an international context. (19) First, the United States exercises broad taxing jurisdiction over corporations that are considered domestic residents. Unlike some countries, (20) which generally utilize a "territorial" tax system by taxing corporations only on income that arises within that country, (21) the United States taxes domestic corporations on their worldwide income, regardless of where the income arises. To the extent a foreign country in which the income arises also taxes the same income, the United States allows the domestic corporation to claim a foreign tax credit to alleviate the potential for double taxation. (22) This broad taxation of domestic corporations is often referred to as worldwide "residence"-based taxation because it focuses on the relationship between the corporate taxpayer and the United States rather than focusing on the source of the income.
Under a residence-based system it is, of course, important to distinguish between corporations that are U.S. residents and those that are not. (23) The United States utilizes a place-of-incorporation rule for determining whether a corporation is domestic or foreign. (24) Thus, a corporation is considered a domestic corporation taxable on its worldwide income if it is organized under the laws of one of the U.S. states. (25) In contrast, several of the United States's major trading partners that impose worldwide residence taxation utilize standards other than place of incorporation for determining corporate residence. (26)
In contrast to its broad taxation of domestic corporations, the United States taxes foreign corporations--i.e., corporations incorporated under the laws of a foreign country (27)--only on income connected to U.S. business operations (28) and certain nonbusiness income from U.S. sources. (29) Accordingly, a foreign corporation generally is not subject to U.S. income tax on income that arises outside the United States.
The second fundamental principle underlying the U.S. taxation of corporations in an international context is that the United States generally treats a corporation as a separate taxpayer, distinct from its shareholders. For example, if a parent corporation owns all the outstanding stock of a subsidiary corporation, each corporation generally will be treated as a distinct taxpayer, taxable only on the income that corporation itself earns. (30)
In the absence of special rules, this separate taxpayer treatment might significantly undermine the residence-based taxation principle. For example, a domestic corporation seeking to earn income from foreign sources could establish a wholly owned subsidiary incorporated in a foreign country and have that foreign subsidiary engage in the foreign income-producing activity. To the extent that the foreign subsidiary is respected as a separate entity, the United States would not currently tax the domestic parent corporation on the income earned by its foreign subsidiary. Moreover, the United States would not tax the foreign subsidiary on the foreign income earned by the subsidiary because, as discussed above, the United States only taxes certain U.S.-related income of a foreign corporation. Eventually, when the foreign subsidiary distributes its earnings to the domestic parent as a dividend, the United States would be able to impose tax because the domestic corporation, which is taxable on its worldwide income, would have received dividend income. (31) However, the timing of that dividend distribution is within the control of the domestic parent corporation.
In effect, by interposing the foreign corporation and delaying the distribution of the foreign corporation's earnings, the domestic corporation could defer the U.S. taxation of those earnings. If the distributions were delayed long enough, this deferral of U.S. taxation would approximate a permanent exclusion of the foreign income from U.S. taxation. (32) Accordingly, despite the general standard of worldwide taxation applied to domestic corporations, in the absence of special rules, well-advised domestic corporations effectively could exempt significant amounts of foreign income from the U.S. tax base by utilizing foreign subsidiaries.
In order to lessen this ability of domestic corporations to defer U.S. taxation on foreign income through the use of foreign subsidiaries, Congress has enacted several special "anti-deferral" regimes. The most significant of these regimes, particularly with respect to corporate expatriations, is the "Subpart F" regime. (33) In effect, the Subpart F regime cuts back on the separate taxpayer treatment generally afforded to corporations by requiring a domestic corporate parent to include certain income of the foreign subsidiary in its own current income. In particular, if the domestic corporation owns a threshold amount of the foreign corporation's stock (34) and the foreign corporation constitutes a "controlled foreign corporation," (35) then the domestic corporation is required to include currently as its own income certain types of foreign income earned by the foreign corporation even though the foreign corporation has not yet distributed those amounts to the domestic corporation as a dividend. (36)
The domestic corporation in the simple fact pattern discussed above, by owning all the stock of a foreign subsidiary, would be subject to the Subpart F regime. (37) However, the regime does not completely eliminate the treatment of the foreign subsidiary as a separate taxpayer. Rather, the Subpart F regime requires the domestic parent to include in its income only certain types of income (Subpart F income) earned by the foreign subsidiary. (38) Accordingly, the domestic parent is still able to utilize the benefits of deferral with respect to income earned by the foreign subsidiary that is not Subpart F income.
In very broad terms, the types of income earned by the controlled foreign corporation that are considered Subpart F income, and that must therefore be included in the domestic parent's income, include highly mobile passive income, such as interest, dividends, and royalties, and certain business income that does not have sufficient connection to the foreign country in which the foreign subsidiary is incorporated. (39) The types of income that are not considered Subpart F income, and that therefore can continue to receive the benefits of deferral when earned through a foreign subsidiary, include active business income with a sufficient connection to the foreign country in which the foreign subsidiary is incorporated. (40)
B. Tax Consequences of Corporate Expatriations
1. Anticipated Future Tax Benefits to Corporation
The recent wave of corporate expatriations was motivated by anticipated reductions in U.S. income tax liability. (41) These tax savings generally reflected reductions in the U.S. tax on both the foreign income of the corporate group and the U.S.-source income of the corporate group. (42) The following discussion addresses the anticipated tax savings prior to the enactment of the American Jobs Creation Act of 2004.
a. Reduction of U.S. Tax on Foreign Income
The anticipated tax savings with respect to foreign income directly followed from the interaction of the residence-based taxation system and the Subpart F regime summarized in the prior section. As an example, consider a corporate group whose publicly-traded parent is incorporated in the United States and has many subsidiaries incorporated in both the United States and in foreign countries. The corporate parent, as well as each of the U.S.-incorporated subsidiaries, would be treated as domestic taxpayers, and would be taxable on their own worldwide income. Moreover, the corporate parent would be taxable on the foreign income of the foreign subsidiaries to the extent that the income is Subpart F income. (43) In contrast, if the corporate parent of that group were incorporated outside the United States, the Subpart F regime would not apply with respect to foreign subsidiaries of the group (because the ultimate shareholder of the subsidiaries would be foreign, not domestic). (44) Thus, by undergoing an inversion and substituting a foreign-incorporated parent for the U.S.-incorporated parent, the group could avoid future application of the Subpart F regime and ensure that the United States would not impose a corporate-level tax on the foreign income earned by the foreign subsidiaries of the group. (45)
Because inversions attempt, at least in part, to eliminate tax on the corporate group's foreign income, the Treasury Department has referred to the transactions as "self-help territoriality." (46) Several commentators have defended this self-help use of corporate inversions to reduce the U.S. taxation on the group's foreign income, arguing that it is a necessary response by U.S. multinationals who must compete in the global economy against corporations whose home countries utilize a more limited territorial system. (47) Others have strongly criticized this argument as being overly simplistic and misleading. (48)
b. Reduction of U.S. Tax on U.S. Income
In addition to seeking a reduction of U.S. tax on foreign income, corporations expatriated in an attempt to reduce U.S. tax on their U.S. income. Indeed, this goal may have been even more important than the anticipated post-inversion reduction in taxes on foreign income. (49)
Following the inversion, only the U.S. subsidiaries of the corporate group generally would be subject to significant U.S. income taxation. (50) The corporate group could then engage in various transactions to reduce the taxable income of those U.S. subsidiaries. For example, a subsidiary could be structured to owe significant indebtedness to the foreign parent. The large interest payments from the U.S. subsidiary to the foreign corporation would be deductible in calculating the subsidiary's taxable income, thereby reducing its tax liability. (51) Similar opportunities for reducing a domestic subsidiary's U.S. income exist through the use of structures involving manipulation of royalties, management fees, administrative fees, and transfer prices. (52) Because these approaches enable the domestic subsidiary to shift taxable income away from the domestic subsidiaries that otherwise would be taxed on it, the phenomenon is often referred to as "earnings stripping." (53)
The Code contains several provisions that purport to limit a corporate group's ability to shift income away from domestic subsidiaries using these techniques. (54) For example, section 163(j) aims to limit "interest stripping" by limiting the extent to which a corporation that is excessively leveraged with debt can deduct interest payments to related corporations. (55) Similarly, section 482 and the extensive regulations thereunder attempt to prevent corporations under common control from charging each other non-arms-length prices in an attempt to shift income improperly within the group. (56) However, there is general consensus that these provisions did not significantly reduce the potential opportunities for reducing U.S. tax on U.S. income following an inversion. (57)
Unlike the reduction of tax on foreign income resulting from inversions, which at least has some defenders, (58) this use of corporate inversions to reduce U.S. tax on U.S. income has been uniformly condemned. (59) Even those who defend, or at least express some sympathy for, corporations inverting to reduce U.S. tax on foreign income, tend to criticize the use of inversions to reduce tax on income arising in the United States. (60)
2. Immediate Tax Consequences to Corporation and Shareholders
