Corporate Inversions 101

Corporate inversions have been in the news recently with the latest being the failed Pfizer-Allergan deal.

Moreover, inversions have been demonized in the political debates as an un-American tax loophole. But inversions aren't really a tax loophole. Inversions, instead, are the result of differences between United States tax law and the taxing regimes of other countries.

Countries assess tax on foreign earned income differently. There are two general methods used to tax income earned abroad by multinational companies: worldwide and territorial.

A corporation headquartered in a country with a worldwide taxing system would pay tax on 100% of its worldwide income whereas a corporation headquartered in a territorial tax country would only pay tax on income earned in that country. The worldwide tax system gives companies a tax credit for tax paid in foreign countries, but if the tax rate in the home country is high, the company will pay the difference.

Over the past 40 years, there has been a global shift from worldwide to territorial taxing schemes. Most of the Organization for Economic Cooperation and Development (OECD) member countries use a territorial taxing system. The United States is the only G-7 country that uses the worldwide taxing method for multinational corporations.

The United States' corporate tax rate of 35% is high compared to other countries. For example, Ireland, another worldwide taxing country, has a top marginal tax rate of 12.5% on business income. A multinational United States-based corporation will generally pay more tax than a foreign-based multinational corporation.

A corporate inversion is when a U.S. corporation is acquired by a foreign corporation and becomes a wholly owned subsidiary of the foreign corporation.

When this happens — poof — the foreign earnings of the U.S. corporation are no longer subject to U.S. taxation.

A corporate inversion, for the most part, only has to be a paper transaction. The corporate officers can remain in the United States and all operations can remain the same. The only difference is ownership passes outside the country and the reach of United States taxing authorities is limited. The U.S. company will still be subject to federal taxation on income earned domestically but not on income earned outside the country.

The timing of income recognition for foreign earned income is another tax issue for multinational corporations. The United States does not tax foreign earnings until they are “repatriated” by bringing the cash back to the country. The time difference between when the income is earned outside of the country and when the cash is brought into the country is called the deferral.

This deferral incentivizes corporations to not repatriate earnings back to the United States. No one knows for sure, but estimates of un-repatriated foreign earned income range from $1.7 trillion to $2.6 trillion.

As an example, if a corporation in the 35% income tax bracket repatriates $1 million of foreign earned income, it will owe $350,000 in United States income tax. The corporation has already paid $200,000 of foreign tax on this income and will get a foreign tax credit for this amount but will still owe the difference of $150,000.

The decision to move from the United States to a different country is a business decision. A corporate inversion is a legal method to reduce taxes, and as corporations and their leadership become more global, the decision to stay in the United States will have less pull than lower taxes.

The argument for the United States maintaining a worldwide taxation system goes back to a theory that the federal government provides its corporate citizens with protections such as secure shipping lines and worldwide legal patent protection. These benefits come at a cost, and the corporations receiving the benefits should share it.

This argument is valid but yet multinational corporations are operating in a competitive global environment where a heavy tax burden could be the difference between success and failure.

A tax loophole generally has the connotation of an omission in the law that allows someone to circumvent the intent of the law. A corporate inversion is not a tax loophole but a symptom of unequal taxing schemes. As long as the inequality of the systems remain, corporations will look at the opportunity to reduce their tax burden by moving to a low-cost tax country. How we as a nation tackle this problem is undecided.

Pamela Schuneman,  C.P.A., is a practicing tax accountant in Sarasota with Kerkering Barberio. She has 33 years' experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her
at [email protected]