It’s tough to beat California’s gorgeous climate, but for those with very high incomes, there is always the temptation to move to Nevada. For locals earning over $1 million a year, 13.3 percent of the next dollar of income is payable to California’s Franchise Tax Board. Nevada has no state income tax at all, so that’s a large potential tax savings. A similarly enticing opportunity to escape taxes is at play on the Oregon-Washington border. Oregon has no sales tax and Washington has no income tax, so even people with middle class incomes can save a lot of money by shopping in Oregon and living in Washington. Imagine what would happen to your household’s finances if all else were equal but you paid neither sales nor state income taxes. None of this calculation is especially complicated. The same cannot be said of the increasingly popular and controversial strategy –mostly pursued by large U.S. corporations- of discarding the relatively high U.S. corporate tax rate for the often much lower rates that prevail in other countries, such as Ireland and the United Kingdom. Known as tax inversion, or inversion for short, this strategy has become increasingly prominent in the past couple of years. What is inversion, how does it work, and why does it matter?

Tax inversion is a complex but fully legal transaction. Typically, in an inversion a relatively large U.S. company agrees to become the subsidiary of a smaller company in a foreign country. So long as the larger company derives a significant portion of its business overseas, or, alternatively, if the shareholders in the acquired foreign company receive stock amounting to at least 20 percent of the merged entity, then the inversion is entirely legal and, in most instances, the U.S. whale is effectively swallowed by the foreign minnow.

At the time of the inversion, shareholders of the U.S. firm are required to pay capital gains taxes. Moving forward, however, the “inverted” company ceases to pay the U.S. statutory corporate tax rate of 35 percent, the highest in the developed world, on income earned in countries outside the U.S. This is critical because currently the U.S. is one of very few developed nations that requires its corporations to pay U.S. tax even on profits earned overseas. Most countries tax only domestic profits. This explains why many U.S. firms “park” huge buckets of cash overseas: at such time that they seek to repatriate profits, they are taxed. (U.S. firms are estimated to have over $1.5 trillion in cash stockpiled abroad.) As for profits earned in the U.S., even after an inversion these are still subject to U.S. taxation – in theory.

Even at the surface level, exchanging America’s 35 percent tax rate for Ireland’s 12.5 percent corporate tax rate seems inviting for corporations eager to cut their tax bill and also gain full access to the hoarded cash overseas. But there’s more. Once the foreign company is the parent of the U.S. company, it can then shift debt to the U.S. subsidiary to fund projects in the U.S. or even buy back stock from U.S. investors. This is accomplished through the issuance of debt. And since the U.S. tax code allows for the full deduction of interest payments, such “hopscotch” transactions can in fact substantially diminish the corporate tax liability previously and fully attributable to domestic profits.

The pace of inversions is increasing in conjunction with a slow but gradual economic recovery that inspires rising merger activity.

Conjoined firms find –to no one’s surprise- that the math teases out far better if the new firm is a non-U.S. entity and likely to pay a lower tax rate.

In turn, if a domestic company knows that its biggest competitors will soon be paying significantly less in taxes, it begins to search for a marriage it hadn’t previously contemplated, even one that may make sense for no reason other than tax savings. Indeed, when in June medical device maker Medtronic bought Ireland’s Covidien, the inversion was specifically structured to allow the U.S. company to walk away from the deal, penalty free, should the tax arbitrage go away as a result of any new legislation.

While this proviso may seem prudently cautious on the part of those who would do deals purely for tax reasons, it seems highly unlikely that U.S. corporate tax law will change any time soon. Politicians on both sides of the aisles agree that the U.S. corporate tax rate is uncompetitive, but as ever the system is also riddled with loopholes and special features dear to those whose paychecks (or campaign contributions) increase in conjunction with complexity. With a comprehensive solution considered unworkable in the current political environment, some are understandably calling for a quicker fix. For example, one proposal would require the foreign company’s shareholders to own at least 50 percent of the merged company instead of the current 20 percent requirement. However, some point out that this requirement might make U.S. corporations more vulnerable to foreign takeovers. As ever with the tax code, what seems to make sense (low and flat tax rates that stimulate growth and promote rational decision-making, yet without the loopholes that distort incentives and favor the connected) is not going to happen any time soon. Expect frustrated politicians to try to shame those they cannot intimidate.

None of this would much matter if the inversion process were rare or if corporate taxes were an otherwise unimportant part of overall government tax receipts. In fact, the inversion trend is growing rapidly, and more than two dozen U.S. companies are said to be considering relocating overseas within the next year. Moreover, the U.S. government collects almost $1 in corporate taxes for every $4 it collects in individual taxes, so the general erosion of the U.S. corporate tax base is costly. To cite just one example, Walgreens is said to be considering an inversion (to Switzerland) that may save the company as much as $4 billion in taxes.

Since the end of the Great Recession, U.S. corporations have been able to achieve and sustain unusually high level of profitability. This is of course one of the main reason share prices have risen as much as they have. All else being equal, profits can be pushed yet higher if companies succeed in shedding a higher tax jurisdiction for a lower tax jurisdiction. Up until now, there has been relatively little political backlash against corporations that have chosen to downsize their domestic workforce as a means of boosting profits. Adding tax inversion to the top of the list of profit maximizing strategies is a bold and unprecedented step, one we expect increases the likelihood of a contentious debate about corporate responsibility. One way or another, the outcome of that debate is likely to influence mergers and acquisitions strategy and returns to stock investors.

Filed under: Investing

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