The anticipated tax benefits for an expatriating corporation did not come without a potential tax cost. In particular, a corporate inversion could generate immediate tax consequences to both the corporation and also to its shareholders. (61)
At the shareholder level, Code section 367 (62) and the Treasury Regulations thereunder could require the shareholders of the domestic parent corporation to recognize gain at the time of the inversion, particularly if the inversion is structured as a stock transaction (i.e., the shareholders exchange their stock in the old domestic parent for stock in the newly formed foreign parent). In effect, the shareholder would be treated as if she sold the stock of the old corporation, with the recognized gain equal to the excess of the fair market value of the stock over the shareholder's adjusted basis in the stock. (63)
At the corporation level, Code section 367 and the Treasury Regulations thereunder could require the old domestic parent corporation to recognize gain at the time of the inversion, particularly if the inversion is structured as an asset transaction (i.e., a transfer of the corporate group assets from the old corporation to the newly formed foreign corporation). Under this transaction, the domestic corporation would recognize gain as if all its assets had been sold for fair market value at the time of the transaction. (64) The corporation might be able to offset some of the tax on this gain by applying a foreign tax credit or net operating losses, thereby reducing the tax cost of the transaction. (65)
As a practical matter, this potential for tax consequences at the shareholder and corporation level did not dissuade numerous corporations from expatriating in the first few years of this decade. This lack of deterrent effect has been attributed to several factors. For example, the fall in the stock market from its historic highs in the late 1990s made the potential section 367 shareholder and corporate taxable gain significantly smaller. (66) The tax impact was further reduced to the extent that the corporation's shareholders were tax-exempt institutions or foreign taxpayers, for which the requirement of gain recognition had no practical effect. (67)
II. THE CONGRESSIONAL RESPONSE TO CORPORATE EXPATRIATIONS
The corporate expatriation phenomenon occupied Congress's attention for almost three years. During that period, more than thirty bills were introduced targeting corporations that engage in inversion transactions. (68) However, despite the strong legislative spotlight focused on inversions, Congress initially enacted only one provision specifically targeting corporate expatriates. (69) That law, rather than focusing on tax consequences, instead addresses an area far removed from tax policy--the ability of the expatriated corporation to enter into government contracts with the Department of Homeland Security. (70) As noted above, (71) this purported contract ban is an example of Congress's recent attempt to impose non-tax "alternative sanctions" in an effort to address perceived abuses of the tax laws. Only after an additional two years of debate did Congress enact legislation targeting the tax consequences of corporate expatriation in late 2004.
The following subparts first explain the Homeland Security alternative sanction, and then summarize the legislative proposals and recently enacted legislation that focus on changing the tax consequences to expatriating corporations.
A. Alternative Sanctions--Restrictions on Future Government Contracts
In November 2002 Congress passed, and President Bush signed, the Homeland Security Act of 2002, (72) establishing the Department of Homeland Security. Section 835 of that Act (73) contained the alternative sanction addressing corporate expatriations. That section provides, in general, that "[t]he Secretary [of Homeland Security] may not enter into any contract with a foreign incorporated entity which is treated as an inverted domestic corporation." (74)
As originally enacted, this alternative sanction contained important exceptions. The exceptions provided:
The Secretary [of Homeland Security] shall waive [the ban] with respect to any specific contract if the Secretary determines that the waiver is required in the interest of homeland security, or to prevent the loss of any jobs in the United States or prevent the Government from incurring any additional costs that otherwise would not occur. (75)
Critics quickly noted that these exceptions eviscerated the statutory ban. In particular, by providing an exception for any contract that imposes "any additional costs that otherwise would not occur," the provision continued to allow a foreign corporate parent to enter into a contract if it was the low bidder. (76) Several months later, in response to these charges, Congress amended the alternative sanction by eliminating the exceptions concerning loss of jobs or imposing additional costs on the government. (77) Accordingly, only the "in the interest of homeland security" exception remains. Despite this amendment, the current provision still has only limited instrumental impact. The significant instrumental shortcomings of the provision are discussed below in the context of symbolic legislation theory. (78)
Although this article focuses on the congressional response to corporate expatriations, it is interesting to note that several states have also enacted alternative sanctions targeting inverted corporations. For example, in 2003 California enacted a law providing, in general, that "a state agency may not enter into any contract with an expatriate corporation or its subsidiaries." (79) Similarly, North Carolina enacted a provision prohibiting state contracts for goods or services with corporations or their affiliates that incorporate in certain specified tax haven countries after 2001 and the stock of which is principally traded in the United States. (80) Legislators in several other states have proposed similar bills. (81)
In addition to its enactment of the Homeland Security Act's non-tax alternative sanction, Congress also debated proposals and considered numerous bills that would alter the tax treatment of inverted corporations. After nearly three years, Congress ultimately enacted a tax-focused provision in late 2004.
The tax-focused proposals regarding corporate expatriation fell into two broad categories: (a) broad suggestions that the entire U.S. tax regime applicable to international transactions be overhauled, and (b) narrower proposals specifically targeted at the post-expatriation tax consequences applicable to corporate groups that engage in inversion transactions.
1. Broad Proposals to Overhaul Entire International Tax Regime
With respect to the first category, critics of the federal tax system argue that corporate expatriations are merely a symptom of much broader problems underlying the manner in which the United States taxes income earned in an international context. In particular, it is argued that the worldwide residence-based income taxation of corporations hampers the competitiveness of U.S.-based multinational corporations in an ever more globalized world, thereby forcing corporations to expatriate in order to remain competitive. For example, Bill Thomas, the chairman of the House Ways and Means Committee, observed with respect to corporate inversions:
I'm less inclined to say "you can't do it" than I am to treat it as a symptom, examine the underlying disease--and it's the tax code and [its] failure to be even minimally useful to these folk--and deal with the fact that the U.S. is out of sync with the rest of the world[.] ... We are not well equipped to deal with trade in the 21st century; we have to change our tax code. (82)
Similarly, the Bush Administration, as evidenced by the Treasury Inversion Study, (83) views the corporate inversion phenomenon as evidence of a need to reexamine the tax code to make it more favorable for U.S.-based companies competing in an international marketplace. (84) Similar sentiments were expressed in congressional proposals, primarily by House Republicans, to address corporate expatriations. (85)
In response, numerous other commentators argue that the focus on the expatriation phenomenon as a reason to move from a residence-based system to a territorial system is merely a "red herring," (86) or an excuse to "change the subject" away from the earnings stripping that primarily is driving the expatriations. (87) These commentators defend the importance of retaining residence-based worldwide taxation as the general rule for corporations. (88) Indeed, some commentators argue that the worldwide residence-based taxation regime should be strengthened by the expansion of the anti-deferral regimes, such as Subpart F, so that U.S. corporations cannot avoid current taxation on their active business income through the use of foreign subsidiaries. (89)
Because the arguments in favor of and against the broad overhaul of the U.S. international tax system have been discussed in detail elsewhere, this article does not purport to revisit them. Rather, this article assumes that the United States will retain the broad contours of its existing system for taxing corporations in an international setting. (90) Of more interest for purposes of this article are those tax proposals, including the tax provision ultimately enacted, that purport to target the inversion phenomenon without changing the general residence-based income tax regime applicable to corporations. Those proposals are summarized in the following section.
2. Narrow Proposals Targeted at Inversion Transactions
As noted above, legislators introduced more than thirty bills addressing corporate expatriations. (91) The large majority of these proposals targeted the specific tax consequences that flow from corporate expatriations. From these bills, two leading proposals emerged: (i) a proposal passed by the Senate that would have treated the new foreign corporate parent as a domestic corporation following a corporate inversion, (92) and (ii) a proposal passed by the House that would have modified specific provisions of the tax code that affect the tax consequences of certain inversion transactions, but would have respected the new post-inversion parent corporation as a foreign corporation under general Code definitions. (93)
The Senate bill, by continuing to treat the post-expatriation foreign-incorporated parent as a domestic corporation, would have overridden the place-of-incorporation rule in the case of inversion transactions. In so doing, it would have effectively shut down future inversions by removing the potential tax benefits--i.e., the ability to escape the Subpart F regime for income earned through foreign subsidiaries and the ability to shift some U.S. income out of the U.S. tax base. (94)
Although the House provisions might have reduced some tax benefits associated with inversion transactions, the expatriated company still would have been able to obtain the benefits of avoiding the Subpart F regime on future foreign income, as it could have under then-existing law. Accordingly, the House proposal would have had less of an impact on companies contemplating expatriation than the Senate proposal would have had. (95)
C. Enactment of New Tax Provision
As part of the American Jobs Creation Act of 2004 (AJCA), Congress ultimately adopted a tax-focused provision based on the Senate approach. (96) In particular, the AJCA provision treats the post-expatriation foreign-incorporated parent as a domestic corporation, thereby overriding the place-of-incorporation rule in the case of inversion transactions. (97) This continued domestic taint removes the potential tax benefits otherwise available if the corporate parent were treated as a foreign corporation.
