Tax Inversion vs. Tax Evasion
Several high profile corporate tax inversion deals have sparked recent media and public attention. The United States government is up in arms, leaving the American people to wonder, “Is corporate tax inversion un-American, or just smart business?” The debate centers around two similar terms with vastly different implications. Tax Inversion is a legal effort to reduce corporate tax liabilities, while Tax Evasion is illegally and purposefully dodging taxes.
Despite misleading information put out by the media, inversions are a legal way for corporations to reduce their US tax liability. Although these two terms sound similar, they mean quite different things. Tax Inversion is the legal relocation of a corporation’s headquarters to a lower-tax jurisdiction in an effort to reduce tax liabilities, while Tax Evasion is illegally and purposefully dodging payment of taxes imposed by the US Federal Government.
The first official inversion took place in 1982, when a US company legally inverted its operations to an international subsidiary, thus saving millions in taxes. McDermott Inc., a construction company based in New Orleans started accumulating greater profits in its Panama-registered subsidiary, McDermott International. This subsidiary served as the holding company for international funds. Instead of paying US corporate income tax on those non-US derived profits, the company spun its corporate structure so McDermott International, the Panamanian company, became the parent company. Suddenly, McDermott's tax liability to the US government was only based on the business done on US soil, rather than a cut of the work done anywhere in the world.
The popularity of inversions is growing among US based companies, and although these businesses are perfectly within their legal right to incorporate as a foreign entity, the US tax authority is screaming as if they are guilty of tax evasion.
Let’s take a glance at the US tax laws. Simply put, it is a matter of worldwide taxation vs. territorial taxation. According to US tax law, a company incorporated in the US must pay corporate taxes on income earned anywhere in the world, whereas in other countries only domestic profits are taxed, which allows companies to retain more of their profits, making them more competitive in global markets. In addition, the US imposes one of the highest corporate tax income rates in the world at 35%, and one of the highest statutory corporate tax rates of 39% when taking into account federal and state taxes, leaving many US based companies looking to reduce tax liabilities as a means of increasing revenues. The US corporate tax rate is currently higher than all 34 OECD countries.
So, if a US based company earns profits in the US, the US is clearly entitled to tax those profits, and the company pays those taxes. But what if the US based company earns profits in international markets? If a company produces its product in China, and then sells it to a customer in Switzerland, does the US deserve a share of the profit, or is it more reasonable for the country where the income was earned to claim a right to tax these earnings?
The US taxes multinational companies on their worldwide income at 35%. In essence, this is the US government saying that it recognizes no difference between a product made and sold in the US, and a product made and sold anywhere else in the world. Those companies may claim a tax credit for taxes paid to foreign governments on income earned offshore, but only up to their American tax liability on that revenue.
Through corporate inversion, a trend resurfacing in the US, American based companies can do some unique international structuring which allows them to avoid this practice. The US company will merge with or acquire a foreign-based company, then re-characterize itself as a foreign corporation. This officially shifts its legal address to a lower-tax nation. The operations of the company can remain in the US but its legal status changes. The companies that ‘invert’ are still liable and do pay taxes on all revenue earned in the US but are no longer required to pay taxes to Uncle Sam on income earned internationally. In addition, foreign income is taxed only when it is repatriated, or brought back to the US. At this point the advantages of corporate inversion should be fairly clear. A small list of the well respected companies who have adopted this practice includes Pfizer, Fruit of the Loom, Medtronic, Liberty Global, Eaton, Burger King, Lazard, and Ensco.
The mainstream media portrays the perfectly legal practice of inversion as evil and refers to companies that incorporate globally as corporate deserters and tax less traitors, leaving the American general population confused about what is really going on. The NY Times recently suggested publicly shaming these companies in hopes that the American people would seek replacement products. The 2016 elections have seen corporate inversions scrutinized by both sides of the political divide. Is corporate tax inversion un-American, or just smart business?
What many may not know is that tax inversions do not eliminate Federal or State Taxes on US profits. The US will receive every red cent that is deserved by the Federal Government for money earned inside the US. Tax inversions do not change the way profits earned inside the US are taxed, they merely change the way profits earned outside the US are taxed. But why is tax inversion necessary in the first place? And really…why should a corporation who is housed in the US have to pay taxes on earnings generated in global markets?
