I. Executive Summary
Corporate Tax Inversions, or also refer as “corporate inversions” or “inversion transactions,” are corporate instances where a U.S. company reincorporate itself in a foreign country, outside of U.S. government jurisdiction. The main objective for a U.S. corporation to engage in an inversion transaction is to avoid U.S. corporate income tax while company operations and economic activity do not change. Originally, in the 1980’s and 1990’s, inversions occurred on offshore islands such as Bermuda and the Cayman Islands, however, today, inverted U.S. corporations exist in countries such as Ireland, the UK, and Canada.
There are a few different types of inversion that companies have used in the past, such as stock inversion transactions and asset inversion transactions. However, since the first corporate inversion in 1983, the U.S. has been implementing regulatory tactics to stop U.S. corporations from inverting. The battle between inverted and soon-to-be inverted U.S. corporations and the U.S. Government has shed light onto some of the advantages and disadvantages of inversion transactions, however, the two parties have yet to find common ground.
In the past, people have criticized both the inverted corporations for cheating the U.S. economy by avoiding taxes that all other U.S. companies are subjected to while others believe that the U.S. International Tax System is the problem. Two policies, that lean towards the notion that U.S. tax system is flawed, are the suggested actions to put corporate inversions to and end. As citizens of the U.S., I believe, it is our responsibility to be informed of the injustices and flaws of our economy and keep our focus on the goal of keeping/making U.S. the ideal place for a corporation to exist.
Table of Contents
- Executive Summary………………………………………………………..…2
- U.S. Internation Tax System…………………………………………….……5
- Technical Structure of Inversion Transactions …………………………..…6
- Inversion Structure……………………………………………………….6
- Types of Inversion Transactions ………………………………………6
- Stock Transaction ………………………………………..…6
- Asset Transactions …………………………………………..7
- Notable U.S. Inversion Transactions ………………………………………..7
A. History ……………………………………………………………….……7
B. Burger King-Tim Hortons Merger………………………………………..8
- Advantages and Disadvantages of Corporate Tax Inversion ……………..9
A. Advantages ………………………………………………………………9
1. U.S. Tax Savings on Foreign Income …………………………..…9
2. Earnings Stripping ……………………………………………..…9
3. “Hopscotch Loans”…………………………………………..……10
B. Disadvantages ……………………………………………………………12
1. Harmful to U.S. Economy…………………………………………12
- Solutions Enacted by the Federal Government ……………………………13
- Policy Options …………………………………………………………….14
A. Lower Corporate Income Tax Rate …………………………………..…15
B. Adopt a Territorial Tax System……………………………………………15
Since the late 1990’s the frequency, size, and visibility of U.S. based multinational corporations that engage in corporate tax inversions has heavily increased. A corporate inversion is a practice adopted mostly by U.S. corporations in an effort to avoid tax on income. Corporations that participate in inversion transactions restructure their headquarters so that the main or parent group of the corporation becomes a foreign entity in a country of that has low or no income tax. The newly-inverted corporations are no longer subjected to the U.S.’s high-income tax rates, saving them millions of dollars.
Corporate inversions, however, are frowned upon by the U.S. Treasury, the Internal Revenue Service, and the Securities and Exchange Commission. While on paper, these corporations are technically foreign their operations remain exactly the same. As more companies engage in this type of activity, it costs the U.S. Treasury millions of income tax dollars. This erodes the U.S. tax base and forces individual taxpayers, small businesses, and domestic corporations to make up the difference.
This has forced the U.S. Government to construct laws and regulations that limit corporations from engaging in this type of activity. Since the first inversion transaction in 1983, there has been an ongoing battle between the U.S. Government and inverted corporations. Thus, the question is raised: Are inversion transactions unjust or is the current U.S. tax system is flawed? This paper explores the arguments of both sides and suggests future policy to alleviate the on-going problem.
III. U.S. International Tax System
The U.S. International Tax System is considered the basic premise for U.S. corporate tax inversion. The U.S. uses a system that taxes U.S. corporations’ domestic-source earnings and the foreign-source earnings. The U.S. tax systems is categorized as a, “Worldwide taxation system…under which corporations deemed “resident” in a country are taxable by that country on their income from all over the world” as opposed to a Territorial Taxation System which only taxes its corporations on domestic earnings (Matheson, Thornton, Perry & Veung 3). Currently, the U.S. has the highest corporate income tax rate in the world at 39.1%. This overall rate is a combination of our 35% federal rate and the average rate levied by U.S. states. The rest of the industrialized world averages a 25% corporate income tax rate. As the industry becomes more globalized, U.S. corporations are put at a disadvantage due to high-income tax burdens and see opportunity in foreign low to no income tax rates countries such as Bermuda, the Cayman Islands, and the Bahamas, whom all have 0% corporate income tax rates.
