US Tax Code ‘Makes Corporate Inversions Attractive’

The US tax code is spurring American companies to change their legal residence for tax purposes, according to an analysis by the Illinois-based Kellogg School of Management.

Kellogg cites data from the Congressional Research Service, showing that over the past 10 years at least 47 US companies have the move known as ‘corporate inversion’. These occur when a US business shifts its tax domicile abroad through an acquisition or merger with a non-US partner, thereby reaping the benefits of a lower tax rate.

“The US has the highest corporate tax rate in the industrialised world,” says Thomas Lys, a professor of accounting at the School and an expert on corporate restructuring. “It’s 35%, and that’s just federal tax. If you factor in state tax, you’re pushing 40%. Combine that with the fact that the government taxes global income, and you can see why companies want to leave. The incentives are simply too strong.”

A corporate inversion enables companies to avoid paying taxes to the US Treasury on unrepatriated foreign income and future income earned abroad. “If Apple sells an iPhone in France, it pays US tax on the income resulting from that sale,” Lys says. As much of Apple’s revenue comes from international sales, this policy significantly impacts on after-tax profits.

“Many US companies generate large amounts of foreign income. What if they could avoid paying US taxes on past and future foreign income? For a company like Apple there are billions of dollars’ worth of reasons to redomicile.”

Another benefit of corporate inversions is “earnings stripping,” or the ability to shift earnings from a US subsidiary to a non-U.S. parent corporation in order to gain the most from that country’s lower tax rate. Earnings stripping can also be achieved through changes in the company’s capital structure. Typically, this is done by shifting the domestic subsidiary’s capital from equity to debt, the latter being tax deductible, so a company can save on taxes if its US business borrows heavily.

In a recent study, Lys and Kellogg School Ph.D. candidate Rita Gunn show that corporate inversions result in significant increases in shareholder wealth.

From a sample of 122 corporate inversions, they found that, after accounting for variables such as unrepatriated foreign cash, expected future foreign income, and media attention, the average company benefited by US$2.1bn.

There are downsides to inversions, however. A company may lose valuable tax credits, and its domestic shareholders may have to pay tax on the gains they earned as a result of the inversion. The most obvious drawback, however, is not financial, but reputational. Inversions are highly unpopular with the American public and several key members of Congress, and they can lead to waves of negative publicity.

The study yielded one paradoxical result. While the US Ways and Means Committee estimates that inversions will cost the Treasury some US$34bn over the next 10 years, Lys and Gunn found that the inversions might not have had an adverse impact on the taxes collected by the US – in fact, they probably resulted in significant increases in tax collections by the US Treasury.

The reason is that before their inversions, US corporations were not repatriating foreign profits but leaving them “permanently invested” abroad; after they inverted, the companies repatriated those funds to the tune of approximately US$103m per company and increased cash dividends. In addition, the inversions themselves resulted in taxable gains to US shareholders through share-price appreciation.


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