III. SYMBOLIC ASPECTS OF CONGRESS'S RESPONSE TO CORPORATE EXPATRIATIONS
A. Symbolic Legislation--In General
Congress's initial legislative response to corporate expatriates--the alternative sanction barring contracts with the Department of Homeland Security--is best understood through the lens of symbolic legislation theory. In addition, this theory sheds light on the tax-focused proposal that was favored by the House of Representatives.
According to this theory, "symbolic legislation serves the needs of the public by indicating that Congress is 'doing something' about a perceived problem and, accordingly, serves the needs of its legislative supporters by making them appear effective and enhancing their chances for reelection." (98) Murray Edelman is credited with laying the foundation for the modern study of symbolic legislation. (99) The author previously summarized Edelman's theory as follows:
Under Edelman's view, for most individuals politics is "a series of
pictures in the mind, placed there by television news, newspapers,
magazines, and discussions," constituting a "passing parade of
abstract symbols." As a result, "most citizens have only a foggy
knowledge of public affairs though often an intensely felt one."
This observation may be particularly true in the context of tax
legislation, where the details are often mired in the densely
worded, definition-laden, exception-filled language of the Code. In
this context, according to Edelman's theory, the principal function
of much legislation, as well as other forms of political
participation, is to provide symbolic reassurance to the public,
while only a small group of interested, involved persons generally
receives any tangible benefit from the legislation. (100)
Subpart B explores the implications of this theory in the context of the Homeland Security contract ban alternative sanction. Subpart C applies a similar analysis to the House's proposed tax legislation addressing corporate expatriations.
B. Alternative Sanctions as Symbolic Political Response
In 2002, during the second session of the 107th Congress, Congress spent considerable time focusing on the perceived problem of corporate expatriations, holding several hearings (101) and entertaining numerous bills. (102) This Congressional attention coincided with extensive coverage of the topic in the popular press. (103) Much of the media attention and legislative debates centered on the symbolic aspects of the phenomenon. For example, critics of inversions characterized the corporations as Benedict Arnolds, (104) traitors, (105) tax dodgers, (106) tax cheats, (107) and participants in a Bermuda beach party. (108) The names of several bills introduced by critics of inversions--including the No Tax Breaks for Corporations Renouncing America Act, the Uncle Sam Wants You Act, and the Corporate Patriot Enforcement Act (109)--as well as the September 11, 2001, retroactive effective date used for several of the bills, (110) reflected this symbolic atmosphere. In contrast, supporters of the corporations argued that the corporations were being forced to expatriate by an overly broad and complex tax Code, (111) favorably comparing a corporation's actions against unfair taxes to "rumrunners of Prohibition days" (112) and the nation's founding fathers. (113)
Despite the spotlight focused on corporate expatriations, as the 107th Congress approached its adjournment Congress had not yet enacted legislation directly targeting the phenomenon. (114) Finally, on the last day of the session, the alternative sanction purporting to ban expatriated corporations from entering into contracts with the Department of Homeland Security was approved by Congress and sent to the President for signature as part of the Homeland Security Act. (115) However, just hours before the legislation was approved by Congress, (116) language was inserted that significantly undermined any instrumental effect the alternative sanction might have had. Specifically, a statutory exception was inserted allowing a waiver of the contract ban to "prevent the Government from incurring any additional costs that otherwise would not occur." (117) Thus, as a practical matter, despite the purported contract ban, a corporate expatriate could enter into Homeland Security contracts as long as it was the low bidder. (118)
This purported ban on Homeland Security contracts was prototypical symbolic legislation. It enabled its supporters to claim credit for some legislation that purported to address a perceived problem, thereby satisfying the general public's demand for action. (119) At the same time, consistent with Edelman's theory, it ensured that the interested, involved group that would actually be affected by the legislation--in this case, corporations that have engaged in an inversion transaction--received their desired result. In particular, given that some legislation was to be enacted, the best outcome for the targeted group of expatriate corporations was a provision that had little, if any, practical effect on their ability to enter into government contracts. As one reporter observed during the course of the Congressional debates over the contract ban provision in 2002, "[r]ecognizing that there may be no way to stop Congress from taking high-profile action on the politically potent issue this year, the businesses are looking for ways to limit the damage." (120)
Several months after the enactment of this alternative sanction, Congress revisited the provision in response to complaints by some lawmakers regarding its ineffectiveness. (121) In February 2003, Congress amended the alternative sanction by eliminating the exceptions concerning loss of jobs or imposing additional costs on the government. (122) Accordingly, only the "in the interest of homeland security" exception remains.
Despite this amendment, the current provision has only limited practical impact. The alternative sanction prohibits the Department of Homeland Security from entering into a contract with a "foreign incorporated entity" (123) that is treated as an "inverted domestic corporation." (124) As those terms are defined in the statute, the ban generally extends only to the new foreign parent arising from the inversion transaction. It does not apply to any domestic subsidiaries that are part of the inverted group. Thus, following the inversion, the corporate group can continue to enter into Homeland Security contracts through the group's domestic subsidiaries. As Representative Richard Neal complained, the provision "bans only contract applications from the foreign parent, leaving unaffected the U.S. subsidiaries, where U.S. federal contracts are normally managed." (125)
The instrumental ineffectiveness of the contract ban was recently demonstrated in a high-profile contract awarded by the Department of Homeland Security. In May 2004, Accenture LLP, a domestic subsidiary of Accenture Ltd., a Bermuda company, (126) was awarded the $10 billion prime contract by the Department of Homeland Security to develop and implement the new U.S.-VISIT system. (127) This system, which is intended to "help strengthen security at America's borders and modernize the border management process," (128) involves the deployment of "end-to-end management and sharing of data on foreign nationals covering their interactions with federal officials before they enter, when they enter, while they are in the United States, and when they exit." (129) Although the foreign parent, Accenture Ltd., is a Bermuda company that is the successor to a former U.S.-based entity (Arthur Andersen), (130) the contract ban in the Homeland Security Act did not bar the award. (131)
Thus, even the 2003 amendment to the Homeland Security contract ban provision, which purported to eliminate significant exceptions to the ban, itself has the markings of symbolic legislation. Supporters of the amendment are able to claim that they have taken additional steps to combat the perceived problem of corporate inversions. In so doing, they would be acting in accordance with Edelman's theory that the enactment of some legislation, regardless of its effectiveness, may be enough to satisfy the public that the perceived problem of corporate expatriation was addressed. (132)
The amendment is also consistent with the second aspect of Edelman's theory--"that a small group of interested, well-organized persons receive tangible benefits while the public receives only symbolic reassurance." (133) In this situation, the expatriate corporate groups undertook well-organized, well-funded lobbying pressure on legislators. (134) By limiting the instrumental effectiveness of the amendment, Congress enabled these expatriate corporations to continue to enter into lucrative government contracts, despite the purported denial of those contracts under the Homeland Security Act and the 2003 amendment.
Thus, Congress's initial legislative enactment targeting corporate expatriates--which was the only legislative response for nearly three years--is best understood through the lens of Edelman's symbolic legislation theory, rather than as a substantive response to a perceived exploitation of the tax code.
C. House Proposal as Symbolic Political Response
Symbolic legislation theory not only explains the alternative sanctions that Congress has enacted in response to corporate expatriations, but also is relevant in understanding the leading tax-focused proposal favored by the House of Representatives. As discussed supra, (135) the House favored a bill that would have altered two tax consequences flowing from corporate inversion. The bill would have (i) limited the ability of the former domestic parent corporation to utilize tax attributes, such as net operating losses or foreign tax credits, to reduce the tax owed on any gain recognized in an inversion transaction occurring after March 4, 2003, (136) and (ii) imposed an excise tax on certain stock options held by executives of expatriating corporations. (137)
As with the debate leading to the passage of the Homeland Security alternative sanction, supporters of the House bill argued that it would address a perceived problem. However, supporters of this provision defined the perceived problem more narrowly than did the supporters of the alternative sanction contract ban. As discussed supra, (138) these supporters asserted that "corporate inversion transactions are a symptom of larger problems with our current uncompetitive system for taxing U.S.-based global businesses and are also indicative of the unfair advantages that our tax laws convey to foreign ownership." (139) Accordingly, they were less willing to define corporate inversions as necessarily bad and to invoke rhetoric challenging the patriotism of the expatriating corporations.
