Football season has arrived once again as summer turns into fall.  The mid-term elections are right around the corner, which means it is time for political football.  One of the political footballs being tossed around in Washington is the idea of Corporate Inversions.  Treasury Secretary Jack Lew announced new regulations hoping to stem the use of this tax device that has created a great deal of consternation in the political class.  Why this issue matters and what should be done about it really is a matter of fundamental policy discussions concerning our entire tax system. 

The short definition of a Corporate Inversion is that an American-based corporation is “acquired” by a foreign corporate entity, usually based in Ireland or another country with a fairly low corporate tax rate, where the merged corporation will set up its headquarters.  Burger King’s proposed merger with Canadian-based Tim Horton’s, followed by a move to Canada, has some politicians up in arms over all those untaxed Whoppers.  Our system taxes American companies on the basis of world-wide income.  Income earned overseas is subject to the American tax system less any applicable credits for foreign tax paid on overseas earnings.  Most foreign countries have a tax treaty with the United States to ensure that income is not subject to double taxation and that there is consistency in treatment by both countries involved.  Foreign companies operating in the United States are subject to our tax system to the extent they generate taxable income in this country.  American companies that go through an inversion process will still be subject to U.S. tax, similar to any other foreign company.  Those Whoppers will still be subject to tax in the United States as they always have been.

If we have all these treaties with all these foreign countries and we are only taxed once then what is the big deal?  One problem is that most countries tax their resident companies on a waters’ edge basis, taxing only activity within their own country.  An Irish company operating in America will pay tax here and not be subject again in Ireland.  An American company operating in Ireland will pay the 12.5% Irish tax and 21.5% in the United States on those same earnings.  The second problem is that that the United States has the highest corporate tax rate in the developed world.  An American-based multi-national can significantly lower its worldwide tax burden if it becomes a foreign-based corporation.

The new regulations will slow down the move towards corporate inversions, but with foreign countries offering significantly lower tax rates and a simplified international taxation regimen the urge to move overseas will continue unless we undergo substantial tax reform.  With the current attitude in Washington it is not likely to happen in the foreseeable future.

Every once in a while we get someone trying to incorporate in Nevada thinking they won’t be subject to tax in New York, even though that’s where they live and where the company actually operates.  Each state operates in a similar manner to the Federal government in relation to foreign countries in that if you have sufficient contact with a state (create Nexus) you will be taxed on that activity.  In order to prevent companies from being subject to double taxation, each state similarly has rules for applying credits against taxes paid to other states to mitigate this problem.

On a smaller level, companies operating in high tax states are looking at ways to minimize their exposure and hold on to more of their profits.  That is why there has been a migration to low tax areas like Texas and Florida.  Tax competition amongst the states and the need to raise tax revenue will keep the various states looking for companies with enough contact to make them taxable.  While the Quill case is still the controlling precedence concerning the collection of sales tax and the commerce clause of the U.S. Constitution controls the ability of states to tax out-of-state companies, high tax states are continuously looking for new way to make them subject to tax.

If you are operating in multiple states, you should be aware of what makes you taxable and what taxes you may be responsible for.  As always, your Dermody, Burke & Brown tax advisor is available to help you through the maze of these Nexus issues.

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.