The United States has one of the highest corporate income tax rates in the world. Multiple studies confirm that even if you take into account credits and deductions, the effective rate (what companies actually pay) continues to be among the highest. Corporate profits between $100,000 and $335,000 are taxed at a 39 percent rate, with higher profit levels taxed between 34 and 38 percent. Add state and local income taxes to the mix and a corporation could pay half of its profits in income taxes. That means less money available for shareholders and for investing in future growth.
Many companies look for strategies that can lower their tax bill while still complying with U.S. law. One such strategy that has become rather popular is to re-incorporate your business in a foreign country with lower tax rates. This won’t work for every business but if you’re worried about your tax bill then it’s worth exploring this option.
Tax inversion – how it works
U.S. tax law is comprehensive; this means that a company incorporated in the U.S. must pay income taxes on profits made anywhere in the world. This is very different from other countries where only domestic profits are taxed. A U.S. company that goes through a tax inversion could both lower their tax rate and pay taxes on a smaller part of their profits.
The process of changing the country of incorporation of your business to lower your taxes is known as “tax inversion”. Companies like Chiquita Brands, Burger King and Ingersoll Rand have completed or are going through the tax inversion process. Many more companies of all sizes have followed.
The IRS tries to discourage tax inversions by imposing certain requirements on companies that choose to go through the process. But these requirements only apply to some inversions and a properly structured inversion can avoid them. There are two ways to execute an inversion strategy:
Self-inversion. A company can simply reincorporate abroad in a low tax country like Ireland assuming that it already has significant business activity in that country. For the IRS this means at least 25 percent of a company’s employees, assets, sales and profits come from that country.
Inversion through merger or acquisition. The more common approach is to buy a small foreign company where the owners of the acquired company will own at least 20 percent of the newly combined business. The new company can incorporate anywhere it chooses.
What are the risks?
A tax inversion carries certain risks and if they aren’t managed properly they could cost you more money than you saved in taxes by going through with the inversion.
Expertise risk. It’s important to work with tax and legal advisors that have experience in executing inversions in the country where you plan to re-incorporate. This is not a “do-it-yourself” project.
Shareholder risk. It’s also important to evaluate any potential tax consequences for shareholders. When you incorporate you will be exchanging shares in the old company for shares in a new company. If not structured properly there could be significant tax consequences for shareholders.
Headline risk. Tax inversions also aren’t very popular in the media these days. Opponents of the practice argue that even though it’s perfectly legal, it’s unpatriotic or unfair. While it’s highly unlikely that Congress will pass new laws anytime soon to ban tax inversions, the Treasury department is evaluating potential steps it could take to further discourage them in light of this media scrutiny.
When does tax inversion make sense?
Going through with a tax inversion is a serious and significant decision. Generally it’s worth considering if your business is highly profitable with most of your profits coming from abroad. This helps justify the costs associated with going through an inversion. U.S. companies exported $2.3 trillion in goods and services last year. One-third of all exports come from and 98 percent of all exporters are small and medium sized businesses. 58 percent of exporters do business with a single foreign country.
A company that exports to a single country and is highly profitable is the type of business where an inversion could have the most benefit. Keep in mind that you don’t have to move abroad; it’s the company’s legal status that changes.