IV.Technical Structure of Inversion Transactions
A. Inversion in the United States
The U.S. Treasury defines “Inversion” transactions as “a transaction through which the corporate structure of a U.S. based multinational group is altered so that a new foreign corporation, typically located in a low-or-no-tax country, replaces the existing U.S. parent corporation as the parent of the corporate group”(Corporate Inversion, 22) The main objective of these transactions is to avoid U.S. taxation without modifying economic activities. The U.S. based corporations, who participate in tax inversion, transfer ownership of the corporation to a foreign entity or parent, which in effect removes the U.S. tax on income from the corporation’s foreign operations. The corporation then can avoid further U.S. tax on income on transactions which occur both in the U.S. and abroad. Often it is assumed that inversion involves moving or changing domicile to the foreign entity, however, the corporation’s new “subsidiary” that remains in the U.S. continues to operate as its headquarters. The Chief Executive Officers of nearly 70% of all inverted corporations out of the U.S. remained in the U.S. Ownership does not change.
B. Types of Inversion Transactions
There are a variety ways in which a U.S. multinational’s can reincorporate into a foreign parent. The two transactions most commonly used by corporations that engage in inversion are Stock Inversion Transactions and Asset Inversion Transactions. These two inversion types differ mostly due to how and when the stocks and assets are exchanged between the U.S. corporation, the foreign parent, and the stockholders.
(1) Stock Transactions: Upon reincorporating through a pre-existing or created foreign subsidiary located in a low- or no-income tax entity, the newly-formed foreign parent acquires the stock of the former U.S. corporation (now subsidiary) and its shareholders exchange their stock for stock in the foreign parent. The former U.S. corporation and shareholders are unaffected in that their ownership of the company is the same and the company operates as it did prior the transaction except without the U.S. income tax burden.
(2) Asset Transaction: The second type of reincorporation involves series of several smaller transactions. The U.S. corporation merges with the foreign subsidiary, turning the subsidiary into the foreign parent, by transferring the U.S. corporation’s assets to the foreign parent in exchange for the foreign parent’s stock, which the U.S. corporation then distributes to its shareholders. The U.S. corporations shareholders then transfer their stock for foreign parent’s stock.
Both transactions effectively relocate U.S. corporations to foreign countries that have a very low-income tax. After inversion, future business opportunities for the former U.S. corporation are no longer subject to U.S. tax jurisdiction.
V. Notable U.S. Inversion Transactions
Corporate tax inversions began in the early 1980’s. The first well know inversion from the U.S. was Mcdermott International, a multinational corporation that specialized in engineering, procurement, construction, and installation. In 1983, McDermott relocated to Panama, through one of its subsidiaries, in an effort to avoid U.S. income tax. In 1994, Helen of Troy, an international manufacturer of personal care electrical products, created its own subsidiary in Bermuda . Then Helen of Troy converted the subsidiary into a parent, a strategy known as self inversion. Corporate inversions in the U.S. have only increased in frequency from there on out. By 2002, there were 18 U.S. multinationals who reincorporated in newly-founded foreign entities. Today there are nearly 80 U.S. multinationals involved in inversion transactions. The most notable companies include Fruit of the Loom (Kentucky to the Cayman Islands), Michael Kors (New York to Hong Kong), and Burger King (Florida to Canada).
B. Burger King-Tim Hortons Merger
Burger King’s relative market share was low during the start of the decade. In 2012, for the first time in its history, Wendy’s unseated Burger King as the second-largest burger chain in the United States. Burger King has also since been passed by Subway and Starbucks in overall restaurant rankings. There are a variety of reasons for Burger King’s steady decline including the great recession, poor marketing campaigns, the emergence of health-conscious and better quality fast food options. In 2012 3G Capital, a major global investment firm purchased Burger King and concocted three new goals for the restaurant— the creation of new products, international expansion, cost cutting, and the acquisition of a Canadian Icon, conveniently located in a country with lower income tax rates.
