By Kenneth H. Bridges, CPA, PFS August 2014
You can hardly pick up a newspaper today (assuming you still do that) without reading about “corporate inversions”. It seems like every U.S. multinational company has done one or is considering one, and members of Congress and President Obama keep talking about the need to shut down this “loophole”. So what is a “corporate inversion” and why the sudden rush to do them? First, a primer on U.S. taxation of multinational businesses.
The U.S. has what is known as a “worldwide tax system” whereby it taxes its citizens and residents (including domestic corporations) on their worldwide income, from whatever source derived, and then permits a credit or partial credit for taxes properly paid to other countries (so long as the effective rate paid the other country does not exceed the effective rate paid the U.S. on that same income). This is in contrast to the “territorial tax system” utilized by most countries, whereby the country only taxes income earned in that country.
There are exceptions to our worldwide system. For example, a U.S. citizen working abroad can avoid U.S. tax on up to $99,200 of earned income and $13,888 of housing allowance per year, and U.S. corporations can defer U.S. taxation of income from the active conduct of a business in another country, so long as the business is conducted through a separate subsidiary and the income is not repatriated (directly or indirectly) to the U.S.
In order to avoid U.S. tax (at a Federal rate of up to 35%, plus possibly state tax) on the repatriation of earnings, U.S. multinational corporations have left substantial earnings offshore in foreign subsidiaries. This lack of flexibility, however, has led some U.S. companies to “expatriate” to a country with a lower corporate tax rate and a territorial tax system. This has particularly been the case in the pharmaceuticals industry, but increasingly companies in other industries are considering this as well.
In a “corporate inversion” transaction, a U.S. company effectively acquires a non-U.S. corporation, but the transaction is “inverted” whereby the foreign corporation ends up as the parent company owning the stock of the U.S. company, but with the former shareholders of the U.S. company now owning most of the stock of the foreign company. Under current rules, if the former shareholders of the U.S. company end up owning 80% or more of the foreign corporation, then the foreign corporation will be treated as a U.S. corporation for income tax purposes. Alternatively, if the former shareholders of the U.S. company end up owning between 60% and 80% of the foreign corporation, then foreign corporation status will generally be honored, but certain gains incurred within the subsequent 10-year period will still be subject to U.S. tax (with no offset for losses, credits, etc.). Accordingly, inversion transactions are typically structured such that the former shareholders of the foreign corporation end up owning at least 21%, if not 41%, of the combined entity (assuming sufficient value in the foreign entity to justify this).
The rules in this area are extremely complex, and the U.S. shareholders may have to recognize taxable gain on the transaction. However, the perceived long-term value to the corporation (and thus, indirectly, to its shareholders) may justify the complexity and potential immediate tax cost, particularly if there is a foreign target corporation of sufficient size to get to the 21% or 41% thresholds and the company perceives its long-term profit growth potential (and potentially an increasing percentage of its shareholders) to be outside the U.S.
President Obama and certain Democratic members of Congress have proposed to move quickly to enact provisions (potentially retroactive to earlier this year) which would tighten the rules in this area and make it harder to do an inversion. Meanwhile, Republicans in Congress say such patchwork changes would be even more harmful to the U.S. economy and that the solution is broad-based tax reform that includes a reduction in the U.S. corporate income tax rate (now amongst the highest in the world at 35%).
While most of you reading this are probably not directly affected by corporate inversions, almost all of you are likely to be indirectly affected by this issue and its ultimate resolution.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.