Corporate Inversion Planning Strategies

In aiming to reduce their worldwide tax burden, an increasing number of U.S. multinational corporations (MNCs) are undergoing (or considering) a corporate inversion. This tax planning strategy, however, carries tremendous tax and nontax consequences, some of which are not always apparent.

Background

Countries throughout the world use two main types of jurisdictional bases when asserting their right to assess and collect taxesa residence and a source. Under a pure residence system of taxation, they assert their right to tax their residents worldwide income. Under a pure source system, however, they exercise their right to tax all income generated within their boarders, whether or not earned by residents.

To alleviate the hardship of potential double taxation, which may result when two countries assess income tax on the same income, residence countries generally yield to source countries in the taxation of the income derived in the source country. This yielding is generally achieved either through exemption of foreign income from the residence countrys tax base, use of foreign tax credits (FTCs) or a combination of both. Most countries use both systems, with one system dominating.

The U.S. generally follows a residence-based tax system under Sec. 61, with offsetting FTCs authorized under Sec. 901. Most of its trading partners, however, use a source-based system. U.S. MNCs term this disparity a competitive disadvantage.

Example: USA, Inc., a U.S. MNC, and D, a German MNC, each earns $100 in country Z, which assesses a 20% corporate income tax. Both companies pay $20 of income taxes to Z. USA pays an additional $15 to the U.S. (which assesses a 35% tax on the $100 and then allows a $20 FTC). Because Germany follows a source-based system of taxation, it does not assess any additional income taxes on D. As a result, USA pays more taxes on its worldwide income than D, making it less competitive.

What Is Corporate Inversion?

An inversion is a process that enables an MNC to change its country of residence. Specifically, it removes the ultimate parent from the U.S and places it abroad. Although an inversion, in itself, is not a new phenomenon, use of it has been increasing significantly. To date, corporate inversions have mainly taken three forms.

Stock-for-stock transaction. In this transaction, a new foreign parent is formed overseas. Shareholders of the old U.S. parent exchange their shares for the overseas parents shares. The result is that the U.S. parent becomes a subsidiary of the foreign parent. Former shareholders of the U.S. parent would then hold shares in the foreign parent.

Asset transaction. In this transaction, a U.S. parent is effectively reincorporated abroad. The MNC accomplishes this either through the merger of the U.S. parent with a newly formed foreign parent or through some other mechanism under corporate law. The result is that the U.S. parent ceases to exist; its former shareholders now only hold shares in the foreign parent.

Drop-down transaction. This transaction involves elements of the other two forms of inversions. Shareholders of the U.S. parent end up with shares of the foreign parent; the U.S. parent survives as the foreign parents subsidiary.

Consequences

Anticipated consequences. After an inversion, a corporation is no longer deemed to be a U.S. company for tax purposes. Thus, the MNC is no longer required to pay U.S. taxes on income not effectively connected with the U.S. (i.e., income earned outside of U.S. borders). As a result, a portion of the MNCs earnings will no longer be included in the U.S.s tax base. If a corporation is relocated to a jurisdiction with either a nominal or no income tax (e.g., Bermuda), hundreds of millions of dollars of profits may go untaxed.

The likely increases in profitability translate into corresponding increases in the companies competitiveness and stock value. Thus, shareholders may benefit as well.

Subtle consequences. A decrease in the overall income taxes paid by an MNC and the resulting benefits to it and its shareholders are not the only consequences of corporate inversions. There may also be negative consequences for all the parties involved.

First, the corporation is likely to owe Federal income taxes for the year in which an inversion takes place if it inverted through either the asset-transfer or the drop-down method, because, under Sec. 367, it is required to recognize a built-in gain (BIG) on assets transferred to a foreign corporation. The BIG is the difference between the transferred assets fair market value (FMV) and their adjusted basis.

Shareholders of the inverted companies are likely to owe Federal income tax as well, because, under Regs. Sec. 1.367(a)-3(a), they are deemed to have sold or exchanged the U.S. companys shares for the shares of the newly formed foreign corporation. As a result, under Regs. Sec. 1.367(a)-3(a) and -3(c), the shareholders are required to pay tax on the difference between the cost of the U.S. shares and the FMV of the foreign corporation shares on their receipt. Although, generally, there are no changes in the way U.S. noncorporate shareholders are taxed before and after an inversion, under Secs. 243 and 245, U.S. corporate shareholders, generally, would no longer be entitled to the dividends-received deduction on dividends received from the newly formed foreign company.

Congress created the Sec. 367 exit tolls, at both the corporate and shareholder levels, to discourage inversions. Tax planning, however, may neutralize or decrease Sec. 367s contemplated effect. For example, a company may effectuate an inversion when the transferred assets FMV is low in comparison to their adjusted basis. In such case, there would be little (if any) potentially taxable BIG.

Effective tax planning can benefit shareholders as well. For example, a company may undergo an inversion when its stock price is relatively low and there is little (if any) realized gain. The general U.S. economic downturn creates a favorable climate for inversions.

Nontax Consequences

A corporate inversion may bring with it many nontax consequences as well. For example, consumers may no longer view a companys product as American. In addition, shareholders may experience a decrease in their rights. Such consequences are of course difficult to quantify, but corporations should nevertheless consider them when deciding whether to expatriate.

Alternative Strategies

Many companies have already been exploring alternatives to corporate inversion tax planning strategies. One popular avenue, for example, is to transfer income-generating intangible assets (e.g., patents and copyrights) to offshore-based affiliated companies. These offshore companies would then charge a licensing fee to their U.S.-based affiliates for the right to use the intangible assets. Thus, U.S. companies can effectively transfer significant portions of their revenues from the U.S. to low- or no-income-tax jurisdictions (i.e., tax havens).

There are other alternatives. For example, start-up companies can choose to incorporate abroad in the first place. An acquisition by, or a merger with, a foreign competitor, with the ultimate parent located overseas, is another strategy.

Conclusion

Practitioners should become familiar with corporate inversions and their consequences. Although not a new phenomenon, the recent flurry of this type of transaction, combined with the surrounding political debate, highlights the importance of understanding this strategys potential. The real task is ascertaining whether the likely benefits outweigh an inversions likely tax and nontax burdens.

From Steven V. Melnik, CPA, J.D., LL.M., Assistant Professor and Director of Graduate Tax Programs, Bernard M. Baruch College, City University of New York, New York, NY (Not affiliated with Baker Tilly International)