Tim Hortons, a Canadian fast food restaurant known for its coffee and doughnuts, has been a source of pride for Canada since its establishment in 1964. It has grown to be the largest fast-food restaurant in Canada. Tim Hortons fit the criteria for all of Burger Kings new goals. On August 25th, 2014— Burger King acquired Tim Hortons for roughly 11.4 billion U.S. Dollars. Restaurant Brands International emerged as the new parent company created by the merging of Tim Hortons (49% stake) and Burger King (51% stake) through a stock inversion transaction. While Burger King claimed that the intention of the merger was not a tax-driven, it does not explain why the parent company, which it owns more of is located in Canada. The American’s for Tax Fairness, a campaign of national, state and local organizations united in support of a tax system that works for all Americans, released a report saying that, “Burger King’s planned “inversion” will allow the company and its leading shareholders to avoid an estimated $400 million to $1.2 billion in U.S. taxes between 2015 and 2018” (Burger Kings ‘Inversion’).
While reactions to the merger between Burger King and Tim Hortons were negative, especially in the United States, it proved to be quite profitable for Restaurant Brands International and its subsidiaries. Since the company began trading publicly on December 15th, 2014 its total revenues increased from 1.198 billion U.S. dollars in 2014 to 4.052 billion. For companies like Burger King, who face steady economic decline, is corporate tax inversion a good business strategy or should corporations refrain?
VI. Advantages and Disadvantages of Corporate Tax Inversion
U.S. based multinationals corporate tax inversion offers a variety of opportunities to avoid U.S. income tax while company operations remain unaltered. Below are a few techniques, which allow multinationals to save large portions of profit through corporate inversion.
(1) U.S. Tax Savings on Foreign Income: As I mentioned previously, the U.S. International Taxation System imposes a heavy tax burden on U.S. corporations on both the income generated within the country and abroad. The U.S. based multinationals, like Burger King which operates in over 100 different countries In an effort to compete with foreign corporations, which are taxed significantly less, U.S. multinationals reincorporate in foreign countries. The potential cost advantage for a U.S. corporation that engages in inversion transactions is quite profound. As I mentioned in the Burger King-Tim Hortons merger section, reports estimated Burger King would save nearly 1.2 Billion U.S. dollars over the next 4 years by avoiding U.S. income tax through its inversion transaction with Tim Hortons.
(2) Earnings Strippings: One of the simplest ways for a reincorporated multinational to avoid U.S. taxation is an inversion technique called Earnings Strippings. American subsidiaries of multinationals borrow money from their foreign parent corporation. The foreign parent then receives payments from the subsidiary through interest on these loans. The interest income that the foreign parent receives is not subjected to U.S. income tax. The foreign parent then gives the interest income back to the American subsidiary in the form of a loan, which is only taxed by the foreign parent’s government, entirely bypassing the U.S. income tax. In an attempt to limit earnings strippings, the U.S. created a withholding tax of 30% on the interest that is received by the foreign parent. However, the U.S. has tax treaties, that reduce or eliminate withholding taxes, with over 70 other countries. The treaties are meant to encourage foreign investment in U.S. corporations and vice verse. So, there are a variety of countries where tax inversion and earnings strippings are a possibility. Canada, not surprisingly, has a treaty with the U.S. that eliminates the withholding tax, making the Burger King-Tim Hortons merger inversion even more obvious.
(3) Hopscotch Loans: Another common tax avoidance strategy using inversion is a hopscotch loan. Currently, U.S. based multinationals are subjected to income tax on the profits generated by its foreign subsidiaries. However, the foreign profits are not taxed until the they are paid to the U.S. multinational in the form of dividends, also known as repatriated. While dividends have to be declared at least once every year, the company directors choose at what point in the year they will declare. Until the dividends are declared and then taxed the profits are known as deferred earnings. U.S. based multinationals, who have an abundance of deferred earnings can avoid the pending U.S. dividend taxes by inverting to a foreign parent before repatriation. After inversion, the deferred earnings from the foreign subsidiary of the former U.S. parent, are then received by the newly-formed foreign parent. These referred earnings are no longer subjected to pending U.S. taxation and therefore they are taxed by the foreign government. Once again, this money can be given back to the former U.S. parent in the form of loans.