Nonetheless, apparently recognizing the need to be seen as doing something about inversions, the House Report accompanying the House proposal claimed that the bill "contains provisions to remove the incentives for entering into inversion transactions." (140) Accordingly, at least to some extent, the House proposal can be viewed as satisfying the public's desire to "do something" about a perceived problem in accordance with Edelman's theory. This conclusion is further supported by Edelman's observation that the public generally has only a vague understanding of the intricacies of legislation. (141) Thus, even if the subtleties of the House Republicans' arguments regarding the anticompetitive aspects of the current tax system were lost on the general public, the proponents of the bill could claim that they were "doing something" about corporate expatriations.
In addition to providing the public with some assurance that something was being done to address a perceived problem, the House proposal can be viewed as conforming with the second aspect of Edelman's theory: it ensured that the interested, involved group that would actually be affected by the legislation--in this case, corporations that have engaged in an inversion transaction--received their desired result. In particular, given that some legislation was to be proposed, the best outcome for the targeted group of expatriate corporations would be a provision with little, if any, practical adverse effect on their ability to expatriate.
As noted above, (142) several commentators pointed out the instrumental ineffectiveness of the House proposal. For example, the principal proposal to limit the use of tax attributes to offset inversion gain may have had only limited effects, due to a corporation's ability to control the amount of gain recognized in an inversion transaction. (143)
Perhaps of even greater relevance, a provision that might actually have had a significant adverse impact on expatriating corporations was dropped prior to passage of the House proposal, due to significant opposition from business interests. That provision, which had been a part of earlier bills sponsored by Chairman Thomas, (144) would have tightened Code section 163(j) to make it more difficult for certain U.S. subsidiaries to deduct interest payments made to related foreign parties. As discussed supra, such earnings stripping techniques provide opportunities for post-inversion groups to reduce the U.S. income tax on their U.S. income, so a provision limiting this technique might have reduced the incentive for expatriating. (145) Multinational corporations had been lobbying extensively against the inclusion of the proposed tightening of Code section 163(j), and that lobbying ultimately convinced Chairman Thomas to drop that provision from the House proposal, (146) leaving only the relatively benign provisions limiting the use of tax attributes to offset inversion gain and modifying the treatment of stock options held by executives of the inverted corporation. (147) The extent to which the proposal's instrumental effectiveness was undercut at the behest of interested corporate stakeholders, consistent with Edelman's theory, is illustrated by a quotation from a representative of a corporate lobbying group following the removal of the section 163(j) provision from the House proposal: "[w]e're thrilled with the apparent decision to take the earnings-stripping language out of the bill," and following the provision's removal "we expect to be lobbying in support of the [revised] version of the bill as hard as we can." (148)
Thus, the House proposal to address corporate inversions had the hallmarks of symbolic legislation as described by Edelman's theory. It would have allowed supporters to claim to the public that the purported problem of corporate expatriations was being addressed, while the small group of interested taxpayers--the relevant multinational corporations--would receive the tangible result they desired (i.e., a provision with limited adverse tax effects).
IV. SOCIAL NORM-RELATED ASPECTS OF CONGRESS'S RESPONSE
A. Social Norms and Corporations--In General
As the preceding part illustrates, for several years Congress postponed enacting legislation with significant instrumental effects on corporate expatriations. Nonetheless, the absence of such legislation does not necessarily mean that Congress's actions did not affect the corporate inversion trend. Indeed, the mere fact that Congress addressed the issue, thereby raising its public profile, had an impact on corporations contemplating inversions. This part briefly analyzes this secondary effect of Congressional action.
In considering whether to expatriate, a corporation obviously considers the anticipated tax benefits and costs. (149) As discussed above, Congress initially did not enact any provisions that would directly influence this calculation. (150) In addition to the tax benefits and costs, the expatriation decision might be influenced by a less tangible consideration--nonlegally enforceable rules and standards, sometimes referred to as social norms. (151)
An extensive body of literature recognizes that actors are influenced not only by legal rules, but also by social norms. (152) Much of this social norms literature focuses on the extent to which social norms affect the behavior of individuals. (153) However, some recent scholarship addresses the effect of social norms on corporations. (154)
According to the social norms literature, norms "influence[] an actor's preferences either directly, through internalization, or indirectly through the imposition of second-order social sanctions such as shaming or ostracism." (155) To the extent a corporate inversion violates social norms, the impact might be felt at two separate levels. (156) First, it could impact at a personal level the directors or corporate officers involved in the expatriation decision, either through an internalized sense of the incorrectness of expatriation, or through fear of sanctions, such as shaming or ostracism. With respect to the latter, commentators have recognized the importance of communities in defining and enforcing social norms. (157) Corporate directors and officers are members of communities, (158) and to the extent their actions in supporting an expatriation were viewed as violating a community's social norms, they might be subject to sanction by that community. (159)
Second, it could impact the corporation at the corporate level. A corporation, as an entity, cannot internalize a norm in the way an individual can. However, a corporation could be the target of second order sanctions to the extent social norms disfavored a corporate parent changing its place of incorporation in pursuit of tax savings. For example, the firm might experience a backlash from U.S. customers and a possible reduction in revenue. (160) This potential decrease in revenue might, in turn, lower the value of the corporation's stock. (161) Concern over these potential sanctions against the corporation could induce the directors or shareholders to oppose inversion proposals even if the social norms do not influence these individuals at a personal level.
B. The Stanley Works Example
Prior to the announcement of the proposed inversion by Stanley Works in February 2002 (162) and the congressional focus on expatriations soon thereafter, (163) there was reason to believe that social norms would not significantly constrain the corporate expatriation trend. (164) With respect to the pre-February 2002 expatriations, (165) it is difficult to measure precisely the effect of social norms at the corporate director level. However, given that several corporations undertook expatriations during that period, it is reasonable to assume that the individual directors of those corporations did not fear significant informal sanctions from peers within their community, and did not feel internalized constraints against approving the inversion. (166) Indeed, within certain industries--such as the oil and gas industry--the significant number of inversions provides strong evidence that directors within some industries felt no such constraints imposed by their community. (167)
Similarly, at the corporate level, the early adopters apparently assumed that there would be no significant public backlash against the company. This assumption is borne out by an economic study showing that share prices of these corporations rose by an average of 1.7 percent immediately following the expatriation announcements. (168) Indeed, a leading commentator, citing the early inversions, observed that "after Tyco, it became clear that share prices do not drop as a result of reincorporation--on the contrary, recently inverting companies have seen their share prices rise in reaction to the expected tax savings. Thus ... there seems to be no market downside to inversions." (169)
While it is possible that the lack of significant adverse reaction against the early corporate expatriation reflected a lack of norm violation, it is also possible that the expatriations violated then-existing social norms (170) but the public was largely unaware of the transactions. Scholars have recognized that public awareness of the potentially transgressing behavior is a necessary prerequisite for the informal enforcement of social norms. (171) After all, if a community is not aware that a person engaged in disfavored conduct, those members will not be able to impose informal sanctions, such as boycotts or other public campaigns, against the transgressor. In the context of corporate expatriations, even if significant segments of the population would have viewed the early tax-motivated inversions as violating acceptable norms, a lack of information might have prevented the public from being able to impose informal sanctions against the corporations. Although corporations publicly disclose details of inversion transactions in their Securities and Exchange Commission filings, (172) it seems safe to assume that the general public does not regularly consult these filings. (173) Moreover, the general press paid little attention to the pre-2002 inversion transactions. (174)
Circumstances changed significantly in February 2002. On February 8, Stanley Works announced that its directors had approved an inversion transaction to reorganize the company under a Bermuda parent corporation, subject to a shareholder vote. (175) Stanley Works was incorporated in Connecticut in 1852, and has its principal executive offices in New Britain, Connecticut. (176) The company is a worldwide producer of tools and door products for professional, industrial and consumer use, (177) and is the best-selling hand-tool manufacturer in the United States. (178)
