Corporate Inversion: Definition & Overview
When a company is based in one country, it will pay taxes on the income that it gains domestically.
However, in the case of some countries, if a corporation also has a significant income from overseas countries, they will have to pay more tax on their profits.
This leads to a desire for these corporations to move their operations abroad in order to lessen their tax burden. This process is known as corporate inversion.
Read on as we dive deeper into corporate inversion and take a closer look at this controversial process.
Table of Contents
- Corporate inversion is the process of a domestic company moving its main headquarters overseas.
- This is for tax purposes. As the corporation will have fewer tax obligations than if they remained in the domestic country. Therefore lowering the corporation’s effective tax rate.
- While this process is legal, it is a hugely controversial process.
What Is a Corporate Inversion?
A corporate inversion is a process by which primarily based U.S. companies relocate operations overseas. This is with the aim of reducing the income tax burden.
A company that receives a significant portion of its income from foreign sources may choose to employ corporate inversion as a strategy. This is because the foreign income would be taxed both by the foreign country as well as in the country of origin.
Companies who undertake a corporate inversion tend to select a country that has a tax rate that is lower than their home country. Therefore lowering the company’s effective tax rate on a net basis.
The countries that have favorable tax rates are often known as tax haven countries.
A corporate inversion is also commonly known as a tax inversion. This is because it is a process that primarily concerns tax.
How Corporate Inversions Work
Corporate inversion is one of the many ways that companies will try to reduce their tax burden.
This happens when a company can reincorporate in a different country than the country of incorporation. This can be by allowing a foreign company to purchase its current operations.
The foreign company will then own the assets and the old corporation can be dissolved. The business is now effectively based out of the new country. This is while remaining the same in its day-to-day operations and activities. All whilst working under the foreign parent company.
Companies can also merge with or buy a foreign business and use that new entity as their headquarters. Despite the new corporate structure, it is relatively common for the U.S. operations of the company to carry on. As well as for business lines and jobs to remain unchanged and unimpeded.
Corporate inversions represent a smart business strategy. This is when it comes to competitiveness and profitability. The reason for this is that they can lower their tax burden for the company’s overall operations.
Although it’s important to note that corporate inversion comes at a price. When a company goes through the process of a corporate inversion, it will end up contributing fewer taxes. This is to the nation where the corporation was originally founded. This will then lower the revenue the government has for services.
People who disagree with corporate inversions will be quick to point out the flaws. This is that companies often benefit from broader societal factors that they don’t want to contribute towards. For example, a business may benefit from having a workforce that is well educated. But they will then quickly look for ways to minimize their contributions to factors such as education as soon as they can.
Corporate Inversion Example
Let’s say that Company X incorporated itself in the U.S., making it an American company. For years most of the revenue came from its U.S. based sales. But then the percentage of foreign sales started to increase. The income that Company X receives from abroad is taxed in the United States. And the U.S. tax credits fail to cover all corporate taxes which the company must also pay elsewhere.
As the foreign sales percentage grows relative to the company’s domestic operations, the company ends up paying more in U.S. taxes. This is because the company is incorporated in the United States. In addition to all of this, the company’s U.S. income is also taxed at a high domestic rate.
If the business decides to pack up and incorporate in a foreign country, it can bypass having to pay the higher U.S. taxes. This is on income that isn’t generated in the United States. With this in mind, Company X decides to undergo a corporate inversion.
This gives them the possibility of financing options that are more attractive, as well as no longer having to pay U.S. taxes on their foreign income.
Tax Advantages of Corporate Inversions
Changing the legal residence of a corporation from the United States to a foreign country allows a number of advantages. The main one is the ability to benefit from the favorable tax treatment that many countries employ. The most favorable of these benefits is the fact that most countries don’t have a worldwide corporate income tax system.
This is in contrast to the United States tax system. This states that any income earned by U.S. corporations is taxed no matter where they earn that income. This could either be domestically or internationally.
To give an example, let’s say that Company X is a U.S. corporation. They earn $100,000 in profits in the United Kingdom, they pay the U.K. corporate income tax rate of 21 percent tax on these profits. This would amount to $21,000.
When these profits are brought back to the United States, an additional tax is charged. This is equal to the difference between the U.K. corporate rate of 21% and the U.S. tax rate of 35%. In this case, it would amount to $14,000 that would be collected by the IRS.
Between these two nations, Company X would have paid a total of $35,000, or 35% in taxes on its profits made abroad. This would have a tax income of $65,000 out of the original $100,000.
Criticism of Corporate Inversions
It is important to note that corporate inversion is a completely legal strategy and is not considered tax evasion. This is as long as the move does not involve any misrepresentation of information on a tax return. As well as there being no illegal activities undertaken with the aim of hiding profits.
However, there has always been a swathe of controversy surrounding the ethical implications of companies that opt for a corporate inversion. Many U.S. companies have been heavily criticized for making the decision to leave the country. Classic examples include:
- Burger King
- Seagate Technology
- Lucky Strike
- Trader Joe’s
- General Electric appliances
Perhaps the most controversial example was in 2015 when pharmaceutical company Pfizer Inc. announced its intention to move to Ireland. This was as a part of a merger with Allergan PLC.
This announcement sparked public outrage in political circles. This ended up with the U.S. Department of the Treasury alongside the Internal Revenue Service creating a new set of strong rules. These new rules aimed to make the deal and other large corporate inversions much less of an attractive prospect. This led to Pfizer Inc. calling the deal off a year later in 2016.
The following year, the Tax Cuts and Jobs Act of 2017 addressed a large portion of the tax disparity that was leading to companies moving towards corporate inversions. This helped to stem the number of companies leaving the country.
As of 2020, there is a new U.S. corporate tax rate. This has stemmed the flow of corporate inversions for the many multinational companies that are housed in the United States.
The practice of corporate inversions remains legal and a corporation can still make the choice to move to a foreign country. But due to these tax changes, the process is no longer as popular as it once was when the tax savings were significant.
Corporate inversion allows corporations to dissolve their base in the country in which they were incorporated. This dissolution allows them to move their headquarters to a foreign country in order to pay favorable tax rates.
The process of corporate inversion is completely legal and is not considered to be tax evasion. However, it is a wholly controversial topic that has historically faced great criticism.
FAQS About Corporate Inversion
Is Corporate Inversion Legal?
Yes, corporate inversion remains a completely legal process under the current tax rules. However, it is generally frowned upon and the potential tax savings remains a controversial subject.
What Firms Benefit From Tax Inversions?
In terms of who benefits from tax inversions, there is a number. This includes CEOs, short-term shareholders, foreign shareholders, and tax-exempt shareholders. These individuals benefit disproportionately from inversions.
Do Corporate Inversions Benefit Stakeholders?
For the average shareholder, inversion has a net positive effect. This is as the reduction in corporate income tax exceeds the cost of the average shareholder’s personal income tax.
WHY BUSINESS OWNERS LOVE FRESHBOOKS
SAVE UP TO 553 HOURS EACH YEAR BY USING FRESHBOOKS
SAVE UP TO $7000 IN BILLABLE HOURS EVERY YEAR
OVER 30 MILLION PEOPLE HAVE USED FRESHBOOKS WORLDWIDE