The Corporate Inversions Tax Loophole: What You Need to Know

On April 4, the Treasury Department took action to limit “corporate inversions” – transactions in which U.S. companies move their tax residence overseas to avoid U.S. taxes. President Obama, who has highlighted the need to close the inversions loophole for years, applauded the action and called on Congress to close the inversions loophole for good. The following explains what corporate inversions are and why this issue is so important for regular American taxpayers.

Here's what we're doing to make sure big corporations are paying their fair share of taxes. https://t.co/1yeF6gVwqT

— The White House (@WhiteHouse) April 5, 2016

The following explains what corporate inversions are and why this issue is so important for regular American taxpayers.

What are corporate inversions?

Corporate inversions are a tax loophole that allow U.S. companies to avoid paying U.S. taxes by relocating – on paper – to a foreign country.

In a typical inversion, a U.S. company acquires a smaller company based in a foreign country – usually a low-tax country – and then locates the residence of the combined company in that other country for tax purposes.

Companies typically invert on paper for tax purposes without moving their actual operations overseas.  That means that they continue to enjoy the benefits of being a U.S. company, including access to U.S. markets, rule of law, patent and intellectual property enforcement, support for research and development, and – not least -- American workers.

How do corporate inversions cost regular taxpayers?

According to Congress’s Joint Committee on Taxation, corporate inversions will cost the U.S. Treasury as much as $40 billion over the next ten years.* As President Obama has said: 

"When companies exploit loopholes like this, it makes it harder to invest in the things that will keep America strong for future generations. . . . Many of those loopholes come at the expense of middle class families – because that lost revenue could have been used to invest in our schools, make college more affordable, put people back to work building our roads, and create more opportunities for our children.”

Check out this infographic for a clear picture of corporate inversions and what they're costing you. 

What has President Obama proposed to do about corporate inversions?

President Obama has been calling on Congress to stop corporate inversions since 2014. In the last three Budgets he has submitted to Congress, the President proposed to fully close the loophole that allows for corporate inversions. The President has also put forward a Framework for Business Tax Reform (first released in 2012 and updated this month) that proposed more fundamental reforms to make our business tax system more efficient and pro-growth. Unfortunately, Congress has not yet acted to address corporate inversions or to enact business tax reform.

But the President has also been clear that where Congress fails to act, his Administration will do everything within its authority to ensure that the system works for hard-working Americans and our economy. That is why he applauded the actions the Treasury Department has taken to make it more difficult for companies to invert and to limit the economic benefits of doing so.

What does the new Treasury Department’s action do?

On Monday (April 4), the Treasury Department took action within its authority under existing tax laws to limit corporate inversions. Treasury’s action builds on two prior actions it has taken to make it more difficult to invert and reduce the economic benefits of doing so.

The new Treasury action limits corporate inversions in two ways:

1. Addressing “serial inverters”: In a “serial inversion,” a U.S. company undertakes an inversion by acquiring a foreign company that itself has inverted or grown larger through acquisitions of U.S. firms. Serial inverters may be able to avoid penalties under existing law that kick in if the foreign firm in an inversion transaction is below a certain size in relation to the U.S. firm that is acquiring it.

To give an example, first, a U.S. company inverts overseas: it moves its residence to another country for tax purposes by acquiring a smaller foreign firm and locating the residence of the combined firm in the foreign country. Next, another U.S. company undertakes an inversion by acquiring the new foreign company that was created in the first transaction. In this way, one tax inversion can beget another tax inversion: One American company can follow another American company out the door.

Treasury’s action restricts serial inversions by not counting inversions or foreign acquisitions of U.S. firms occurring within the last three years when applying the formula that determines whether an inversion is subjected to penalties or blocked by existing tax code rules. That means that companies cannot use a recent inversion or a recent foreign acquisition to enable an inversion and avoid triggering penalties.

2. Addressing “earnings stripping”: Earnings stripping is a tactic that large foreign-based companies use to avoid paying U.S. taxes by artificially shifting their profits out of the United States. They are able to shift profits by having their U.S. affiliate pay interest on a loan from an affiliate in another country, typically a low-tax country. This is a win-win for the corporation: the U.S. affiliate lowers its taxes in the United States by deducting the cost of their interest payments, and then the foreign affiliate owes little or no tax on those interest payments. 

The ability to strip earnings out of the United States using such related-party loans is a major incentive for U.S. firms to acquire a foreign tax residence by inverting. Earnings stripping also erodes the U.S. corporate tax base and puts other firms at a competitive disadvantage.

Treasury’s new action addresses earnings stripping by recharacterizing certain related-party interest payments as dividends that cannot be deducted – in other words, preventing debt that doesn’t actually finance new investment in the United States from receiving a tax break.  

What will happen going forward?

Treasury has said that it will continue reviewing its authority under existing law to limit, and where possible stop, corporate inversions.

As the President has made clear, while Treasury’s new action will make it more difficult and less lucrative for companies to exploit the inversions loophole, only legislation – like that proposed in his Budget – can close it for good. That is why he has called on Congress to act immediately to stop corporate inversions.

Seth Hanlon is Special Assistant to the President for Economic Policy at the White House National Economic Council. 

*Revenue estimate for H.R. 415, Stop Corporate Inversions Act of 2014 (Rep. Sander Levin)