Shortly after this announcement, the media and Congress began focusing on the corporate expatriation trend. (179) In May 2002, after significant press attention, Stanley Works shareholders narrowly approved the proposed inversion, but the following day Stanley Works announced that a new shareholder vote would be held due to confusion surrounding the initial shareholder vote. (180) Because of the extensive press and Congressional focus on the proposed Stanley Works transaction, in part because Stanley Works' tools and garage door openers made it a familiar household name, (181) Stanley Works soon became the "poster child" for the corporate inversion trend. (182) In the months following the voided shareholder vote, numerous public protests were held against the company, (183) and hundreds of newspaper articles, editorials, and letters to the editor criticized Stanley Works for its proposed transaction. (184) Finally, in August 2002, after enduring this bad publicity for several months, the Stanley Works board of directors voted to cancel the proposed inversion transaction. (185) The company did not directly cite the bad publicity as a reason for canceling the proposed transaction. Rather, "the company cited the growing prospect of comprehensive tax legislation.... Most positively, Congress has started down a path to deliver comprehensive tax reform that would eliminate the inequities of U.S. international taxation and thereby accomplish Stanley's original and continuing goal." (186)
To some extent, Stanley's decision to abandon its expatriation appears to stem not from informal social norm enforcement, but from concern about legal-based instrumental factors. For example, according to the previously cited press release, members of Congress offered Stanley directors assurances that legislation providing tax relief for domestic manufacturers might be forthcoming. (187) Furthermore, by the time of the August 2002 abandonment, numerous tax-focused bills had been introduced in Congress that might have eliminated many of the tax benefits Stanley sought by expatriating. (188) For example, the Grassley-Baucus REPO Act proposal in the Senate, (189) had it been enacted as proposed, would have continued to treat the post-expatriation Stanley corporate parent as a domestic parent. Also, in August 2002, Congress was actively considering the Homeland Security provision that would have banned corporate expatriates from future Homeland Security contracts. (190) In addition, the Connecticut attorney general had sued Stanley Works to prevent the company from completing its plans. (191)
Nonetheless, there also appear to have been some aspects of nonlegal social norms enforcement in play. Despite the official press release's focus on the legislative assurances received by Stanley as an inducement to abandon its plans, press reports at the time were more forthcoming about the role that outside public pressure, spearheaded by labor unions and politicians, played on the company. (192) In particular, the public press highlighted the potential effect that the inversion might have had on Stanley's sales in the United States. As one contemporary newspaper article observed, "The question is whether all this ill will [arising from the planned expatriation] is headed out to the Home Depot in Peoria." (193) Another article on the same topic observed that "[t]he typical Stanley customer is an American male, age 25 to 54. Often, he is a tradesman who belongs to a union. And union members generally know which companies are perceived as friendly to American workers and American causes." (194) To the extent the Stanley Works decision to cancel the planned transaction resulted from concerns about this type of public backlash, it represents an example of the ability of social norms to influence an actor's behavior. (195)
The concern about public backlash may have been significantly greater for Stanley Works than for corporations that had expatriated previously. Whereas Stanley sold retail products to the public under its own name, most of the other expatriating corporations had little direct public contact. (196) Accordingly, the public was less likely to pay attention to those other companies' inversion transactions and, even had the public been aware of them, the lack of a public consumer base would have lessened the opportunities for the public to boycott or otherwise impose sanctions on those other companies.
In this regard, concern about social norm compliance has the potential to create a de facto two-tiered corporate residence regime. U.S.-based multinationals with little direct public contact could expatriate and become foreign corporations for U.S. tax purposes, while U.S.-based multinationals with significant public contact might feel pressure to retain their U.S. incorporations, thereby remaining domestic corporations.
C. The Role of Congress
As discussed previously, beginning in 2002 Congress entertained numerous legislative proposals, held several hearings, and passed the Homeland Security alternative sanction purporting to ban contracts with expatriated corporations. Although the alternative sanction legislation that Congress enacted had no direct instrumental effect, (197) it is important to consider whether Congress's initial actions might have had some indirect effect on expatriations in the context of social norms. This subpart considers two possible effects in this regard. First, Congress's activity in 2002 might have played an informational role, helping to provide information about expatriation activities that generally would not have come to the public's attention. The public then could have used this information to sanction informally corporations or their directors for violating an already existing social norm against corporate expatriation (if, indeed, such a norm existed). Section 1 of this subpart concludes that the Congressional focus on expatriations served this informational role, at least to some extent.
Second, the Congressional activity might have had an "expressive" effect, altering the then-existing social norms regarding corporate expatriations. After briefly examining the legal literature's theories regarding expressive legislation, section 2 of this subpart extends these theories to address the expressive effects of legislative debate and concludes that Congress's actions had, at most, only a small amount of expressive effect.
1. Information-Providing Effect
As discussed in the prior subpart, prior to February 2002, there was reason to believe that social norms would not significantly constrain the corporate expatriation trend. (198) In this context, it is possible that Congress, merely by publicly discussing the names of companies that engaged in inversion transactions, might have had some social norm-related impact. Regardless of whether the legislators viewed the corporations as violating social norms, (199) the publicity surrounding the legislative proposals and hearings helped furnish information to the public about affected corporations so that members of the public who perceived the transactions as violating social norms might have been able to act on that information.
Just prior to Congress's heavy focus on corporate expatriations, the general press had begun to place a spotlight on the phenomenon. (200) Indeed, it is reasonable to assume that the media's attention to the issue made various legislators aware of the potential political benefits of focusing on the issue. (201) However, it is also clear that once anti-inversion bills were introduced in Congress and hearings were scheduled, press coverage increased significantly. (202)
Thus, Congress's focus on the inversion phenomenon in 2002 appears to have been part of a snowballing effect--by focusing on the phenomenon as a result of early press coverage, Congress produced additional press coverage, which in turn heightened the political importance of the issue in Congress, ensuring additional Congressional attention and further press coverage. In the end, this heightened publicity increased the likelihood that members of the public would become aware of the fact that certain corporations had engaged in an inversion transaction, or planned to do so. In turn, this increased the possibility that the public might informally sanction those corporations, to the extent the transactions were viewed as violating then-existing social norms.
It is difficult to quantify the extent, if any, to which the public imposed informal sanctions for violations of already-existing norms, utilizing the factual information that Congress helped provide. While some corporations--particularly Stanley Works (203)--apparently changed their behavior at least in part because of the public reaction to a planned inversion, it is not clear whether the public was enforcing previously existing norms against expatriation, utilizing Congress as merely a source of factual information about the companies engaged in the activity, or whether Congress's actions themselves altered the then-existing norms. This latter possibility is discussed in the following subpart.
2. Expressive Norm-Altering Effect
The prior section treated social norms as an exogenous variable, implicitly assuming that Congress, while possibly providing information to the public, was not itself influencing the public's view of whether corporate expatriations violate social norms. However, social norms are not static. Numerous commentators have studied the mechanisms by which norms arise and change over time. (204) Of particular relevance for this discussion, there is general agreement that legislation enacted by Congress can have an expressive effect that changes social norms and thereby alters an actor's behavior, apart from any direct instrumental aspects of that legislation. (205) There is disagreement, however, as to the precise mechanism by which this "expressive" function of legislation works and how effective it is. For example, as previously summarized by the author:
[U]nder Richard McAdams's esteem-based theory of norm development, the enactment of legislation plays an important role in publicizing to the community that a consensus on desired (or undesired) behavior exists. Once individuals become aware of this consensus, they are more likely to perceive that an esteem gain is available by complying with it. Thus, under McAdams's theory, the enactment of legislation can provide "the jolt necessary to create a new norm, or strengthen an old one." Cass Sunstein also advocates a role for expressive legislation in norm management. He recognizes the collective action problem that faces agents who seek to alter norms and views politicians as potential norm entrepreneurs who are in a position to overcome this collective action problem, alerting the public to the existence of a shared complaint and suggesting a collective solution. Under certain circumstances, the enactment of legislation may lower the cost to individuals of expressing the new norms, resulting in a norm bandwagon that encourages an ever-increasing number of people to reject a previously popular norm. Eventually, a tipping point is reached, where the new norm becomes generally accepted and adherence to the old norm produces social disapproval. (206)
The relevant question is to what extent, if any, do these theories apply to Congress's response to corporate expatriations? That is, to what extent might Congress's actions have altered social norms that existed prior to Congress's focus on expatriations, rather than merely highlighting factual information about inversion transactions to enable enforcement of existing norms?
