Corporate Inversions [an error occurred while processing this directive]

Introduction [an error occurred while processing this directive] Corporate inversions have become popular with U.S. publicly-held corporations seeking to lower the U.S. tax bite. A corporation organized in the U.S. pays federal taxes on its worldwide income, whereas a foreign corporation pays federal taxes only on its "U.S. source" income. Also, a foreign corporation typically pays state taxes only on income generated within that state.

When a U.S. corporation undergoes a corporate inversion, the U.S. corporation becomes a subsidiary of a foreign corporation ("parent") organized in a tax haven country - a country that imposes little or no tax on corporations. The new parent corporation receives income throughout the world, and pays U.S. taxes only on the U.S.-source income generated by its U.S. subsidiary.¹

In contrast, if the U.S. corporation did not engage in the corporate inversion, income from all sources, whether U.S. or foreign, would be subject to U.S. taxes. The bottom line: By engaging in a corporate conversion, the corporation no longer pays federal income taxes on its foreign source income.

How It Works [an error occurred while processing this directive] A U.S. corporation creates a parent company in a tax-haven country, a country that imposes little or no taxes on income received by international corporations headquartered in that country. The U.S. corporation then engages in a merger or reorganization, the result of which makes the U.S corporation a subsidiary of the foreign parent. Thus, only U.S. source income received by the newly created foreign parent is subject to U.S. federal taxation.

Avoiding U.S. Taxes [an error occurred while processing this directive] After a corporate inversion, any profits generated by business operations outside the U.S. will not be subject to U.S. corporate income taxes. If the taxes incurred in the foreign country are lower than the 35% U.S. corporate tax bracket, the corporation pays a lower tax overall and has larger after-tax profits.

For example: Assume a corporation has $100 million in income from Country X that imposes a 10% corporate income tax. A U.S. corporation is subject to taxes on its world-wide income and will wind-up paying $35 million in taxes - $10 million to the foreign country and $25 million to the U.S. If the corporation engages in a conversion, it will pay only the $10 million to the foreign country and will save the $25 million otherwise payable to the U.S.

Earnings Stripping [an error occurred while processing this directive] Not only does a corporate inversion eliminate U.S. tax on foreign source income, any tax-deductible payments made by the U.S. corporation to its foreign parent create a tax-free transfer on income to the foreign parent. This is called "earnings stripping" and although the U.S. tax law attempts to limit earnings stripping, there are many techniques to accomplish this tax-free transfer.

For example: Assume a U.S. corporation has a $1 billion bank loan and pays 5% interest on the loan. The U.S. corporation is entitled to a $50 million deduction for its interest payment on its U.S. tax return. If the U.S. corporation engages in an inversion and then the parent assumes the bank loan and then reloans the funds to the U.S. subsidiary at 6%, the U.S. corporation now has a $60 million interest paid deduction and the foreign parent receives $60 million, $50 million of which is used to repay the bank. Thus, there has been a $10 million tax-free transfer from the U.S. subsidiary to its foreign parent, although the substance of the loan has remained the same (the U.S. company received a $1 billion loan both before and after the inversion.²

This earnings stripping strategy can apply to all types of transfer payments from the U.S. subsidiary to its foreign parent, including license and royalty fees, overhead and administration costs, research and development costs, labor costs and expenses. Although U.S. tax law attempts to reign in the most abusive transfer payments, transactions structured under an arm's-length business standard can still provide plenty of opportunities to shift income away from the U.S. subsidiary to the foreign parent.

Costs Involved[an error occurred while processing this directive] A corporate inversion is not a tax-free reorganization and is considered a taxable sale of assets to the foreign parent under IRC Sec. 367. Generally there is a tax on the appreciation of the assets being sold. Corporate inversions have become popular during the recent downturn in the stock market when corporate assets have dropped significantly in value. Obviously, a start-up corporation that planned to go public could create a foreign parent with little or no tax cost.

Congressional Reaction [an error occurred while processing this directive] Congress is upset about the number of recognizable U.S. corporations engaging in conversions and is considering legislation to curtail the practice. Thus far, however, the corporate lobbyists have beaten back Congressional efforts to change this practice.

Conclusion: [an error occurred while processing this directive] The corporate inversion is another technique U.S. corporations are using to lower their federal tax bite. Because of the distinction between U.S. and foreign sources of income, the corporate inversion has become a popular tool with corporations with foreign source income. Whether congress or the corporation's shareholders will rebel against the technique remains an open question.

Footnotes:

1 Note: a foreign corporation could have U.S. source income if one or more of its foreign subsidiaries engages in a trade or business within the U.S. and generates U.S. source income.

2 This is intended to be a simple example of earnings stripping. In reality, the transaction is often complex to circumvent existing U.S. tax laws designed to prevent earnings stripping.

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© 1995-2004 Robert L. Sommers, attorney-at-law, all rights reserved. This article and internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.