Corporate Inversion: Definition & Overview

KEY TAKEAWAYS

• Corporate inversion is the process of a domestic company moving its main headquarters overseas.
• This is done for income tax purposes. As the corporation will have fewer tax obligations than if they remained incorporated in the domestic country. As a foreign corporation they are only taxed on income generated in the U.S.   
• While this process is legal, it is considered highly controversial. 

What Is a Corporate Inversion?

A corporate inversion is a process by which primarily based U.S. companies relocate operations overseas with the aim of reducing the income tax burden. 

A multinational company with a U.S. based parent, that receives a significant portion of its income from foreign sources may choose to employ corporate inversion as a strategy. This is because of both their domestic and foreign revenues being subject to tax in the U.S. Once they become a foreign corporation, they are only required to pay tax on income generated in the U.S.

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, as its primary purpose is to lower the amount of corporate tax expense.

How Corporate Inversions Work

Corporate inversion is one of the many ways that companies will try to reduce their tax burden. 

For example, a company can reincorporate in a different country than its original country of incorporation 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, while continuing the same day-to-day operations and activities. In the U.S., a company’s tax status is based on the country of incorporation of its 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, when it comes to competitiveness and profitability, because they can significantly decrease corporate tax expense.

It is important to note that corporate inversion also has drawbacks. When a company goes through the process of a corporate inversion, it results in lower tax revenue for the government of the country of original incorporation. This tax revenue is used to fund public services such as education, healthcare, and roads.

People who disagree with corporate inversions will be quick to point out these flaws. The same companies that often benefit from broader societal factors such as having an educated workforce, will look for ways to minimize their tax obligations. 

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. foreign tax credits fail to cover all corporate tax expenses  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, because the company is incorporated in the United States. Additionally, 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 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 provides 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, which states that any income earned by U.S. corporations is subject to tax, 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 result in net 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, as long as the move does not involve any misrepresentation of information on a tax return or illegal activities undertaken with the aim of hiding profits. 

It may be considered a form of tax avoidance, which involves legal ways to minimize tax obligations.

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
• Budweiser
• Medtronic
• Purina
• Seagate Technology
• Lucky Strike
• Trader Joe’s
• General Electric appliances
• 7-Eleven

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 resulted with the U.S. Department of the Treasury and 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 caused a slowdown in 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. 

Summary

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. 

Written by Sandra Habiger

Sandra Habiger is a Certified Public Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Learn more about her work at https://www.sixfiguresaccounting.com/ .

Written by Sandra Habiger

Sandra Habiger is a Certified Public Accountant with a Bachelor’s Degree in Business Administration from the University of Washington. Sandra’s areas of focus include advising real estate agents, brokers, and investors. She supports small businesses in growing to their first six figures and beyond. Learn more about her work at https://www.sixfiguresaccounting.com/ .