In order to analyze the extent to which Congress's actions fulfilled this expressive role altering social norms, it is important to consider the state of social norms regarding corporate expatriations at the outset of the recent inversion trend. Prior to the late 1990s, few large publicly-held corporations underwent corporate inversions. (207) Accordingly, the corporations that were the early adopters of this strategy faced an important uncertainty--i.e., to what extent would the corporate expatriation be viewed as violating social norms.
Several social norms could have been viewed as having relevance with respect to a corporate group changing the place of incorporation of its corporate parent in order to reduce taxes. (208) For example, given the high profile accorded tax reduction by newly-elected President Bush in 2001, these transactions could have been viewed as legitimate steps to ameliorate excessive U.S. taxation. Also, to the extent the inversions were undertaken in order to "level the playing field" between U.S.-based multinationals and foreign-based multinationals, they could have been viewed as consistent with general norms involving fair play. (209) On the other hand, norms of fair play might have dictated that a U.S.-based corporation not engage in tax-cutting maneuvers unavailable to U.S.-based individuals. Similarly, even if the corporation complied with all its tax obligations arising from the inversion transaction, it could have been viewed as violating general norms of tax compliance to the extent it was reducing its tax obligations in a manner not available to the general public. (210) The public might have been particularly predisposed to this perception in light of the high profile corporate scandals involving Enron, WorldCom, and others, which were unfolding at approximately the same time as the inversion trend. (211) In addition, particularly after September 11, 2001, inversion transactions could have been viewed as unpatriotic behavior by ungrateful corporations that owed much of their original success to the United States. (212)
As discussed in the previous subpart, (213) corporate inversions prior to 2002 faced little public attention and little adverse reaction. This lack of significant backlash against these early inversions potentially had important implications for future inversions. Once several large publicly traded corporations expatriated without significant adverse consequences to their directors or to the corporations' revenue, directors of other corporations might have sensed that they would not suffer informal sanctions at the personal level from their communities, and their firms would not suffer informal sanctions from the public for expatriating. As one researcher observed, "firms may have been reluctant to incorporate abroad for fear of public relations damage. Once several firms undertook reorganizations, the damage potential may have been perceived to have fallen, and other firms followed." (214) Indeed, once a significant number of firms in a particular industry expatriate, the directors of the remaining U.S.-incorporated groups might feel compelled to initiate inversions in order to remain competitive. (215)
This shift toward acceptability within the relevant executive community is analogous to the norm shift that occurred among professionals in the 1970s with respect to hostile takeovers. As described by Melvin Eisenberg, until the mid-1970s, "the social norms of the business, financial, and legal establishment were strongly opposed to hostile takeovers," and most "establishment" corporations, commercial banks, investment bankers, and lawyers, would not participate in hostile takeovers. (216) However, the norm quickly shifted in 1974 when International Nickel made a hostile takeover bid for ESB, a battery company, and "a premier investment bank, Morgan Stanley, decided to break ranks and assist [International Nickel's] hostile bid." (217) Eisenberg summarizes the effect on social norms, observing that "[o]nce Morgan Stanley flipped, the old, inefficient social norm crumbled.... Once Morgan Stanley sanctioned hostile takeovers, competitors jumped in." (218)
At the corporation's level, there are several possible explanations for the early lack of public resistance to expatriations. As discussed in the preceding subpart, (219) it is possible that social norms might have dictated an unfavorable public attitude to expatriating corporations, but the public was not aware of the early transactions. A related possibility is that social norms might have disfavored expatriation, but the public was not in a position to impose meaningful nonlegal sanctions, such as boycotts, against transgressors. This explanation might make sense in the case of corporations with little public interaction, such as drilling companies and industrial manufacturers, (220) but it would not explain the lack of public sanction of well-known retail companies, such as Fruit of the Loom. (221) A third possibility is that then-existing social norms might not have viewed corporate expatriation as "bad" behavior.
Had the inversion trend continued without significant public attention, it is possible that at some point informal sanctions would have become ineffective, even if the public (once informed of the trend) viewed expatriations as inappropriate. In particular, if significant percentages of the market leaders in various industries had already undergone expatriations by the time the public became aware of the phenomenon, it is unlikely that public sanctions, such as boycotts, would have much affect, even if the collective action problems described by Sunstein could have been overcome. (222) At that point, even if the public initially would have reacted unfavorably to an isolated expatriation, the public probably would have accepted the new reality once a significant number of U.S.-based multinational corporations had moved their parents' place of incorporation abroad.
However, as discussed previously, the corporate inversion trend did not continue to stay "below the public radar" long enough to allow significant expatriation across large numbers of industries, and thus the state of affairs described in the prior paragraph was not reached. Sparked by media reports, Congress focused significant attention on the phenomenon beginning in 2002. (223)
As noted above, the literature addressing the expressive function of law focuses on the norm-shaping effects of legislation actually enacted by Congress. (224) Under this focus, Congress's initial response appears to have had little expressive effect on the social norms surrounding corporate expatriation. As previously discussed, despite focusing on the expatriation issue throughout much of 2002, Congress did not actually pass legislation--the Homeland Security contract ban--until late in the year. (225) However, the informal social disapproval of corporate expatriations--particularly as evidenced by the reaction to the Stanley Works proposal (226)--took place before Congress finally enacted the Homeland Security alternative sanction in late November 2002. Thus, social norms opposed to corporate expatriations appear to have been in place before Congress finally enacted legislation purporting to condemn corporate inversions.
It is possible, however, that a slightly modified version of the theories on expressive legislation might have been in effect. In particular, rather than focusing on the expressive effect of statutes enacted by Congress, it is possible that the legislative debate itself had an expressive effect on social norms, (227) even before Congress actually enacted legislation at the end of 2002.
It is possible to fit this modified theory--which I will refer to as the theory of expressive legislative debate--into the framework of the expressive theory of legislation set out by McAdams, Sunstein, and others. For example, extending McAdams's theory of expressive legislation, if the legislative debates and hearings reflected that a clear consensus on desired (or undesired) behavior existed, (228) it is possible that members of the public would receive the jolt they needed to perceive an esteem gain by complying with the reflected norm. For example, if the legislative debates and hearings made clear that there was widespread disapproval of expatriations, members of the public might be more willing to comply with informal sanctions, such as boycotts, of violators. Similarly, extending Sunstein's theory of expressive legislation, if
the legislative debates and hearings reflected a clear consensus against expatriation, the debates might help overcome collective action problems and encourage members of the public to join a norm bandwagon enforcing informal sanctions against corporate violators
It appears that this theory of expressive legislative debate had, at most, only limited applicability with respect to the corporate expatriation trend. One limitation of the theory is that the public might pay little attention to the details of ongoing debate in Congress. (229) More importantly, even if the public were aware of the debates, the debates and related political pronouncements did not produce a clear consensus as to the acceptability (or lack thereof) of corporate expatriations. A significant number of legislators--primarily House Democrats and Senate leaders of both parties--publicly expressed their views that corporate expatriations were inappropriate and should be stopped. (230) In contrast, several leading legislators--primarily House Republicans--defended corporate expatriations as legitimate responses to an overburdensome tax code. (231) To the extent the public perceived this lack of agreement regarding the merits of corporate expatriation, the legislative debates would not have an expressive effect in altering or confirming social norms regarding this issue. (232)
It is possible, however, that the public perceived a legislative consensus against corporate expatriations despite statements by some legislators defending corporate expatriations. In particular, some legislators who viewed the inversion trend primarily as a legitimate response to an overburdensome tax code nonetheless made some public statements critical of expatriating corporations. For example, Chairman Thomas "told reporters that he might draft a three-month moratorium to send a signal to firms that are currently considering setting up parent corporations abroad." (233) To the extent the public viewed these statements as reflecting at least a baseline sentiment that corporate inversions were "bad" (even if they were understandable responses to a problematic tax code), the legislative debate surrounding expatriations might have had at least some minimal expressive effect in solidifying social norms against the transactions, even before any expatriation-targeted legislation was enacted.
In summary, Congress's initial response to the wave of corporate expatriations appears to have played only a limited role in the social norms context. By giving significant attention to the issue, Congress served an indirect informational role, furnishing information about expatriating corporations so that members of the public who perceived the transactions as violating social norms might have been able to act on that information. However, Congress's actions appear to have had little expressive effect in altering social norms. In particular, the alternative sanction legislation Congress passed in late 2002 had little expressive effect because, by that time, there already appeared to have been a significant public consensus against expatriations. At most, the legislative debate and hearings on the issue might have had some small expressive effect to the extent the public perceived a limited consensus among legislators that expatriations were "bad."
