The most popular game for US companies investing overseas has long been 'beat the taxman'. To win, US multinationals simply select the foreign location where they will pay the lowest corporate tax – or possibly none at all – and move their tax residence there. The regular loser in this game is the US tax collection agency, the Internal Revenue Service.

However, after witnessing a number of businesses recently adapting this strategy, the US Treasury – which has responsibility for the IRS – has bared its teeth in a bid to stop the game, or at least make it less profitable. On September 22, Treasury secretary Jacob J Lew issued a notice intended, he said, “to meaningfully reduce the economic benefits of inversions after the fact” and said he would keep looking for new ways to hobble those US businesses that had relocated to low-tax destinations.

“By effectively renouncing their citizenship but remaining here, these companies are eroding the US's tax base,” Mr Lew asserted in a speech.

Seeking an end

The US Congress is also considering several pieces of legislation intended to curb tax inversions, though many would prefer to see a complete overhaul of the tax system. US president Barack Obama has also denounced the practice.

As defined by US Treasury: “A corporate inversion is a transaction in which a US-based multinational restructures so that the US parent is replaced by a foreign parent.” Frequently, the US corporation does so by merging with a company in a country with a favourable tax structure, and adopting its nationality. It may also shift ownership of its foreign assets to its new foreign parent to avoid paying US tax.

The reason for the exodus of US corporations to Europe and tax havens in the Caribbean and elsewhere is clear: they consider the US corporate tax rate, at 35%, too high. And it is one of the few countries to tax a company on its worldwide operations. By contrast, Ireland – a favoured destination for US tax inverters, has a 12.5% corporate tax, and the UK’s – another popular choice – is to fall to 20% by 2015. Indeed, the UK Treasury states that: “The tax system can and should be an asset for the UK, improving the business environment and helping to attract multinational businesses and investment to the UK.”

A united front

The US is not alone in its concerns. In September, the Organisation for Economic Co-operation and Development (OECD) announced recommendations for a coordinated international approach that would create a single set of international tax rules, later endorsed by G20 finance ministers, to combat tax avoidance by multinationals.

The EU has also taken steps to curb tax avoidance, by closing loopholes that some companies have used to exploit differences in the way intra-group, or transfer, payments are taxed across the EU, often enabling some firms to pay no taxes at all. In June, the EU announced related investigations of the activities of three companies: Apple in Ireland, Starbucks in the Netherlands, and Fiat Finance and Trade in Luxembourg – three countries often accused of enabling tax avoidance.

While it is clear that the home country loses tax revenue when a company emigrates for taxation purposes, it is less certain what the new host country gains when viewed from the perspective of FDI.

This became an issue in the UK this year when Pfizer, the US pharmaceutical company, made a hostile £69.4bn bid, structured as a tax inversion, for the UK’s AstraZeneca. Though attracting Pfizer would be a feather in the UK's FDI cap, public outcry against the deal’s potential impact on jobs and science research forced prime minister David Cameron to demand stronger guarantees that the company would keep jobs and investment in the UK.

One deal that has aroused the ire of the American public is the planned $12.8bn merger of fast-food chain Burger King Worldwide with Canadian coffee and doughnuts chain Tim Hortons, in a move that shows all the signs of a tax inversion but that the companies claim is actually about growth and synergy. The deal will, however, be scrutinised under the Investment Canada Act, which specifies that it must be of "net benefit" to Canada.

Who gains what?

Omri Marian, a professor at the University of Florida Levin College of Law, has analysed the home country effects of corporate inversions. While the US may lose tax revenue when a company inverts purely for tax reasons, other losses may be limited, since its headquarters, research and development, workforce and customers often remain in place, he says. On the other hand, if a corporation moves to another jurisdiction that has similar infrastructure and skilled labour, the tax differential may trigger the inversion and also motivate the company to shift some of its operations, representing a true substantive loss for the US, he notes.

“To the extent that there’s business sense to it, the host jurisdiction may gain something from a competitive tax inversion,” says Mr Marian. “But that will not happen if the host country does not offer infrastructure and skilled labour to support it.”

Ireland's advantage

Ireland is one country that has skilfully used its low corporate tax rate to attract FDI and worked equally hard to establish itself as a good place to do business,

These advantages have also prompted several US companies to locate in Ireland through tax inversions – drawing criticism from the US government. Three such acquisitions currently under way are pharmaceutical company AbbVie ($56bn), medical technology firm Medtronic ($47bn), and food distributor Chiquita Brands International ($500m).

However, Irish cabinet ministers insist they do not seek out tax inversions, which they say cost the state money. That is because Ireland’s required contribution to the EU is based on GDP, and profits of multinationals are counted as Irish GDP, even though they do not contribute to gross national product, i.e. income, according to Frank Barry, a professor at Trinity College, Dublin. Mr Barry says Ireland would still prefer FDI that brings jobs to the country. Nor does he think the amount of FDI generated purely by tax inversions is substantial. “Multinationals are the majority of the top 50 employers in Ireland,” he says. 

Ron Davies, an economics professor at University College Dublin, also believes most companies that invert already have a presence and some activity in Ireland. “Otherwise, why would they not go to a tax haven such as Bermuda, where the corporate tax rate is zero and no paper shuffling is required?” he asks.

Experts believe Ireland will never voluntarily give up its 12.5% tax rate. However, Ireland is “fully supportive” of the OECD initiative, according to Feargal O’Rourke, PwC Ireland’s head of tax. However, he believes Ireland’s corporate tax regime will have to change to accommodate the initiative.

Mr O’Rourke also expects that some tax strategies Ireland facilitates – such as the notorious 'double Irish', which he says “has caused some optical issues” and allows companies to shift income from a high-tax to a low-tax jurisdiction – will change, with no material impact on FDI.

The ultimate solution to tax inversions, many believe, is for the US to change the rules of the game and adopt a corporate tax regime suited to a competitive world.