A recent ruling by the U.S. Treasury Department scuttled a proposed and very large merger between two drug companies—the U.S.-based Pfizer Corporation and the Dublin-based Allergan. The proposed merger was motivated in part by expected tax savings that would have been realized by Pfizer moving its headquarters to Ireland after the merger. Ireland’s corporate tax rate is 12 per cent while the U.S. corporate tax rate is 35 per cent.

The deal was discontinued after the Treasury announced new rules that reduce the ability of foreign businesses to become eligible for so-called tax inversions and also limit businesses’ ability to accept loans from parent companies and then deduct interest payments on those loans from their taxable revenues.

The new rulings by Treasury reflect the Obama Administration’s commitment to discourage tax inversions by using tax rulings rather than by proposing legislation that would move U.S. corporate tax rates closer to the OECD average. While President Obama said he favours lowering U.S. corporate tax rates, he has coupled this with calls for closing corporate tax “loopholes,” which, on balance, might lead to higher effective corporate tax rates for U.S. companies. Republicans in Congress have shown no enthusiasm for corporate tax reform that does not result in significantly lower effective U.S. corporate tax rates.

The net effect of the new tax rulings is to make it less financially attractive for foreign-owned companies, including Canadian companies, to merge with U.S. companies. This would be an unfortunate economic development, particularly for the Canadian economy, since more than 40 per cent of Canada’s outward stock (the outstanding value of foreign business assets) of foreign direct investment is in the United States. Foreign direct investment contributes to a more efficient allocation of productive resources on an international basis and also promotes the improved efficiency and growth of home country firms.

To be sure, the U.S. government is not the only government concerned about companies avoiding paying their “fair share” of taxes. For example, the European Commission recently charged Apple with using potentially illegal tax shelters in Ireland. Indeed, as long as corporate tax structures differ significantly across countries, governments are motivated to discourage companies from taking actions to reduce their overall global corporate tax liabilities regardless of the efficiency benefits of foreign direct investment.

A radical but sensible solution to this issue is for governments to eliminate corporate taxes altogether and, by doing so, eliminate the double taxation of corporate profits (once when they are earned and again when they are distributed to shareholders). Dividends distributed to shareholders, as well as capital gains, should be taxed only when they are realized by shareholders. This initiative would eliminate corporate investment decisions undertaken primarily to arbitrage differences in tax rates across countries. It would also eliminate the tax code bias that favours companies using debt rather than equity as a source of financial capital.

Perhaps the Canadian government might consider taking the lead in promoting a radical change in how governments tax the incomes of companies. As a small, open economy, Canada stands to benefit substantially from multilateral initiatives that encourage international foreign direct investment flows.

The recent actions of the U.S. government, and prospects for even stronger measures, will achieve the opposite result.