The old saying goes “Nothing is sure but death and taxes,” but it seems some clever tax accountants and attorneys have found a loophole in the U.S. tax code that means they pay little to no tax on income generated overseas. New York University Finance professor Aswath Damodaran recently penned a blog explaining what “corporate inversion” means and why it’s a clear sign the U.S. tax code is in desperate need of reform.

U.S. tax code

Global vs territorial tax system

Damodaran begins with an overview of the U.S. “global” tax system and compares it to “territorial” tax systems. “The US requires domestic corporations, i.e., companies incorporated in the US, to pay the domestic marginal tax rate on their global income. It is one of eight OECD countries that continues to use a global tax system, while the remaining twenty six OECD countries have shifted to a territorial tax system, where corporations  pay the domestic tax rate on income that they generate domestically and the local tax rates on income generated in foreign locales.”

U.S. tax code – Example of how profits get “trapped”

For an example of how the U.S. tax code causes profits to get trapped, let’s look at a hypothetical U.S. company that generates $50 million of its income in the US  (tax rate of 40%) and $50 million of its income in China (tax rate is 25%). The firm owes a total of $32.5 million in taxes on that income, 40% of the $50 million of US income and 25% of the $50 million of Chinese income. However, if the firm chooses to return the $50 million in Chinese income to the U.S., it will have to pay the differential tax of $7.5 million reflecting (differential tax rate of 15% = US tax rate – Chinese tax rate).

Damodaran goes on to explain how this tax system causes profits to become trapped. “What happens if the company chooses to leave the cash in its Chinese subsidiary? That cash of $50 million cannot be used for investments in the United States or to pay dividends/buybacks to stockholders. In effect, it is “trapped”, but it can be used for investments anywhere else in the world. The longer the company continues to hold back cash in foreign locales, the larger the trapped cash balance becomes and after a decade of not repatriating cash, it can amount to hundreds of millions or even billions of dollars.”

U.S. tax code – Avoiding “trapped” funds is the motivation for corporate inversion

The benefits of corporate inversion can be best understood through reference to an example, which makes it clear how firms use corporate inversion to free trapped funds.

Let’s assume assume the company in the example above relocates its headquarters to Singapore, a nation with a territorial tax system. The taxes it owes on its U.S. income remain at $20 million, but there are two significant tax benefits.

First, the trapped cash is no longer trapped and the $7.5 million differential tax due to the U.S. no longer applies. Not having to pay any differential tax is obviously a huge motivation for firms that have very large “trapped” balances, and can result in hundreds of millions or even billions of dollars in savings.

Second, the firm’s future income in China is no longer subject to a differential tax. This means that the tax advantages derived from relocation will be greater for businesses with strong global growth.