What is a business inversion?
A corporate inversion – also called a tax inversion – is a process by which companies, primarily based in the United States, relocate their operations overseas to reduce their tax liability. Companies that receive a significant portion of their income from foreign sources may use corporate inversion as a strategy, as foreign income is taxed both abroad and in the country of incorporation. Companies that undertake a business inversion usually choose a country that has a lower tax rate than their home country.
Key points to remember
- Corporate inversion, also known as tax inversion, involves a domestic company moving its headquarters or base of operations overseas.
- The destination company will have a lower tax rate and generally a more favorable regulatory environment than the home country, thereby reducing the company’s effective tax rate on a net basis.
- Although legal, the practice has been criticized as a loophole that artificially lowers corporate taxes and keeps US dollars offshore.
What is business inversion?
How Business Inversions Work
Business inversion is one of the many strategies employed by companies to reduce their tax burden. A company can reincorporate overseas by having a foreign company buy its current operations. The foreign company then owns the assets and the old company is dissolved. The company, while remaining the same in its day-to-day operations, is now effectively domiciled in the new country. Companies can also buy or merge with a foreign company and use that entity as their new headquarters. Despite the new corporate structure, it is not uncommon for the company’s US operations to continue and for jobs and industries to remain unchanged.
From a profitability and competitiveness perspective, business inversions represent a smart business decision because they reduce the tax burden on a company’s operations. However, that does not mean that business reversals are free. When a company undergoes a corporate inversion, it ends up contributing less taxes to the nation where it was originally founded. This, of course, reduces the revenue the government has for services. Many critics of corporate inversions point out that companies often benefit from broader societal factors, such as a well-educated workforce, but are quick to look for ways to avoid or minimize contributions as soon as they have other options.
Example of business inversion
Take the example of a manufacturing company that incorporated itself in the United States in the 1950s. For years, most of its revenue came from sales in the United States, but recently the percentage of overseas sales has increased. Income from abroad is taxed in the United States and the United States tax credits do not cover all the taxes the business has to pay elsewhere. As the percentage of sales from overseas operations increases relative to domestic operations, the business pays more taxes in the United States because of where it is domiciled. In addition, his US income is taxed at a high national rate.
If the business incorporates overseas, it can avoid paying higher US taxes on non-US income. The company would undertake a corporate inversion to achieve this goal. Business inversions have other potential benefits, including the possibility of more attractive financing options, but the main benefit is no longer having to pay US taxes on foreign income.
Criticism of corporate inversions
Company inversion is a legal strategy and is not considered tax evasion as long as it does not involve false information about a tax return or engage in illegal activities to conceal profits. However, there has been controversy surrounding the ethics of companies opting for corporate reversals. Many American companies have been called upon to leave the country, such as with Burger King’s move to Canada in 2014 through a merger with Canadian coffee and donut chain, Tim Hortons.
The controversy came to a head in 2015, when Pfizer Inc. announced it would move to Ireland in a merger with Allergan PLC, setting up one of the largest corporate reversals ever. This announcement was met with widespread outrage in political circles and new rules were drawn up by the US Treasury Department and the Internal Revenue Service that made the deal – and most large corporate inversions – much less attractive. In 2016, Pfizer Inc. canceled the deal.
A year later, the Tax Cuts and Jobs Act 2017 addressed much of the tax disparity that was driving business inversions, slowing the use of this tax strategy. As of 2020, the new US corporate tax rate has put corporate inversion on the back burner for multinationals calling American home. The practice remains legal and corporate reversals can still take place, but the strategy is not as popular as it was in the previous two decades when tax savings were greater.