What is a Corporate Inversion?

By Stanley Rose August 7, 2014

An Editorial by Stan Rose, Managing Director, Tax Practice

A corporate inversion sounds a lot like a sadistic exercise prescribed by a personal trainer. But in the tax context, the phrase is getting a lot of press lately, and many do not know what it means. It also is inadequately explained (if not entirely misrepresented) routinely by the press. Here’s a primer.

First, it is critical to understand how countries tax corporations, and how the U.S. is unique in its approach. A U.S.-incorporated company that operates entirely within the U.S. could pay federal income tax at a top rate of 35%. A foreign-incorporated company operating entirely within that foreign country will generally pay tax in that country of 25%. (This is based on a recent KPMG estimate of average global corporate tax rates.)

What if that foreign-incorporated company branches out into the U.S., and is now operating in both countries? In that case, the U.S. will tax that foreign company only on its activities conducted within the U.S., and the foreign country generally will only tax the activity that occurs within its borders as well. Each portion of income (US and foreign) is therefore taxed only once.

Here is where it gets interesting: What if a U.S.-incorporated company branches out into a foreign country? Predictably, the foreign country will assess tax only on the activity taking place within its borders. One would think that the U.S. would only tax the balance (the income earned in the U.S.), right? Not so. The U.S. continues to assess tax on the company’s worldwide income, because it is incorporated in the U.S. It is the only country in the civilized world to tax worldwide income. A “foreign tax credit” is provided in many circumstances that can reduce the U.S. tax, but the complex rules often do not allow complete neutralization of this double-taxation.

So companies that are incorporated in the U.S. may be competing with similarly-positioned competitors that happened to incorporate in a foreign country, and the latter companies are for that simple reason paying far less tax. What should that U.S.-incorporated company do? Raise its prices, and risk losing market share? Simply accept less profit? (Recall that it already is facing the highest corporate tax rate in the civilized world – 35% vs. an average of 25%.) Many companies that are contemplating activity spread over two countries will simply incorporate in the foreign country to avoid this double taxation. Others begin in the US, see their foreign activity increase over time, and are less profitable than competitors simply because of where they originally chose to incorporate. To remedy this, they “invert,” or find a way to incorporate overseas. This can involve many forms, like forming a new entity that is incorporated overseas and merging the existing entity into it. It also may involve selling assets to an existing entity incorporated in the foreign country. It is perfectly legal, and the company will still pay U.S. tax on its activity conducted in the U.S. The inversion is done to avoid double-taxation that is unique to US-incorporated entities, and to force the U.S. tax authorities into a position comparable to the rest of the world.

There is much in the press that vilifies inversions, and questions the patriotism of those who undertake them. But such vilification is legitimate only if one accepts that U.S. citizens or companies should pay more than what is legally required (and in this case, what is legally required already is greater than the burden imposed by other countries). Also, many multinational companies have shareholders all over the world. Are foreign shareholders expected to understand management’s patriotism to the U.S. (and its high effective tax rate) and support the forgoing of inversion, when doing so would reduce the overall worldwide tax rate? Do those who so vocally oppose inversions routinely pencil in a “patriotism surcharge” on their own 1040s every April 15, and voluntarily mail in more than is required of them?

Tax evasion is illegal, and involves under-reporting income, over-reporting expenses, or something similar. Tax avoidance, however, involves legitimately structuring one’s affairs to reduce his or her tax burden. Inversions represent tax avoidance, and they generally are perfectly legal. Judge Learned Hand is well known for this famous quote that is applicable here: “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”

Congress is welcome to change the rules to prevent inversions. But let’s not be misled about why companies are doing this.

If you have any questions, please contact Stan Rose or your BNN tax advisor at 1.800.244.7444.