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Question of the Week - September 29, 2014

Question of the Week - September 29, 2014

Guest Post - Monday, September 29, 2014

What's a corporate 'tax inversion?'

As implied by the name, tax inversions describe a tax/legal technique used by a handful of U.S. corporations to reduce their income taxes and/or increase flexibility in tapping into untaxed foreign earnings. The U.S. has among the highest corporate tax rates in the world, so this technique has become increasingly popular in the last several years, as has the pressure on the administration and Congress to act—both to stem the tide of inversions, as well as revamp the corporate tax code (and reduce tax rates) to improve global competitiveness. The President has even gone as far as to deem such tax-driven inversion transactions 'unpatriotic.' Companies do what they're economically incented to do in order to maximize profits (their reason for existence), and every provision of the tax code offers side effects, of which this is one.

Here's a quick primer on what the 'inversion' is and how it works. While some of the steps seem odd, each accomplishes a specific purpose. For example, a larger U.S. company merges with a smaller foreign firm, then moves the headquarters overseas. This is because the corporate operations have to be officially re-domiciled abroad, and, since 2004, the combined company has to be at least 20% owned by a foreign entity—represented by the partnered firm—to be recognized by the IRS as an offshore operation and no longer subject to U.S. tax jurisdiction. That's why a company can't just unwind itself and reestablish itself offshore for the same benefit—it takes foreign ownership, but firms don't want too much. There are also other techniques to minimize taxes to an even greater degree—there is the shady-sounding 'earnings stripping,' where a U.S. subsidiary can borrow funds from the foreign parent and claim a tax deduction for interest paid (and, conversely, the foreign firm can often avoid tax on the interest it earns on that same loan—talk about a win-win). As you might expect, some of these techniques are politically controversial, since the tax minimization intentions are quite obvious.

Firms that choose to stay here and not relocate overseas (the vast majority) can still take advantage of other tax loopholes, such as keeping revenues earned by foreign subsidiaries offshore, so the amounts remain non-taxed by the U.S. as long as they're not 're-patriated' back. This has been a point of contention with many well-known American blue chips, such as Apple, who have large offshore cash stakes partially as a result of this strategy.

While the number of larger firms conducting a full inversion have been few in the last several years (some notable ones are Transocean and Ensco a few years ago, and currently pending are Medtronic, Applied Materials and Mylan), as the costs of doing so aren't small, iconic Burger King announcing it was leaving for greener pastures in Canada was apparently the last straw. The U.S. Treasury, under which the IRS falls, has laid out toughened talk on stemming inversions. What happens now? While the approval of Congress is required for major statutory changes, 'interpretation' and 'enforcement' of the tax code is left up to the Treasury Dept., and that's when things become gray. It is still under debate how many of these rules can be changed in the short-term without Congressional action, but political threats and executive branch action, such as limiting firms with U.S. government contracts from operating elsewhere, is a significant possibility. Other interpretive changes may involve adjusted requirements of percentage of ownership, accounting procedures, restrictions on tax rules for U.S. subsidiaries of inverted foreign entities, or other actions to tighten the reins and make such strategies less attractive. From an overall standpoint, reduced revenues from inversions don't account for a huge number relative to the size of corporate America in total; some of this discussion is political and perhaps a needed catalyst for broader tax reform.

Other than this, congressional discussion about simplifying the overall tax code (for corporations and individuals) has been in the works for some time, although it's a very partisan issue. Democrats insist on any changes remaining 'revenue-neutral' (meaning the byproduct won't be a tax cut on a net-net basis) while Republicans tend to favor what's in the best interests of the free market and don't mind reducing taxes. So, that's the backdrop for a likely much larger battle over time as the tax code continues to grow annually beyond its currently almost-75,000 pages.

Additional Reading

Read our Weekly Review for September 29, 2014.

Read the previous Question of the Week, September 22, 2014.

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