What are inversions, and why do they happen?
An inversion is a transaction in which a US-based multinational company merges with a smaller foreign company and then establishes a foreign residence. As a foreign resident, the company can significantly reduce its taxes without changing the location of any real business activities.
The current US system treats multinational enterprises whose parent companies are incorporated in the United States (US-resident multinationals) differently from those that are resident elsewhere. The United States taxes its multinationals on dividends they receive from their foreign affiliates, while our major trading partners have so-called territorial systems that exempt these dividends. In addition, US anti-abuse rules limit the ability of US-based multinationals to use debt-equity swaps to shift reported income out of the United States, but do not apply similar limits to foreign-resident multinationals.
The United States bases its definition of corporate residence on place of incorporation. This definition need not be consistent with where a company’s production is located, where its sales take place, where its shareholders reside, or even where its top managers live.
The tax benefits of foreign residence, combined with the residence definition’s lack of economic substance, have led some US-based multinationals to shift the formal incorporation of their parent companies overseas. This type of transaction (“inversion”) can often be accomplished without changing the location of any real business activities. Some recent research (Rao 2015), however, finds that inverted companies over time increase their shares of employees and investment overseas compared to companies that did not invert.
In recent years, US multinationals have accumulated a large amount of un-repatriated foreign cash, increasing the motivation for inversion transactions (Clausing 2014). The shift of reported income to low-tax foreign countries is responsible for much of the accruals. As a result, taxes on dividends paid back to the US parent will not be shielded by foreign income tax credits.
Over the years, Congress has enacted rules to limit inversions. Simple inversions—a US company establishes a foreign affiliate, which then becomes the parent company—no longer work because the United States would continue to treat the new company as US resident. A company can still “re-domicile,” though, by merging with a foreign-based company under certain conditions; these include a requirement that the original foreign company contribute at least 20 percent of the shares of the newly merged company if other conditions are not met.
A recent wave of inversion transactions, like previous waves, has generated considerable concern among US policymakers and has led to proposals for additional limits on merger transactions. Legislative proposals that have recently been considered in Congress and discussed in the Presidential campaign would have required that the original foreign company contribute at least 50 percent of the shares of the merged company, would have placed new limits on interest deductions by US subsidiaries of foreign multinationals to prevent income stripping through debt-equity swaps, and would have imposed a one-time exit tax on the accrued foreign profits of inverting companies (Rosenthal 2015). In addition, the Treasury in 2014 issued new regulations to prevent ways of avoiding the 20 percent threshold on foreign ownership and to make it more difficult for the newly merged companies to repatriate earnings they accrued prior to the merger tax-free.
In 2016, Treasury issued additional regulations (U.S. Treasury Department, 2016) that used its current authority (Shay, 2014) to reclassify certain debt transactions between related parties as equity instead of debt to deter income stripping by foreign-based multinationals. These regulations are controversial and may not survive the change in Administration following the 2016 Presidential election.
New proposed anti-inversion legislation could stem the latest types of inversions, as past legislation halted earlier transactions. Changes in the residence of existing US corporations, however, are not the only way the share of world output by US-based multinationals can decline over time. Foreign-based multinationals can purchase smaller US companies or divisions of larger ones. New companies can be chartered overseas instead of in the United States. And foreign-based multinationals can expand faster than US-based companies if US tax laws place US multinationals at a disadvantage. In the long run, new limits on inversions, like previous ones, may be ineffective if tax laws continue to place some US-resident companies at a disadvantage compared with foreign-resident companies.
Clausing, Kimberly. 2014. “Corporate Inversions.” Washington, DC: Urban-Brookings Tax Policy Center.
Marples, Donald J., and Jane G. Gravelle. 2014. “Corporate Expatriation, Inversions, and Mergers: Tax Issues.” Report R43568. Washington, DC: Congressional Research Service.
Rao, Nirapuma S. 2015. “Corporate Inversions and Economic Performance.” National Tax Journal 68(4): 1073–98.
Rosenthal, Steve. 2015. “Another Way to Slow Corporate Investions: Collect an Exit Tax on US Firms with Deferred Earnings.” Tax Vox, November 30.
Shay, Stephen E. 2014. “Mr. Secretary, Take the Tax Juice out of Corporate Inversions.” Tax Notes. July 28: 473.
U.S. Treasury Department. 2016. “Fact Sheet: Treasury Issues Inversion Regulations and Proposed Earnings Stripping Regulations. April 4.