On September 22, 2014, the U.S. Treasury announced new rules making it more difficult and less profitable for U.S. companies to move their headquarters overseas through a process known as inversion. Inversions have received significant media attention over the last few months, and the action by federal regulators brought a new level of scrutiny that might stimulate further action on corporate taxes.
As an investor and taxpayer, you may want to learn more about why this strategy has become a hot-button issue, and about the potential implications for tax revenues and shareholders of inverted companies.
A Percentage Game
The 35% U.S. tax rate on corporate income is the highest in the developed world. Furthermore, unlike most countries, the United States taxes earnings by overseas subsidiaries when the funds are returned to the United States. For example, a company that earns $1 million through an English subsidiary would pay $210,000 at the English corporate rate of 21%, and then an additional $140,000 (14%) when the profits are returned to the U.S. corporate headquarters, for a total of 35%. State taxes raise the rate to an average of 39.1%.1
In an inversion, a U.S. company typically buys a smaller foreign company and then “inverts” the corporate structure so that the foreign entity becomes the parent company, which then owns the former U.S. company and any foreign subsidiaries. Profits earned in the United States are still subject to U.S. taxes, so the tax benefit for the company is on profits earned by foreign subsidiaries; with increasing globalization, these profits might play a large role in a company’s overall financial picture.
Unlike offshoring, which moves operations to another country, an inversion generally moves only the corporate headquarters for tax purposes. Company executives may continue to work in the United States, and typically there is only a small office in the foreign country.
Under current law, a company can reap the tax benefits of an inversion if it meets certain requirements regarding: (1) the percentage of business carried out in the new “home country,” and (2) the percentage of the new multinational company that is owned by the old U.S. company’s shareholders.
The new regulations make it more difficult to exaggerate the size of the foreign parent company and/or reduce the size of the U.S. company prior to inversion. Just as important, the rules make it more difficult for an inverted company to access funds from a foreign subsidiary while circumventing U.S. taxes. These changes reduce the financial incentive to execute an acquisition primarily for an inversion.2
In response to the changing landscape, a large pharmaceutical company cited the new Treasury regulations when it announced that it would reconsider its planned acquisition of an Irish company. A new Irish law closing a loophole for royalties from intellectual property may have contributed to this decision, and it reflects international pressure to level the playing field.3
A Mixed Bag for Shareholders
In an inversion, the shareholders of the former U.S. company typically exchange their shares for shares of the new foreign parent company. This exchange is considered a taxable event, so shareholders may be liable for taxes on capital gains.
Theoretically, company leadership would execute an inversion only if they believed it would put the company on a stronger financial footing that might generate long-term growth. However, shareholders in a company that plans to invert should be aware of the potential for a tax bill in the short term.
What Is the Impact?
Since 1983, 76 companies have inverted or are planning to do so. Considering that there are about 1.6 million C corporations in the United States — almost 4,000 of which are publicly traded companies — this may seem insignificant. However, the pace of inversion has increased, with 47 occurring in the last decade and 14 planned in 2014.4
Even so, the economic impact remains small. Because inverted companies generally do not move operations, there is little or no loss of jobs. And tax losses are relatively minor. A proposed bill aimed at limiting inversions estimated that it would generate $20 billion in corporate tax revenue over the next 10 years, a fraction of the $4.5 trillion that the Congressional Budget Office projects will be collected from corporate taxes during that period.5
Considering these statistics, inversions may have greater significance as a symbol and discussion point for the larger issue of corporate taxes and erosion of the U.S. tax base. Many lawmakers agree that the corporate tax system needs reform, but there has been little progress in finding solutions. The Treasury regulations, which were accomplished through executive action, were a first step, and it remains to be seen whether they will generate further discussion and broader reform of corporate taxes.
All investments are subject to risk and loss of principal. Investments, when sold, may be worth more or less than their original cost. Before taking any action regarding taxes, consult with your tax advisor.
1, 4–5) Tax Foundation, 2014
2) U.S. Treasury, 2014
3) Forbes, October 15, 2014
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright 2014 Emerald Connect, LLC.