The United States has one of the highest corporate income tax rates in the world. Multiple studies confirm that even when you take credits and deductions into account, 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, while higher profit levels are taxed between 34 and 38 percent. Add state and local income taxes to the mix, and a corporation could pay half its profits in income taxes. That means less money is available for shareholders and for investing in future growth.
In order to lower their tax bills, many companies search for effective solutions that still comply with U.S. laws. One such strategy that's become rather popular lately is to re-incorporate your business in a foreign country that has lower tax rates. While this won’t work for every company, if you’re worried about your tax bill, then it could be worth it to explore this option.
How Tax Inversion Works
The process of changing your business's country of incorporation to lower your taxes is known as “tax inversion.” Companies like Chiquita Brands, Burger King and Ingersoll Rand have all completed or are going through the tax inversion process. Many more companies of all sizes have followed their lead.
So what's the benefit of incorporating in another country? First, a look at U.S. tax laws: In the United States, tax laws are "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 the way other countries treat taxes, 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. And keep in mind that you don’t have to move abroad to make an inversion work for you—it’s the company’s legal status, not your location, that changes.
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 country with lower taxes, like Ireland, assuming it already has significant business activity in that country. For the IRS, this means that 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.
The Risks of Inversion
A tax inversion carries certain risks, and if they aren’t managed properly, they could cost you more money than you save by going through with the inversion. These are the three critical risks you need to protect your business against:
1. Expertise risk. It’s important to work with tax and legal advisors who have experience executing inversions in the country where you plan to re-incorporate. This is not a “do it yourself” project.
2. Shareholder risk. It’s also important to evaluate any potential tax consequences for your shareholders. When you incorporate, you'll be exchanging shares in the old company for shares in a new company. If it's not structured properly, there could be significant tax consequences for shareholders.
3. 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 U.S. Treasury Department is evaluating potential steps it could take to further discourage them in light of this media scrutiny.
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. Last year, U.S. companies exported $2.3 trillion in goods and services. Ninety-eight percent of all exporters are small and medium-sized businesses, and 58 percent of exporters do business with a single foreign country. If your company exports to a single country and is highly profitable, an inversion could have positive ramifications for you.
A version of this article was originally published on August 31, 2014.
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