This article is written by Abhishek Dubey, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.com.

What is a corporate inversion?

A corporate inversion or tax inversion is the process by which domestic company move its operation outside the country in which it is operating to reduce the tax burden. The destination company will have a lower tax rate and more favourably environmental plan than the domestic company, it will lower the corporate tax rate on a net basis.

Advantages of corporate inversions

The maximum corporate federal tax rate in the US is 35 per cent on every dollar earned whether earned domestically or abroad. The change in the legal residence from the U.S. to other countries is to take advantage of a certain law of that country. The advantage that US companies see in other countries is the flexibility in banking laws, lower tax rate, more accommodating corporate governance rules.

The key benefits that there are:

• It gets the intellectual property benefit that is under development.
• It has plans or substantial acquisition.
• It’s non us earning are subject to a lower rate.
• There are sufficient foreign earnings to absorb significantly interest expenses. 
• Its shares are undervalued or it has significant losses due to economic or other conditions.

Objectives of the inversion

• Avoidance of current or eventual income tax on earnings generated outside.
• Enhancement of financial flexibility.
• Increasing access to non-US debt and the equity markets.
• While many other jurisdictions can be chosen, Bermuda has been one of the good countries for allowing foreign company. 
• It increases access to US debt and equity markets.

The corporate inversion tax consequences

The tax consequences will mainly depend upon the precise nature of the transactions. Generally, inversion is done in stock or asset acquisition. It can also be a combination of asset and stock acquisition. In all these cases reincorporation expenses result in the potential tax.

Stock transactions:

A stock transaction is also the reorganisation within the meaning of section 368 under the internal revenue code. Because this transaction also involves the transfer of property so section 367 also applies.

Tax-free reorganisations:

Section 367 permit outbound transfer of stock as the tax-free subject to some condition:

• Where US shareholders of the transferor receive the 50 per cent or less of the voting power and tidal value of the stock of the transferee company.
• The transferee foreign company satisfied active trade or business requirements.
• Reporting requirements are satisfied.
• Each 5 per cent of the shareholders enters into gain recognition agreement.

In a stock transaction, where the foreign acquiring corporation typically is a newly formed entity without significant assets, the 367 regulations require the shareholder to recognise gain on the exchange for the tax purpose. The amount of taxable is equal to the excess if any of the market value over shareholders adjusted basis therein.

Shareholders with a loss of exchange do not recognise the loss for the tax purpose. Although the company shareholders are required to recognise the gain in the stock transaction, there are no reporting requirements such as apply in case of a disposition of cases. 

Asset Transaction:

Because a transaction involves an outbound transfer of assets by our company to the newly formed company, our company must look where the gain is no loss. Calculated as if all the assets have been sold at the time of the transaction for their fair market value. The shareholder of the company is not subject to the second level of tax provided that the transaction qualifies as the second level of tax, if the transaction qualifies reorganisation then the transaction will qualify as the then the shareholder will have the same share on the same tax.

The controversy surrounding tax inversion:

Corporate inversion is a legal strategy and these are not considered as the tax evasion that means the person is not paying the tax and he is liable to pay if it does not involve misrepresenting information or hide the profit of the business or undertaking illegal activities of the business.

The controversy that is going surrounding the corporate inversion is the ethics of the companies that opt for the corporate inversion, there have been several high profile corporate inversion where the ethics have been ignored several strategies have brought this case in front. One of the famous examples is burger king worldwide inc left the united states for Karnataka when it purchased the doughnut chain Tim horizon ltd.announced it to move Ireland as part of the merger with Allergan plc.these and other relocations have prompted to a strong reaction from the government to make the inversion more difficult.

Abuses and penalties of a corporate tax inversion:

The tax law has many rules, violation of tax rule is subject to penalty, the imposition of the tax in the form of the penalty. The abuse of corporate inversion became very famous from the last decade. At that time maximum, the corporate tax rate is 35 per cent, therefore the boundary of tax penalty was fixed. In the scope of international taxation, corporate merger and acquisition with foreign entities have become the normal course of activity. Unfortunately, the strategy has become to the scheme of tax avoidance. Us treasury department observed this since then congress enacted IRC 7874 in 2004 and internal source of revenue in the year 2014, us treasury bill in the year 2016.

Capital gain on the exchange of stock in an inversion transaction:

The best strategy of corporate inversion is to create a foreign corporation in a foreign country which in turn will issue the stock to the parent company of the US in exchange for its stocks. Should the gain on an exchange be taxable on the part of shareholders? The answer was negative because the stock is not property. This happened in the case of mc Dermott and Helen troy.

Distribution of untaxed foreign earnings by means of an inversion:

In an ordinary relationship, us parent company owns an old foreign subsidiary company CFC. any type of dividend distribution from old CFC to new parent company would be taxable in the US. The US parent company may create the new CFC which in turn issues stock to the US parent company and also to the old CFC. the new CFC become the parent corporation of us parent company.

The new foreign corporation as a US domestic corporation due to an inversion:

A corporate inversion also involves the combination of a domestic corporation and foreign counterpart. It is known as a merger. After the merger should the merged entity will be treated as the domestic corporation. This gives the question of tax liability of the taxing entity. IRC 7874 concerns the ownership of new foreign incorporation. It is correct that the status of a foreign corporation is treated more favourably than the domestic US corporation. Even after the inversion if the combined entity corporation is still at least 25 per cent of the foreign company it is treated as a foreign corporation. If the US shareholders hold at least 60 per cent but less than 80 per cent of the stock it is treated as the surrogate foreign corporation. Where the earnings in proportion to the ownership percentage are taxable in the US. on the other hand, if the US shareholders own at least 80 per cent of the stock the combined new foreign corporation would be treated as the US domestic corporation. Where it is subject to worldwide income tax. These new tax rules define how much of the income after the corporate inversion is taxable since the tax rate in us is always higher than those of the world.

Determining the ownership of new foreign corporation after the inversion:

There is another corporate inversion that may lead to tax penalties. It involves the manipulation of the size of the US parent corporation and a foreign corporation. The company may find a way for it. For example, it may distribute the large dividends to us, shareholders, before the inversion. This will be like like at one side it will shrink asset value. As a result, it will reduce the ownership size of the foreign corporation.

Intercompany loans subsequent to an inversion:

There is still another strategy to distribute to the earnings of CFC to US parent company without paying us tax. Before the inversion, if a CFC makes intercompany loans to the US parent company, then the amount is treated as the dividend distribution.

Conclusion

This article deals with the problem and the corporate inversion.it also reveals abuses and penalties associated with it. This also points out that US parent corporation cannot derive from us only but also from many foreign countries. The tax treatment is different in all countries. The income from the US is taxable immediately but the income from other country are not taxable until and unless cash dividends are received. The rate of tax of the US is higher than the other countries.

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