Tax Inversion: What It is and How It Works

Posted on July 28, 2023

Tax Inversion: What It is and How It Works

Taxpayers devise new methods to evade taxes. Both individual taxpayers and corporations sometimes legally evade taxes using the loopholes in the tax code and sometimes evade taxes illegally by breaking the law. Tax inversion is one way corporations are legally avoiding paying taxes to the government. SF Gate elaborates how tax inversion works and why it’s being used to get around taxes:

“But U.S. corporations have a nifty way to avoid tax on their foreign income and reduce their U.S. tax without really leaving home. It’s called tax inversion, and it’s becoming all the rage.

“In the past year, at least 14 U.S. companies have announced inversion deals with foreign (mostly Irish and British) companies, although a few, including Pfizer’s deal with AstraZeneca, have fallen through.

“Left unchecked, these deals will continue to erode the corporate tax base, leaving others to pick up the slack.

“Last week, President Obama called on Congress to limit them, saying, ‘If you are doing business here, if you are basically an American company but you are simply changing your mailing address in order to avoid paying taxes, then you are really not doing right by the country and the American people.’

“Lawmakers from both parties have called for limits, but disagree on how to do it and whether it should be retroactive.

“Here are answers to some questions about inversions.

“Q: What is tax inversion?

“A: A U.S. company reincorporates overseas by getting acquired by a smaller company in a country where the corporate tax rate is much lower than the top U.S. rate of 35 percent. Generally, the U.S. firm’s management and operations remain in the United States, but it is no longer taxed on income earned outside the United States. It still pays taxes on income earned inside the U.S., but it gets easier to minimize that tax.

“For example, the U.S. subsidiary can borrow money from its foreign parent, then deduct the interest it pays on that debt, which reduces its U.S. income and taxes. ‘There is a rule that limits this, but it’s not a strict enough limit, you can strip lots and lots of income’ from the U.S. company, says Edward Kleinbard, a professor of at the University of Southern California Gould School of Law and author of ‘We Are Better Than This.’

“An inversion also gives companies ways to avoid U.S. tax on profits that have been piling up overseas, largely in tax havens such as Bermuda. Kleinbard says U.S. companies have about $1 trillion sitting in foreign subsidiaries. They would love to bring it home and use it to pay dividends or buy back shares, which would increase their stock price. But they would have to pay U.S. tax on it.

“However, if the U.S. company gets acquired by an Irish company, for example, the Irish company can borrow that cash from the Bermuda company. The Irish company can use it to buy back shares or pay dividends without paying U.S. tax. The shareholders of the former U.S. company benefit because they own most of the Irish company.”

Tax inversions aren’t new. They were curbed by the IRS in the early 1990s by modifying a rule that allowed them to be used. The enacted rule was that if a foreign corporation absorbs a U.S. corporation and greater than 50 percent of the foreign company’s shareholders were shareholders of the U.S. company, the merger would ultimately be taxable to American shareholders.

“Normally, when a company acquires another one for stock, shareholders of the acquired company don’t pay tax until they sell the shares of the acquiring company. Taxpaying shareholders like that.

“But today, about 75 percent of stock is held by institutions, many of which pay no tax. ‘Shareholder-level tax is not as much of a concern to companies,’ says Mindy Herzfeld, a contributing editor with Tax Analysts.”