V. TAX POLICY IMPLICATIONS OF CONGRESS'S RESPONSE
A. Tension Between New Tax Provision and Place-of-Incorporation Rule
Thus far, the article has focused on two aspects of the Congressional responses to corporate expatriations--the enacted alternative sanction purporting to ban Homeland Security contracts and the House-passed proposal modifying certain tax provisions. Part III concluded that these two responses are best understood as symbolic legislation that purports to do something about a perceived problem, but that has (or would have had, in the case of the House proposal that was not enacted into law) little direct instrumental effect. As discussed in Part IV, at most these responses and the debate surrounding them might have had limited impact on shaping the social norms, thereby indirectly affecting corporate expatriations.
In contrast to these limited impacts on corporate expatriations, the ultimate Congressional response--the AJCA tax legislation passed in 2004, based on the Senate-passed tax proposal--undoubtedly has a direct instrumental effect on corporate expatriations. (234) As discussed previously, (235) the AJCA provision treats the new foreign parent arising from the inversion transaction as a domestic corporation for U.S. income tax purposes. (236) As a result of this domestic taint, the two principal tax benefits of an inversion transaction--avoidance of the Subpart F regime with respect to certain income earned by foreign subsidiaries and the ability to use earnings stripping techniques to reduce U.S. tax on income arising in the United States (237)--are no longer available to an expatriating corporation.
A corporate inversion involving the transfer of substantially all of the properties of a domestic corporation to a foreign corporation after March 4, 2003, is subject to the new provision if two factual tests are satisfied: (238)
(i) after the transaction, at least eighty percent of the stock of
the foreign corporation is held by former shareholders of the
domestic corporation (the ownership continuity test), (239) and
(ii) neither the foreign corporation nor its corporate group has
substantial business activities in the foreign country under whose
laws the foreign corporation is organized (the no substantial
business activity test). (240)
Accordingly, if these tests are satisfied, the post-inversion corporate parent is treated as a domestic corporation for U.S. tax purposes, even though it is incorporated in a foreign country, such as Bermuda, rather than the United States.
This newly enacted provision addressing corporate inversions constitutes a significant departure from the long-standing place-of-incorporation rule for determining corporate residence. The place-of-incorporation rule, which has been the jurisdictional touchstone for corporate taxation since the early days of the modern income tax, (241) looks solely to the jurisdiction in which the corporation is incorporated: corporations incorporated under the laws of one of the U.S. states are domestic, while those incorporated under the laws of a foreign country are foreign. (242) Factual inquiries, such as the identity and residence of the corporation's shareholders, the location of the corporation's management, or the place where the corporation conducts its business activities, (243) are ignored under the place-of-incorporation test. (244)
Even after enactment of the AJCA provision, the place-of-incorporation rule remains the general rule for determining corporate residence, applicable to the vast majority of corporations. The legislation's special domestic taint rule applies only in the case of inverting corporations that run afoul of the ownership continuity and no substantial business activity tests. In effect, the tax code now has a two-tiered test for determining corporate residence: the place-of-incorporation rule for most corporations, and the domestic taint rule for certain corporate inversions.
The normative justifications offered for this two-tiered approach cast significant doubt on the continuing viability of the general place-of-incorporation rule. In particular, the very reasons given by the Senate Finance Committee Report for supporting the special rule for inversions lead to the logical conclusion that the place-of-incorporation rule should be reconsidered and, perhaps, abandoned. In effect, the arguments supporting the special rule for inversions are the tax policy equivalent of declaring that the Emperor (in this case, the long-standing place-of-incorporation rule) has no clothes. (245)
According to the Senate Finance Committee Report accompanying the Senate-passed proposal (upon which the AJCA provision was based), the reason for enacting a special residence test for inversion transactions is that these transactions, by changing the place of the parent's incorporation, generally result in only
a minimal presence in a foreign country of incorporation.... In
particular, these transactions permit corporations and other
entities to continue to conduct business in the same manner as they
did prior to the inversion, but with the result that the inverted
entity avoids U.S. tax on foreign operations and may engage in
earnings-stripping techniques to avoid U.S. tax on domestic
operations. The Committee believes that certain inversion
transactions ... have little or no non-tax effect or purpose and
should be disregarded for U.S. tax purposes. (246)
Statements by the supporters of the recently-enacted AJCA provision further reflect this view that a change in place of incorporation is a mere paperwork formality, devoid of any substance. For example, on a nationally syndicated television show, Senator Grassley summarized an inversion transaction as follows: "Go down there [Bermuda], set up a file cabinet with a sheet of paper in it." (247) Also, the late Senator Paul Wellstone, who had sponsored legislation similar to the Senate proposal, (248) argued that
a number of prominent U.S. corporations, using creative paperwork,
have transformed themselves into Bermuda corporations in order to
avoid paying their share of U.S. taxes. These new Bermuda companies
are basically shell corporations. They have no staff, no offices, no
business activity in Bermuda. This exists for the sole purposes of
shielding income from the IRS. (249)
This lack of confidence in the tax code's general focus on place of incorporation is furthered by the "no substantial business activity" test of the legislation. (250) By calling off the special domestic taint if the post-inversion corporate parent conducts substantial business activities in the country in which it is incorporated, the provision implies that the location of a corporation's business activities may be a more legitimate determinant of residence than is the place of incorporation. (251) Indeed, a bill introduced by Senator Evan Bayh, which would have imposed a domestic taint on expatriated corporations in a manner similar to the AJCA provision, went so far as to use the defined term "nominally foreign corporation" to refer to the post-inversion parent. (252)
If, as the supporters of the new provision imply, a change in the corporate parent's place of incorporation is mere "paperwork" involving a new "sheet of paper," the logical question is why does the U.S. tax code generally rely on a corporation's place of incorporation as the touchstone for defining residence? After all, if the place of incorporation is a mere formality devoid of substance, it seems difficult to justify imposing worldwide taxation, as well as the Subpart F anti-deferral regime, based solely on that factor.
The remainder of this part examines this inherent tension between the recently-enacted domestic taint provision for inverted corporations and the general place-of-incorporation test. In particular, Subpart B examines the allegations by supporters of the new provision that a corporation's place of incorporation, and thus a change in its place of incorporation, is merely a matter of paperwork with no substantive meaning. In particular, it focuses on the extent to which the benefits, rights, and obligations of the corporation and its stakeholders are dependent on the place of incorporation. The subpart concludes that there are some substantive non-tax consequences that depend on the place of incorporation, but that these factors might not be sufficient to justify the significant tax consequences that flow from a domestic characterization under the place-of-incorporation test. Subpart C then considers whether any other considerations might justify a distinct test for determining corporate residency in the context of a corporate expatriation. Subpart D concludes that the recently enacted two-tiered system is not justifiable, and that Congress should adopt a uniform rule for determining whether a corporation is treated as domestic or foreign for tax purposes. This could be accomplished by either retaining the place-of-incorporation rule, with its inherent weaknesses described in Subpart B and its inherent facilitation of inversion transactions, or, preferably, by eliminating the place-of-incorporation rule and replacing it with a more substantive test of corporate residence as the general rule.
Before proceeding to the analysis, it is important to consider one additional preliminary issue. The following discussion of a corporation's residence implies that residence is relevant in determining a corporation's tax liability. In particular, it assumes that the United States will retain a residence-based tax system that taxes domestic corporations (however defined) on their worldwide income, providing a foreign tax credit to alleviate the potential for double taxation. (253) This article does not address the merits of whether the United States should retain a residence-based system for corporations or should, instead, move toward a territorial system. That issue has been addressed in detail by other commentators. (254)
B. Substantive Aspects of Place of Incorporation
As discussed in the prior subpart, supporters of the recently-enacted provision, which imposes a domestic taint on a corporation that undergoes an inversion, argue that the inversion transaction should be ignored because it is merely a shuffling in paperwork, devoid of substance. This subpart explores this claim.
1. Corporate Governance
One potential difference between the pre-inversion corporate parent (incorporated under the laws of a U.S. state, such as Delaware) and the post-inversion corporate parent (incorporated under the laws of a foreign country, such as Bermuda) concerns corporate governance. The laws of the two jurisdictions regarding shareholder rights and the actions of directors and officers might differ significantly.