Perspective is quite important when evaluating corporate tax inversions. While it is quite profitable for U.S. based multinationals, the U.S. Government and economy are negatively affected. In an attempt to benefit from the cost advantages of inversion transactions, the U.S. based multinationals who reincorporate outside of the U.S. harms the U.S. economy in a variety of ways.
(1) Harmful to U.S. Economy: As corporate tax inversion becomes more popular and fewer multinationals are subjected to the U.S. income tax, the U.S. treasury loses billions of potential corporate tax revenue dollars. For example, in 2015, if Apple Inc., a U.S. based multinational, repatriated its deferred earnings from its foreign subsidiaries the U.S. Government would receive nearly 60 billion U.S. dollars in tax revenue. Hypothetically, if Apple inverted prior to repatriation using the hopscotch loan inversion technique, the U.S. Government would have lost 60 billion. In an attempt to recover from inversion tax revenue losses the U.S. Government is forced to increase taxes imposed on small business and consumers. In addition, U.S. based corporations of relative size are no longer able to compete with inverted corporations, providing further incentive to for U.S. corporations to invert and further perceived unfairness of the U.S. International Tax System. As a result, everyone in the country is affected. U.S. based multinationals, due to their size and power, have a great deal of influence over the U.S. economy. This influence can be quite positive at times, however, when U.S. based multinationals reincorporate that influence is quite negative.
VII. Solutions Enacted by U.S. Government
In 2002, the U.S. Treasury identified the three main concerns, which I touched upon in the Harmful to U.S. Economy section: an erosion of the U.S. tax base, a cost advantage for foreign-controlled firms, and a reduction in perceived fairness of the U.S. International Tax System. Due to the increasing amount of inversion transactions in the late 1990’s and early 2000’s the U.S. Government created and still continue to modify laws and regulations to limit inversion transactions in the U.S.
In 2004, newly elected President George W. Bush signed the American Job’s creation Act of 2004 (AJCA). The AJCA, the first reconstruction of corporate taxes since 1986, adopted two tax reforms that influenced inverted corporations’ ability to avoid U.S. taxes. The AJCA made it so that if a former U.S. parent’s stockholders own more than 80% of the newly-formed foreign parent company’s stock, then the newly-formed foreign parent is considered a U.S. based company subjected to U.S. income tax. This law, thereby, denied the former U.S. parent the ability to further avoid U.S. income taxes. The second reconstruction made it so if that any transfer of assets from the former U.S. parent to the newly-formed foreign parent thereafter increased in value, then the assets were not permitted to be offset by foreign tax advantages and instead taxed by the U.S.
These reconstructions eliminated the generic first generation inversions impossible, however, U.S. corporations found ways around these the AJCA. This new set of reconstructions did not address the problem behind corporate tax inversions. After 2004, inversions with countries such as Bermuda, the Cayman Islands, and the Bahamas were less common, instead companies reincorporated in larger countries such as the UK, Canada, Ireland, and others. These countries had lower corporate income tax rates than the U.S and were economically active compared to the smaller offshore islands. It was more difficult for the U.S. Government to prove an inversion transaction when the foreign parent was very economically active.
The incentive to invert will continue if something is not changed with regards to the U.S. tax system. Since the AJCA, it has been an ongoing battle between the U.S. Government and reincorporated multinationals. Treasury regulations regarding inversion were issued again 8 years later in 2012, then in 2014, and again in 2016. However, since 2004, over 40 U.S. corporations engaged in inversion transactions compared to the 29 between 1983 and 2004. Corporations will continue to keep finding various loopholes in the U.S. International Tax System. Inversion does not seem to disappear, instead it evolves and takes a new form. Continuous regulations are not the answer, instead the U.S. Government should explore new policy options that reevaluate the underlying problems.