Simply put, tax inversions rely on domicile (home) and residency (where the business is really operating for tax purposes). Governments declare the right to tax a company if that company resides in its jurisdiction. Residency is determined whether that business has a “permanent establishment” in that jurisdiction.
A tax inversion doesn’t make any difference to the taxation of US derived profits, it only makes a difference to foreign derived profits of the formerly US domiciled firm.
So why is it different for corporations? Corporate inversions are portrayed as unpatriotic, but other assertive tax reduction practices aren't receiving nearly as much attention. Is it okay for GE and Apple to use aggressive tax strategies to reduce worldwide tax liabilities, but not okay for other US based companies to merge with foreign companies to do the same?
Apple uses innovative accounting to lower its tax bill by domiciling three subsidiaries in Ireland. These companies are used to receive Apple's global revenues, and they pay the Irish corporate tax rate of 12.5%. The subsidiaries do pay royalties to the US headquarters, but they leave most of the profits in Ireland. Google also uses similar accounting practices. They house profits in Bermuda, a country that currently has no corporate income tax. Amazon is yet another company that has faced scrutiny over its tax practices. Amazon used its location in Luxembourg to record sales, because Luxembourg adopted a lower tax rate than the UK. Most of the sales came from the UK, but the taxes are paid in Luxembourg instead. These are not the only companies that use inventive methods to reduce taxes. It’s not illegal, it’s smart planning.
This type of restructuring of finances is commonly referred to as the Double Irish Arrangement.
The Double Irish Arrangement is a tax planning strategy that transnational corporations use to lower their corporate tax responsibility. Companies structure themselves in such a way that profits from one higher-tax subsidiary flow to a lower-tax subsidiary. It harnesses the very definition of corporate residency. The US defines tax residency on where a company is registered, where Ireland defines tax residency as where a company is managed and controlled. Here is an example in practice.
A company puts their intellectual property into a subsidiary in Ireland that is legally controlled from a third company in a tax haven, such as British Virgin Islands. Ireland considers the company to be a tax resident of British Virgin Islands, while the US considers the company to be a tax resident of Ireland.
When royalty payments are sent to the company, they go untaxed, unless the money is sent home to the US parent company, as the US can only tax the money once it crosses US borders. By layering profits in subsidiaries, the quirkiness of national tax codes can be used as a great benefit for a savvy company. When you hear the television yelling about loopholes, this is what they mean.
Government officials and US politicians do not like inversions, nor do they like the Double Irish Arrangement, or as some refer to-The Shamrock Shady, but they are divided on how to handle them. Some look to completely revamp the tax code, where others suggest lowering domestic and foreign rates, making US tax rates more competitive with the rest of the world. Most all agree that the loopholes need to be knotted to reduce or eliminate inversions.
The media led by the Obama administration refers to these tax planning practices as “unpatriotic” and is threatening to tighten the rules, making it more difficult for companies who have the majority of their operations and ownership in the US to adopt a foreign parent. But is this practice really unpatriotic? Wouldn’t any taxpaying American citizen look to reduce their tax debt, to save money? The job of a successful CEO is to make the company successful, and choosing to pay more taxes isn't a winning strategy.
Does the American tax code effect new business development in the US? Worldwide taxation puts American firms at a great disadvantage over foreign firms. Entrepreneurs will likely bypass the red tape of inversion and start new businesses in a foreign country that offers more competitive rates. The overly complex and outdated US tax code does not by any means encourage economic growth and development; instead it puts American companies at a disadvantage. By incorporating a business in a foreign country, lower tax rates and options for partnerships/investors become more attractive. By setting up an international business in the US, companies may be exposing themselves to a huge tax burden that is not competitive in today’s market. Paying a lower corporate tax rate allows corporations to achieve greater revenues, leading to more resources to hire, invest, develop, and build their businesses.
Inversion and international tax planning structures are not the problem. They are merely symptoms of a broken and appallingly unfair tax system as well as the brainchild of overzealous tax collectors. The techniques used by billion dollar companies can be applied to almost any smaller company or individual to maximize profits and reduce tax liabilities. You can seek out investment opportunities and structure yourself, your business, and your assets in a way that you are able to keep more of your hard earned money and expand your horizons at the same time. Want to level the playing field? Contact an international tax/estate planner and start reaping the rewards.
Rebecca Murphy is a freelance writer/blogger born and raised in the unforgiving Canada north, with a background as a financial advisor for Ameriprise Financial. She currently lives with her husband and children in Seattle.