Indeed, these potential differences have led to some of the most vocal criticisms of corporate inversions. In particular, numerous institutional investors and labor unions have objected to the potential loss of shareholder rights following a corporate inversion. (255) For example, the California Public Employees' Retirement System (CalPERS), in urging the Tyco Board of Directors to undo Tyco's expatriation by reincorporating in the United States, argued that:
Shareowners lost a significant level of accountability when Tyco
reincorporated from Delaware to Bermuda.... Bermuda incorporation
makes it more difficult for shareholders to hold companies, their
officers and directors legally accountable in the event of
wrongdoing; class actions are generally not available under Bermuda
law; and shareholders have extremely limited ability to sue
officers and directors derivatively on behalf of the
corporation. (256)
Moreover, inversion opponents have criticized the lack of transparency and predictability of Bermuda corporate law relative to Delaware law. (257) The expatriated corporations have challenged some of the assertions about post-expatriation diminution of shareholder rights, (258) but have acknowledged that at least some of these concerns regarding shareholder rights "are well-founded." (259)
The differences in shareholder rights before and after an inversion flow from the judicially created "internal affairs" doctrine. As summarized by the Supreme Court:
[t]he internal affairs doctrine is a conflict of laws principle
which recognizes that only one State should have the authority to
regulate a corporation's internal affairs--matters peculiar to the
relationships among or between the corporation and its current
officers, directors, and shareholders--because otherwise a
corporation could be faced with conflicting demands. (260)
The internal affairs contemplated by this doctrine include the election or appointment of officers and directors, the adoption and amendment of bylaws, the holding of directors' and shareholders' meetings, and the determination of methods of voting. (261) Indeed, the Delaware Supreme Court applied the internal affairs doctrine to a shareholder rights dispute following an early corporate inversion, finding that Delaware corporate law did not apply to a voting rights dispute after the corporation was incorporated in Panama. (262)
Thus, the internal affairs doctrine appears to support, at least to a limited extent, the concern of inversion opponents concerning the possible loss of shareholder rights after a corporate parent reincorporates from a U.S. state to a foreign country that has less protective (or less transparent) corporate governance laws.
There is one additional consideration that might limit this corporate governance concern, particularly with respect to publicly traded corporations that expatriate. Following recent inversions, the corporations generally have retained significant benefits concerning the marketability of their stock--in particular, the expatriating companies remain included on the S & P 500 (if they were included prior to the inversion), (263) and the stock of the new parent corporations continues to be listed on the New York Stock Exchange (NYSE). (264) As a result of this continued NYSE listing, the corporations remain subject to the exchange's listing agreement, which includes certain corporate governance-related provisions. (265) However, these listing agreement provisions are relatively limited, and foreign-incorporated entities are exempt from several of them. (266)
In summary, while the claims of labor unions and institutional investors regarding the diminution of shareholder rights upon an expatriation might be somewhat overstated, there is at least some merit in them. Accordingly, claims by proponents of the recently-enacted AJCA legislation that corporate inversions are mere paperwork shams, with no substantive non-tax consequences, (267) are themselves not fully accurate in light of these corporate governance consequences. (268)
2. Trade, Commerce, and Investment Benefits
Although a thorough analysis of the trade, commerce, and investment law implications of corporate inversions is beyond the scope of this article, it is useful to consider briefly whether the place of incorporation has significant consequences for international trade, commerce, and investment law purposes. (269)
With respect to the broad range of international treaties and agreements dealing with trade in goods to which the United States is a party, such as the North American Free Trade Agreement (NAFTA), (270) a corporate parent's place of incorporation has only limited effects. In particular, the focus of these trade treaties is the origin of the goods--where they are produced--rather than the place of incorporation of the producer. (271) However, a company's place of incorporation might have some relevance in determining eligibility with respect to cross-border services under NAFTA. (272)
The United States also has a network of more than three dozen Bilateral Investment Treaties (BITs), (273) which protect foreign investments of U.S. investors. (274) The current draft of the Model BIT defines an "enterprise of a Party," which is entitled to investment protection under the treaty, to mean "an enterprise constituted or organized under the law of a Party, and a branch located in the territory of a Party and carrying out business activities there." (275) Thus, under this language, eligibility for protection under a BIT is not dependent solely on a corporate parent's place of incorporation, but would apply also to a business branch of the corporate parent in the United States (in the unlikely event the post-expatriation parent had such a branch). (276) However, earlier iterations of U.S. BITs use only a place-of-incorporation rule to define the company eligible for BIT coverage. (277) Thus, under these earlier BITs that are still in force, place of incorporation has some relevance.
In addition to these potential treaty consequences, a change in place of incorporation might affect eligibility for various trade and commercial benefits under U.S. law. The Homeland Security Act contract ban on expatriated corporations could be viewed as one such adverse consequence. (278) However, as discussed supra, this alternative sanction is primarily symbolic and has little instrumental effect on an expatriating corporation. (279)
Another potential example of the relevance of place of incorporation concerns recent reconstruction-related contracts arising from the recent war in Iraq. In a highly publicized action, (280) the Deputy Secretary of Defense announced that twenty-six major construction and services contracts to be awarded by the Coalition Provisional Authority and by the Department of Defense would only be awarded to "firms from the United States, Iraq, Coalition partners and force contributing nations." (281) The Deputy Secretary's declaration listed sixty-three countries whose companies were eligible to bid on these prime contracts, (282) but it did not contain any details specifying how to determine whether a company was "from" a particular country. (283) However, subsequent contract solicitations by the Department of Defense set forth a narrow definition of a company's home country for this purpose. (284) In particular, a company is considered to be "from an eligible country" only if it is "organized under the laws of an eligible country and ... has its principal place of business in an eligible country. Further, the corporation ... cannot be a subsidiary (wholly owned or otherwise) of a parent company that is organized under the laws of a non-eligible country." (285)
Accordingly, a corporate expatriation might have substantive consequences in this context. In particular, if the post-expatriation corporate parent were incorporated in a non-eligible country, neither the parent nor its subsidiaries (even subsidiaries incorporated in the United States and with their principal place of business in the United States) would be eligible to bid as a prime contractor. (286)
In summary, U.S. laws, treaties, and administrative guidance regarding international trade and commerce do not adopt a uniform standard regarding the relevance of place of incorporation. (287) As a broad generalization, the place of incorporation of the parent corporation is significant in some isolated circumstances, such as the Iraq contract ban, but a corporation's place of incorporation would not appear to have substantial relevance in many significant trade and commercial areas. This conclusion is buttressed by the fact that recent prospectuses of companies considering expatriations have not mentioned the potential loss of trade or other commercial benefits as a potential adverse consequence of the expatriation. (288)
3. Other Possible Benefits
There are other potential benefits to being incorporated under the laws of a U.S. state. For example, from a symbolic perspective, there might be additional prestige associated with being incorporated under U.S. law. Similarly, there may be some marginal benefit to being perceived by the U.S. public as an "American" corporation to the extent the U.S. public prefers to "buy American." However, there is some question as to whether the public would base this buying decision on a seller's place of incorporation (as opposed to where it actually manufactures its goods or other factors). (289)
In addition, a U.S. legislator might be more willing to champion the cause of a corporation incorporated within the United States and U.S. diplomatic personnel might be more willing to provide aid to such a company. (290) However, it is reasonable to assume that such benefits--particularly support from legislators--would also be available to a U.S. branch or subsidiary of a foreign-incorporated entity. For example, even had Stanley Works completed its proposed Bermuda inversion, it is reasonable to assume that Senators and Representatives from Connecticut would have continued to represent the interest of the company to the extent necessary to keep manufacturing and headquarters jobs located in New Britain, Connecticut, and elsewhere in the state. (291)
4. Tax Policy Implications
a. Benefits Theory
As discussed in the preceding sections, a corporation's place of incorporation might have some limited significance regarding corporate governance, international trade and commerce, and other areas. It is important to consider the tax policy implications of this conclusion with respect to the general place-of-incorporation rule for determining a corporation's tax residence.
One possible justification for the place-of-incorporation rule for determining tax residence is under a benefits theory. (292) To the extent a corporation receives benefits by being organized under the laws of a country, those benefits might justify the country treating the corporation as a resident. (293)
In order for a benefits theory to support a place-of-incorporation test, it is not sufficient that the corporation receive benefits within a country. For example, a corporation incorporated abroad but doing business through a branch in the United States might receive certain benefits, such as the protections of property and contract law, the benefits of the transportation infrastructure, and other public services including police and fire protection. While these broad benefits might justify the imposition of source-based taxation of income earned in the United States by a foreign-incorporated entity, (294) they do not provide a basis for a definitional distinction between domestic and foreign corporations, because they are available regardless of the place of incorporation. Accordingly, under a benefits theory, in order to justify treating a corporation as domestic based on its place of incorporation, the relevant benefits must be available only to a corporation incorporated in that jurisdiction. (295)
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