VIII. Policy Options
Based on the notion, with which I agree, that the U.S. is the most desirable location in the world for substantial business activity, it is not wise for the U.S. Government to push U.S. based multinationals away through extensive taxation policy. The U.S. income tax rates are the highest in the world and unlike most countries the U.S. taxes foreign-source earnings. It is time that the U.S. Government reevaluates its International Tax System and reduce the incentive for U.S. corporations to engage in inversion transactions. Lowering corporate income tax rate, adopting a territorial tax system, or the banning of inversion transactions altogether
A. Lower the Corporate Income Tax Rate
The United States International Taxation System offers the highest income tax rates in the entire world and taxes foreign-source earnings. The other 33 industrialized countries average an income tax rate of 25%. Even corporations in high-tax European countries such as Belgium (34 %), France (34.4 %), and Sweden (22 %) are not nearly as affected by income tax than those in the U.S. Tax Foundation, a company that collects data and publishes research studies on US tax policies wrote, “Our [U.S.] largest trading partners—Canada, Japan, and the United Kingdom—have each cut their corporate tax rates over the past few years to become more competitive”(Pomerleau & Lundeen). The U.S. Government should reduce corporate income tax rates on domestic earnings and broaden the tax base. In effect, corporate inversions will decrease in number because there will no longer be a need to avoid U.S. corporate income taxes and the U.S. Government will not lose tax revenue dollars due to the broadened tax base.
B. Adopt a Territorial Tax System
Currently, the U.S. operates under a Worldwide taxation system, which allows the U.S. to tax U.S. based multinationals on foreign-source earnings. The other taxation system commonly used by other large industrial countries is the Territorial Tax System. This system taxes its domestic corporations on domestic-source earnings, but not on foreign-source earnings. U.S. based multinationals flock to countries with tax systems like these because they are able to avoid taxation on income from foreign business. According to the International Monetary Fund (IMF), “All G-7 countries [United States, Canada, France, Germany, Italy, Japan, and the United Kingdom] other than the United States have now adopted territorial taxation (or a partial version thereof) for active business income” (Matheson, Thornton, Perry & Veung 3). This type of system encourages globalization, but at the same time reduces the need for countries to engage in inverse transactions. It would cost the U.S. Government tax revenue from foreign-source earnings, but U.S. based multinationals will no longer have the incentive to reincorporate overseas.
While I do not think these plans should be implemented together due of the amount of income the U.S. government would lose in revenue tax, I believe either lowering the U.S.’s corporate income tax rate or adopting a territorial taxation system with continued regulations on inversion transactions will be very effective. The incentive to reincorporate overseas will decrease due to tax cuts either from domestic or foreign income and the continued regulations will further deter U.S. based multinationals from inverting.
The incentives behind corporate tax inversion as I said multiple times in this paper come from the U.S.’s International Tax System. U.S based multinational corporations fear that they are at a disadvantage and as a result will lose market share to their competitors who do not face U.S. income taxes. Inversion does not only come in the form of taxation. An inversion occurs when labor laws become strict and minimum wage increases, Nike and Apple are two simple examples. When Apple and Nike were faced with difficult regulations that cost them money, they outsourced materials to dodge the U.S. cost of labor. Inversion is not an uncommon practice by corporations in the U.S. and does not only concern avoiding tax burdens.
I suppose, from the perspective of the corporation, inversion tactics are beneficial because they increase revenue simply without changing any operations. However, beneficial may not be the right word. Inversions make generating income easier, which in my mind is not beneficial to a corporation. Just like an athlete, a corporation must be conditioned, which is designed to be challenging. So when corporations find loopholes and take the easy way out, they increase revenue, but the development of new business is stagnant. The corporation then has an empty value.
Being a corporation based in the U.S. should people to be better businessmen and women, and I’m sure to a certain extent that it does. U.S. corporations are held to a higher standard than countries with lower wages and lower income tax. I actually took pride in the fact that the U.S. has the highest income tax rate because it makes our companies that much stronger than rest. In order for us to compete with the rest of the world, we are forced to develop new business more efficiently. And when done without loopholes, U.S. based companies have the highest value. Companies that result in this type of behavior normally do so because they are failing. Inversion transactions do not stop the internal failure of a corporation, rather it prolongs the corporation’s inevitable decline.
Ideally, my policy to regulate inversion transactions would be anything that inspires U.S. based companies to use the limitations of the U.S. International Tax System to make them stronger. It is somewhat of a Kantian approach based on the German Philosophers third formulation of the categorical imperative, in that when U.S. corporation holds itself to a higher standard, as a whole the U.S. economy would become more advanced and developed. However, when one corporation engages in activity that would if done by all U.S. corporations, lower the standards of the entire U.S. economy it would be wrong. If all U.S. corporations participated in corporate inversion, the U.S. economy would no longer exist. Therefore, corporate tax inversion is wrong and should continue to be regulated until it no longer exists.
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