Recently, Congress and the media have been abuzz over “corporate inversions.” Some worry that the recent wave of inversions will harm the U.S. and its taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. base. Others point to them as evidence of a broken U.S. corporate tax code.
In order to help you sort through the chatter, here are some common questions and answers about corporate inversions, how they interact with our tax system, and why they matter:
What is an inversion?
In its simplest form, an inversion is simply the process by which a corporate entity, established in another country, buys an established American company. The transaction takes place when a foreign corporation purchases either the shares or assets of a domestic corporation or a when a U.S. corporation purchases the share or assets of a foreign corporation. Some inversions involve the purchase of both the shares of ownership and the corporate assets. The shareholders of the domestic company typically become shareholders of the new foreign parent company. In essence, the legal location of the company changes through a corporate inversion from the United States to another country. An inversion typically does not change the operational structure or functional location of a company.
How does an inversion benefit the U.S. corporation?
The change in legal residence from the United States to another country allows the company to take advantage of the more favorable tax treatment of the new home country. The most obvious benefit is that most countries do not have a worldwide corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. system. The United States taxes income earned by U.S. corporations no matter where they earn that income, domestically or abroad.
For example, if a subsidiary of a U.S. firm earns $100 in profits in England, it pays the United Kingdom corporate income tax rate of 21 percent (or $21) on those profits. When those profits are brought back to the United States, an additional tax equal to the difference between the U.S. tax rate of 35 percent and the U.K. corporate rate of 21 percent ($14 in this case) is collected by the IRS. Between the two nations, the U.S. firm will have paid a total of $35, or 35 percent, in taxes on its foreign profits.
Most countries have what are called territorial systems that only tax income earned in their border. This means that any profits earned inside a country are taxed by that country and any profits earned outside of a country is not taxed. So if the U.S. corporation in the above example relocates to the United Kingdom, it would no longer be liable for that additional U.S. tax on its foreign profits.
It is also important to point out that a U.S. corporation that inverts will still need to pay tax on any income that it earned in the United States.
What is the impact of an inversion on employees?
A corporate inversion does not typically change the operational structure of a company. In most cases, an inversion simply means the addition of a small office in the company’s new foreign "home." Therefore, a re-incorporation rarely, if ever, leads to the loss of American jobs. In fact, to the extent that a corporate inversion leads to significant savings from a lower tax burden, employees may benefit through increased wages or more jobs.
How common are corporate inversions?
According to the Congressional Research Service, there have been approximately 76 companies that have either inverted or are planning to do so since 1983. 14 of those planned inversions have occurred in 2014 alone. 47 inversions have happened in past decade.
While the acceleration of corporate inversions sounds troubling, the number of inversions is actually really low compared to the total number of C corporations in the United States. According to most recent IRS statistics there are 1.6 million C corporations in the United States, a little fewer than 4,000 of them are publicly traded.
What is the impact of corporate inversions on federal tax collections?
If a corporation is able to invert, it would no longer be considered a U.S. corporation. As a result, it would no longer be liable for the U.S. tax corporate income tax on its income earned outside of the United States. For the corporation this means a tax savings, but for the Treasury it means lower revenues.
Judging by the rhetoric on the issue, one would assume that these inversions will lead to a large swath of corporate income being untaxed by the U.S. This really isn’t the case.
According to the JCT analysis of the “Stop Corporate Inversions Act of 2014,” a bill that aims to limit the ability of corporations to invert for tax purposes, this bill will raise $20 billion over the next ten years. Compare this to the $4.5 trillion the CBO predicts the corporate income tax will raise over the same period. In other words, corporate inversions are predicted to cost 0.5 percent of the corporate tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. over ten years.
Are corporate inversions a form of tax evasion?
Tax evasion is the avoidance of taxes through illegal means such as misrepresenting income on a tax return. Inversions are a legal means by which a company lowers its tax bill. When a company’s shareholders choose to re-incorporate in another country, it is a business decision like thousands of others that executives and shareholders must make every year. It can be thought of as a move similar a business relocating to Texas from California.
What is the underlying cause of the recent trend in corporate inversions?
As global operations become an increasingly important aspect of business, multinational corporations are under increasing pressure to lower their overall tax burden. There are two specific problems with the current U.S. corporate income tax that corporations are attempting to overcome through re-incorporation transactions:
The United States corporate income tax rate, 35 percent (39.1 percent combined with state rates) on corporate income, is relatively high by international standards. The U.S. corporate income tax rate is the highest rate among the 34 countries of the Organization for Economic Cooperation and Development (OECD). The fact that inversions have been accelerating reflects the fact that the U.S. is actually falling farther behind as time as gone on.
The second reason, is that the United States taxes domestic companies on their world-wide income, while most other countries tax their domestic companies only on domestically-earned income. This means that U.S. companies face a marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. of at least 35 percent on every dollar earned whether earned domestically or abroad, while their competitors do not.
Does re-incorporation lead to large capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. These taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. es for shareholders, including employee-shareholders?
If a company’s re-incorporation is accomplished through a stock transaction, in which the overseas corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). purchases significantly all the shares of ownership in the domestic corporation, existing shareholders (whether or not they become shareowners in the new, foreign corporation) may face capital gains taxation at the time of inversion. This is due to section 367 of the U.S. Internal Revenue Code, added in 1998, which requires shareholders to recognize a gain on the exchange of stock for tax purposes.
This provision was added to the code as an "exit toll" with the intention of making inversions less palatable to U.S. corporations. Typically, corporate executives anticipate that the savings in corporate taxes from the inversion over the long-term is of greater value than the immediate capital gains hit. Thus, in theory, an inverted corporation’s stock should appreciate in value enough to overcome the wealth lost in capital gains tax.
One reason many corporations are considering re-incorporation in another country now is the relatively depressed value of their stock, due in part to the general drop in the broader equity markets. This fact means that shareholder losses to capital gains taxation on the transaction are minimized.Share