Tax inversions have been around for decades, but they are increasingly in the news because of the size of recent tax inversion deals and the Obama administration’s recent efforts to limit the practice.
In short, a tax inversion is when a U.S. company merges with an overseas firm and switches its home address to the overseas address — making it subject to the new host country’s lower tax rate. There may be some consolidation as with any merger, but these companies maintain significant operations in the U.S. while enjoying tax rates that may be less than half of the U.S. rate. The U.S. tax rate remains the same, but U.S. taxable income is lowered.
The shareholders of the now former U.S. company must own less than 80% of the combined company; otherwise, it is still considered a U.S. company for tax purposes.
Corporations save on taxes, and the stock typically rises after inversions. That would seem to be in the best interests of shareholders, since the company you hold stock in is minimizing its tax burden while maximizing returns. Yet these offshore mergers can ultimately be bad for taxpayers.
One can see why they are bad for taxpayers with respect to the overall economy, since inversions deprive the U.S. of billions in potential tax revenue. However, they are bad for the average shareholder for another reason.
If you are a shareholder in the company that undergoes an inversion, you may receive an unpleasant tax surprise. The IRS treats the stock in the inverted company as though it had been sold — thus, you will owe capital gains taxes on the collective gains from the time you purchased the shares. It does not matter whether or not you sell the stock, or whether you hold the shares directly or indirectly as part of a mutual fund.
Some are arguing the U.S. tax rate is the main problem, noting that the U.S. has one of the world’s highest corporate tax rates at almost 40%. Critics claim that the use of tax loopholes by many large companies negates the higher rate — so much so that they pay virtually no taxes at all. That is certainly true, but rest assured that if a company is using an inversion for tax reasons, those loopholes are less valuable to them.
A common sense way of dealing with this issue is to reform (not just lower) the corporate tax rate by offsetting a lower overall tax rate with a closing of loopholes. This spreads the burden a little more evenly across U.S. corporations. However, at this point the Obama administration is more interested in addressing some of the mechanisms that make tax inversion more lucrative.
The Treasury Department has fired the first salvo by issuing rules that make tax inversions less profitable and potentially more difficult to execute. Steps that have been taken include prohibiting companies from sliding in under the 80% ownership rule through special transfers and dividends to their foreign offices, and taxing “hopscotch” loans from the foreign component to the U.S component that were previously untaxed. Additional rules and regulations from Treasury and/or Congress are likely.
Rules have just taken effect, catching a few companies such as Burger King and Tim Horton’s in the midst of an inversion. As of this writing, nobody has announced plans to delay or cancel a merger based on the new rules. Time will tell if the regulatory approach works alone, or whether it will be necessary to eventually tackle the root of the problem — the U.S. corporate tax code.