Posted by Ray Polantz, CPA, MT
Can my private company benefit from a corporate tax inversion? I’ve been asked this question more frequently over the last few years as corporate tax inversions have gained momentum in the media and attention from politicians. The answer is, while you may be able to undergo a conversion, it actually may not benefit a private company quite as much as you may think.
What Is a Corporate Inversion?
An inversion occurs when a foreign corporation combines with an established American company. The shareholders of the domestic company typically become shareholders of the foreign company as part of this process. In effect, a U.S. company re-incorporates itself and moves its headquarters overseas to reduce its tax burden.
Most recently, Burger King acquired the Canadian company Tim Horton’s and as part of a corporate inversion strategy, becoming a Canadian company. Technology giant Apple has also has taken much of its profit overseas using an inversion strategy.
Is It Legal?
Yes, corporate inversions are legal and are not tax evasion, which is the avoidance of tax through illegal means. When a company’s shareholders choose to undergo an inversion and re-incorporate in another country, it’s similar to U.S. companies choosing to incorporate in Delaware due to its favorable corporate laws, or choosing to conduct business in Texas (instead of, say, California) due to the respective business and tax climates. While there may be a philosophical debate to be had on whether this practice is “right” or “wrong,” it’s within the confines of tax law.
Inversion Alone Is Not Enough
There’s definitely a strong case for wanting to relocate overseas. With the average tax rate among other industrialized countries at 25%, the U.S. combined federal and state rate of nearly 40% makes the U.S. corporate tax rate the highest in the industrialized world.
In addition, the U.S. continues to maintain a worldwide taxing regime on its citizens, residents and corporations organized here. Our country taxes income earned by U.S. corporations no matter where it is earned, both inside and outside its borders. (Note there is an option for U.S. taxpayers to defer taxes on overseas income earned in a foreign subsidiary, prior to repatriating these profits. However, once repatriated, the profits will be subject to the U.S. tax system.) Many other countries across the world have territorial systems whereby only income earned within their own borders will be subject to their income tax.
But, and this is important, regardless of their legal location, corporations will continue to be subject to U.S. income taxes on the income earned in the United States. For that reason, the mere act of legal inversion does not automatically mean the company’s worldwide taxes will be lower. To achieve desired tax savings, an inversion is usually coupled with a strategy of earnings stripping — creating tax deductions to offset U.S. income. This is typically done by either infusing corporate debt requiring interest payments be made to the foreign parent, or by transferring intangible assets such as patents or trademarks overseas to necessitate deductible royalty payments. Absent earning stripping strategies, a corporate infusion will likely do little to reduce a company’s U.S. taxes.
Deeper Tax (& Business) Impact
Technically the U.S. tax laws are set up so that, in theory, any company could undergo an inversion. But the long-term goals of publicly held companies are often different than privately held companies. While both seek to increase shareholder value, private company owners must be particularly mindful of profit repatriation and potential business exit strategies. These concerns are usually not as important to publicly held companies that can exist in perpetuity. Even if a transaction is structured in a way to successfully build up cash overseas, that cash would eventually be subject to U.S. tax when repatriated to its U.S. owners (if not before that). If an exit strategy involves liquidating distributions or a sale to another party, those gains would still be subject to U.S. taxation in most cases.
Since the end result of inversions is a foreign company owning the U.S. company, S Corporations are not candidates for inversions. S Corporations are only permitted to have U.S. individual owners (and certain U.S. trusts). Therefore, for the owners of an S corporation to undergo an inversion, the company would have to convert to a C Corporation, an entity inherently subject to two layers of tax.
The IRS also has a number of rules that could subject this transaction to U.S. tax. Generally, the tax consequences will depend on the percentage of shareholders remaining from the former U.S. company.
- Less than 50%: Generally, this type of inversion will be respected for tax purposes.
- Between 50% & 60%: Shareholders will pay tax on the gain in their shares of the U.S company.
- Between 60% & 80%: Shareholders will pay tax on the gain in their shares of the U.S company. In addition, the company will recognize gain on the value of the company, which cannot be offset by certain tax attributes such as net operating losses. Certain corporate officers will be subject to a 15% excise tax on certain stock-based deferred compensation payments.
- 80% or over: The inversion will not be respected and despite being legally organized in a foreign country, the parent company will be considered a U.S. company for U.S. tax purposes.
So if undergoing an inversion potentially creates U.S. tax, why do companies still do them? There’s a couple reasons. Many large publicly held companies believe the upfront tax cost is worth paying compared to the long-term savings possible on future earnings. In addition, for publicly held companies the owner taxation is not a major concern. With the percentage of ownership held through tax-deferred retirement accounts or mutual funds, the tax cost is often not completely transparent to the owners, and owners of individual shares do not yield much clout with public companies.
When looking beyond the media hype, corporate inversions are generally more complex and less beneficial to private companies when it comes to their time and resources.
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