The Corporate Inversion: From Obscure Strategy to Hot Trend

by Moskowitz LLP

Capitalist ideals of “free enterprise” and “competition” make great debate topics, but when compared to the business-friendly tax codes of other nations the United States Tax Code cannot compete. With the highest corporate income tax rate in the developed world, many businesses and longstanding American icons have made the move towards corporate inversion, a tax reduction method of re-incorporating a company in another country if a significant portion of the company’s income is derived from foreign sources.

How do corporate inversions work?

This once obscure corporate tax strategy has made recent headlines with a record number of major U.S. corporations currently seeking inversions. CNN Money reports that from 2004-2013, 47 U.S. companies relocated, compared to 29 from 1983-2003. What makes corporate inversion such an attractive proposition to so many U.S. companies?

Corporate inversions enable companies to reduce their U.S. tax burden by re-incorporating in a country that has lower tax rates.  When the company’s residency changes, the way the U.S. taxes that company changes. The company still pays U.S. tax on its U.S. profits at U.S. corporate tax rates (the combined U.S. federal-state corporate tax rate is currently 39.1 percent).  However, the company’s worldwide profits are no longer taxable in the U.S. since its status has changed from U.S. domiciled to non-U.S. domiciled.

In addition to benefitting from a lower tax rate, a number of companies that undertake corporate inversions also practice earnings stripping, with the company in the U.S. taking on debt in order to fund foreign operations, and paying excessive interest on that debt which can be deducted from U.S. taxes. The arrangement is structured so that the debt is owed to a related party (usually the U.S. company’s foreign parent) for whom the interest may be either partially or wholly tax exempt. 

Are There Any Conditions?

Since it is illegal for a company to claim residency in a locale where it conducts little or no business, inversions are generally preceded by mergers with foreign corporations —either the foreign corporation will take over the U.S. company or the two companies combining to create a new entity in another jurisdiction.

Under 26 U.S. Code § 7874, the foreign entity must own at least 20 percent of the new business.  In an effort to curb the practice, President Obama proposed raising this threshold to 50 percent. If this plan succeeds, U.S. companies would be required to surrender control to their foreign partners. An exception to this rule provides ownership may remain with the U.S. company if it has “substantial business activities” in the foreign country consisting of:

  • 25 percent of its business in the foreign country; and
  • 25 percent of its employees and employee compensation in the foreign country.

In the meantime, a number of major U.S. corporations have inversions currently pending, including:

  • Chiquita Brands International, Inc., which announced on March 10, 2014 that it will combine with the Dublin-based Fyffes. The merger, a billion dollar deal, will result in the creation of the largest banana producer on the planet.
  • Walgreens, the largest drugstore chain in the U.S. has exercised its option to buy controlling interest in Switzerland’s Alliance Boots.  Inversion was considered and revealed to  save Walgreens approximately $4 billion in taxes in the next five years alone.   However, on August 6, 2014, a statement was issued stating that Walgreens maintain its tax domicile in the United states because of the likelihood of IRS scrutiny and action.
  • Applied Materials recently announced a merger with Japan’s Tokyo Electron. The new combined company will be incorporated in the Netherlands, where it expects to pay an effective tax rate of approximately 17% by 2017.

Keep in mind that corporate inversion is not tax evasion. U.S. companies have a duty to their shareholders to preserve corporate assets, and use legal means to save taxes is perfectly legitimate. Protecting your potential to successfully use corporate inversion for your company requires thorough knowledge of the latest tax developments.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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