Much of What You’ve Heard about Corporate “Inversions” Is Wrong

With yet another big U.S. corporation (this time it’s the medical device maker Medtronic) announcing its intentions to “invert” and officially become a “foreign” company for tax purposes, it’s time to correct a few misunderstandings.

1. What is a corporate inversion?

Incorrect answer: A corporate inversion happens when a company moves its headquarters offshore.

Correct answer: A corporate inversion happens when a company takes steps to declare itself a “foreign” corporation for tax purposes, even though little or nothing has changed about where its business is really conducted or managed.

The law used to be so weak that an American corporation could simply reincorporate in Bermuda and declare itself a foreign company for tax purposes. In 2004, Congress enacted a bipartisan law to prevent inversions, but a gaping loophole allows corporations to skirt this law by acquiring a smaller foreign company. The loophole in the current law allows the company resulting from a U.S.-foreign merger to be considered a “foreign” corporation even if it is 80 percent owned by shareholders of the American corporation, and even if most of the business activity and headquarters of the resulting entity are in the U.S. (A proposal from the Obama administration to change these rules has been introduced in Congress by Carl Levin in the Senate and his brother Sander Levin in the House.)

2. How are the offshore profits of American corporations taxed?

Incorrect answer: When American corporations officially bring their offshore profits to the U.S., they must pay the 35 percent U.S. tax rate, and this is why they want to escape the U.S. tax system.

Correct answer: When American corporations officially bring their offshore profits to the U.S., they must pay the U.S. tax rate of 35 percent only if their profits have been shifted to tax havens.

When American corporations “repatriate” offshore profits (officially bring offshore profits to the U.S.) they are allowed to subtract whatever corporate taxes they paid to foreign governments from their U.S. corporate tax bill. (This break is called the foreign tax credit.) The only American corporations that would pay anything close to the full 35 percent U.S. corporate tax rate on offshore profits are those that claim their profits are in countries where they are not taxed — countries we know as tax havens.

American multinational corporations report to the IRS massive amounts of profits earned in countries that either have an extremely low (or zero) corporate tax rate or otherwise allow them to escape paying much in corporate taxes. It is obvious that these reported tax haven profits are not truly earned in these countries, and in fact that would be impossible. For example, the profits American corporations overall report to earn in Bermuda are 16 times the size of Bermuda’s economy. Obviously, these profits are truly earned in the U.S. or other countries with real consumer markets and real business opportunities, and then manipulated to appear to be earned in countries where they are not taxed.

The corporations that make the most use of these tax haven maneuvers — maneuvers that are probably legal, but which should be barred by Congress — are the corporations that would pay close to the full 35 percent tax rate if they repatriated their offshore profits.

3. What profits are corporations trying to shield from U.S. taxes when they invert?

Incorrect answer: When American corporations invert, they do it to escape the U.S. system of taxing offshore profits, which is something most other countries don’t do. After they become a foreign company, their U.S. profits would still be subject to U.S. taxes.

Correct answer: American corporations invert to avoid paying taxes in any way possible, and often that includes avoiding U.S. taxes on their U.S. profits. It’s true that, in theory, all corporate profits earned in the U.S. (even profits of a foreign-owned corporation) are subject to the U.S. corporate income tax. But corporate inversions are often followed by “earnings stripping” to make any remaining U.S. profits appear to be earned offshore where the U.S. cannot tax them.

Earnings stripping is the practice of multinational corporations reducing or eliminating their U.S. profits for tax purposes by making large interest payments to their foreign affiliates. Corporations load the American part of the company with debt owed to a foreign part of the company. The interest payments on the debt are tax deductible, reducing American taxable profits, which are shifted to the foreign part of the company and are not taxed.

If the American part of the company is the parent corporation shifting its profits to offshore subsidiaries, then the benefit is that U.S. tax will not be due on those profits until they are repatriated, which may never happen. But if the American part of the company can claim to be just a subsidiary of a foreign parent company — which would technically be the case after a corporate inversion — then the benefits of earnings stripping are even greater because the profits that are officially “offshore” are never subject to U.S. taxes.

This is part of what motivated the 2004 reform and a 2007 report from the Treasury Department that found that rules enacted earlier to address earnings stripping did not seem to prevent inverted companies from doing it.