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How Obama Can Stop Corporate Expatriations, for Now

The Obama administration has broad legal authority to stop corporate inversions.

Professor Stephen E. Shay recently published an article in the trade journal Tax Notes, calling on the Obama administration to take unilateral action to impede the surge of tax-motivated corporate expatriations without waiting for Congress to pass new legislation. Professor Shay, a professor of practice at Harvard Law School and former deputy assistant secretary for international tax affairs at the Treasury Department, argued that the Treasury Department has the legal authority to reduce the incentives to give up United States citizenship. This could be done, he said, by limiting the deductions for interest payments that an American subsidiary pays its foreign parent company, and by ensuring that profits of overseas subsidiaries will continue to be subject to American taxes.

President Barack Obama
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President Barack Obama

The New York Times reported Tuesday that the administration, which had previously suggested that there was little that it could do on its own, was now rushing to assemble an array of options that would change the economic incentives for companies to give up citizenship.

Robert Willens, an influential tax commentator, dismissed Professor Shay's article in a bulletin to clients as merely "interesting reading with little, if any, practical significance." Mr. Willens noted that Treasury has never been able to set workable regulations under Section 385 of the tax code, one of the key sections Professor Shay suggested as legal authority. Mr. Willens also explained that rules limiting interest deductions may cause some consternation among the nation's trading partners. "If these weapons were so readily available," he concluded, "it stands to reason that they would have already been utilized."

Read More Lowering tax rate won't stop inversions: Rep. Levin

The dispute boils down to law versus politics. There is no question that Professor Shay gets the law right. To be sure, there are limits on what the Treasury Department can do. It is limited in its ability to define who is, and who is not, a United States corporation; those rules are fixed by statutory language.

But Professor Shay has nudged the Treasury to focus on related legal questions — what constitutes debt versus equity, and what is the definition of United States property under Section 956 — where the law is unclear and the Treasury Department has broad authority to interpret those rules in a manner consistent with the legislative framework of the tax code.

Read More 'Outversions': They're the new corporate tax trick

Tax often seems like a legal island all its own, but it is a subset of administrative law. Under administrative law principles, the Treasury Department has broad authority to write regulations interpreting the Internal Revenue Code so long as its interpretation of the law is reasonable and does not contradict the plain meaning of the statute.

In this case, a regulation stating that a United States subsidiary's interest payments to a newly inverted foreign parent company will not by fully deductible would merely reflect the economics of the arrangement. A loan from a related party differs economically from an arms-length loan, and a portion of the loan may be fairly characterized as equity, not debt, for tax purposes. Without the ability to strip income out of the United States, some of the incentive to expatriate disappears.

Of course, it is possible that Mr. Willens has the politics right. The fact that the Obama administration has the legal authority to change the incentives of inversions does not necessarily mean that it will. It must consider the reaction of Britain and our other trading partners. It should think about whether investors have settled expectations about deals that have already been announced.

But I see no obvious reason that the Treasury Department should feel constrained by these political issues. Our trading partners are equally concerned about the erosion of the corporate tax base.

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Some legislators have objected to rifle-shot solutions to the inversion issue, noting that inversions are a symptom of a flawed system in need of reform. But temporary regulations would not prevent Congress from taking action, if it should ever manage to focus on structural changes to the tax code.

Nor is it clear that Wall Street would resist new regulations. The shareholders of companies contemplating inversions are aware of the tax risk in these deals and cannot credibly claim surprise. Indeed, many chief executives, sensitive to competitive pressure to reduce taxes by way of expatriation, may welcome unilateral action by the Treasury Department to give them cover for resisting inversions that don't make sense businesswise.

By Victor Fleischer, The New York Times

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