September 24, 2014 / 3:11 PM / 5 years ago

Tax Inversions 101: A pocket guide

NEW YORK (Reuters) - The Treasury department this week announced a new set of regulations to crack down on the wave of “corporate inversions,” in which American companies lower their tax bill by, simply put, relocating their legal corporate addresses overseas. The Obama administration is trying to make these inversions more costly and difficult – but how do they work? Some answers to your questions:

Q: So what exactly is an inversion?

A: A corporate inversion typically happens when a multinational company based in America relocates its official headquarters to a country with a lower tax burden, without physically moving its operations. Nominally relocating to places like Bermuda, Switzerland or Ireland can greatly decrease the amount a company pays in taxes. This move takes the shape of an American firm acquiring a smaller foreign company, with the new operation formally based abroad.

Q: What are the new restrictions that the Treasury department has put in place, and why are they a disincentive to invert?

A: They’re meant to reduce the economic incentives for leaving the U.S. In other words: “think twice” before moving ahead with your relocation plan, said Treasury Secretary Jack Lew. The Treasury will try to prevent companies from eluding American tax men by moving around international profits from one foreign subsidiary to another. In addition, companies will also no longer be able to shrink themselves to meet the 80 percent U.S.-ownership limit by purging capital via dividends right before inverting. On the flip side, the foreign buyer can’t artificially beef up its assets so that it can meet its 20 percent minimum threshold. Some proposed inversions may now be at risk.

Q: What are the economic benefits for the company?

A: The United States has the highest corporate tax rate among the 34 countries in the Organization for Economic Cooperation and Development. The corporate income tax rate stands at 35 percent, and that’s before the states get their cut. (The effective rate is much lower, thanks to tax loopholes.) What’s more, the U.S. taxes income that American companies earn around the world - not just within the country. By relocating its legal base to somewhere with more merciful tax rates, companies can stand to take home a larger portion of their earnings.

Q: Is it a good thing for shareholders?

A: Yes and no. Inversions cut the company’s tax bill, which isn’t a bad thing for shareholders of course. But as Reuters wrote earlier this year [ID:nL2N0QN0KE], inverted companies have as good a chance of underperforming the general market as they do overpreforming it. And while the inversion can mean lower taxes for the company itself, it could mean higher taxes for a shareholder. Because the inversion is an exchange of shares between the domestic and the foreign firm, the transaction leaves investors vulnerable to capital gains taxes.

Q: Are there any other ways shareholders can get burned?

A: A rule implemented in 2004, the last time inversions were tackled by the Feds, placed a 15 percent excise tax on any options that vested in the six months before or after the close of the transaction. When medical device maker Medtronic Inc. announced intentions to acquire the Ireland-based Covidien for $42.9 billion, the second biggest proposed inversion yet, the American company decided it would cover the taxes its officers and directors incurred from the deal. But the law also taxes such subsidies in an attempt to disincentivize this from happening. So Medtronic, as Fortune Magazine reported in July, “grossed up” those payments: the company not only paid for its directors’ taxes, but the taxes on those subsidies. All told, instead of letting the officers and directors pay the excise tax themselves, shareholders were on the hook for $63 million.

Q: What does it mean for U.S. taxpayers?

A: The move keeps more money inside the company’s coffers and outside of the tax base - to the tune of as much as $20 billion over the next decade, according to White House estimates.(A tiny percentage of tax revenues over this period, to be sure.) While the Treasury does benefit from the capital gains taxes upfront, it says that this revenue is far outweighed by the long-term loss of tax receipts.

Q: What was the first company to invert and when?

A: Oil-field services conglomerate McDermott International Inc kicked off the modern inversion trend in 1982, when the Texas company planted its flag in Panama. There was no foreign merger involved, but it created a precedent for a company moving offshore to whittle down its tax bill. The headquarters remain in Houston to this day.

Q: Why does a company have to be purchased by a foreign company?

A: Blame it on McDermott and other companies that relocated. The American Jobs Creation Act of 2004 attempted to stem the exodus of companies by making it illegal for a company to buy a P.O. box in the Cayman Islands and call it a day. But there was a loophole: a company could invert via a merger, as long as U.S. entities owned less than 80 percent of shares in the new company. Since that law was enacted, most of the expatriations have taken place through these kinds of mergers.

Q: So the administration could only go so far - what’s next? What would the Democrats do if they had their druthers? The Republicans?

A: Any more substantial reform to inversion law will take an act of Congress, and odds are very low that’ll happen this year. Democrats are working to pass a bill that would retroactively block inversions dating to May 8. Republicans, meanwhile, have indicated they won’t support any bill with retroactive penalties. In an ideal world, the White House would surely like to simply increase the size ratio required for a foreign company to bring an American company offshore from the current 20 percent to, say, 50 percent. That would make it much more difficult for a company to get “acquired” by a smaller firm, with the legal headquarters moving abroad.

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