MONEY

Inversions: Why This Newish Tax Loophole May Be a Goner

The Obama administration is considering a move against a controversial tax shelter used by big companies. But small businesses might feel the consequences too.
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If you're one of the growing number of U.S. small businesses incorporating overseas, driven either by tax considerations or the demands of private equity firms that see advantages internationally, pay attention.

The Treasury Department said earlier this week that it may act unilaterally to close a tax loophole, referred to as an inversion, from which you might benefit.

Here's a quick primer on the issue. Inversion is a process whereby a U.S.-based company, usually a large one, merges with or acquires a small company in another country and reincorporates there to avoid paying higher taxes here.

While big businesses have operated subsidiaries overseas for many decades, the concept of an inversion appears to be relatively new, with probably no more than 30 companies conducting the procedure since 2011, according to a recent story in the Wall Street Journal. At the same time, demand for such deals has grown to 66 percent of all proposed mergers and acquisitions overseas in 2014, compared to 1 percent in 2011. 

(Walgreens, for example, which had considered such a strategy, said Wednesday it was abandoning its plans, reportedly due to the ruckus the loophole has been provoking lately.)

While the higher U.S. tax rate is typically around 35 percent, corporate finance experts say that with the number of tax loopholes available to big businesses in the U.S., they rarely pay that much. Nevertheless, the companies taking advantage of inversions usually reincorporate in places such as Switzerland or Ireland, whose corporate tax rate is closer to 12 percent.

The loophole is potentially very important for companies that develop intellectual property in a subsidiary offshore, experts say. 

It may just be more important to the U.S. government, however. The Joint Committee on Taxation estimates lost tax revenue from such deals over the next 10 years will be about $20 billion. While that may not seem like a lot, it's enough to rile the Obama administration. The president's budget request for 2015 contains an appendix that would essentially outlaw the practice. In his weekly address on July 26, the president went to great lengths to single out the practice. 

"A small but growing group of big corporations are fleeing the country to get out of paying taxes," President Obama said. "Something that cannot wait in my budget earlier this year proposes closing that unpatriotic tax loophole for good."

Congressional action, introduced in May by Democrats, would attempt to close the loophole by forcing U.S. companies to merge with overseas concerns of equivalent size, which would make it harder to close such transactions. While that's not likely to clear the bitterly divided House any time soon, Treasury Secretary Jacob Lew indicated the Treasury may attempt to bypass Congressional stalemate with a more expedient action. Here's what he had to say about aspects of the plan in a Washington Post editorial from July 28:

The president’s plan also would eliminate the incentives a U.S. corporation has to acquire a foreign company and use its foreign address to claim tax status beyond our borders. To make sure the merged company is not merely masquerading as a non-U.S. company, shareholders of the foreign company would have to own at least 50 percent of the newly merged company--the current legal standard requires only 20 percent. 

The issue for small businesses begins to take shape once you consider the stockpiling of cash that's been going on with many businesses, like Apple, much of whose staggering $150 billion cash hoard is held overseas in countries such as Ireland, where Apple also has numerous subsidiaries.

"For a lot of companies, much of their resources can be in intellectual property, and for all practical purposes, the IP can be anywhere," says Dean Baker, co-director of the Center for Economic and Policy Research, who has written extensively about the tax inversion issue.  

With that in mind, any fast-growth company with copyright or intellectual property assets developed overseas that might have considered the inversion route, is likely to find itself facing significant challenges going forward. 

Treasury, for example, could pull levers with the Internal Revenue Service, and elsewhere.

"The IRS could say any company that switches incorporation we will review very carefully and ask for more documentation and slow this down," says Baker. 

Last updated: Aug 6, 2014

JEREMY QUITTNER | Staff Writer | Staff Writer, Inc. and Inc.com

Jeremy Quittner is a staff writer for Inc. magazine and Inc.com. He previously covered technology for American Banker and entrepreneurship for BusinessWeek.




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