Corporate Inversion: What it is, How it Works, Example

What Is a Corporate Inversion?

A corporate inversion—also called a tax inversion—is a process by which companies, primarily based in the U.S., relocate operations overseas to reduce their income tax burden. Companies who receive a significant portion of income from foreign sources may employ corporate inversion as a strategy because the foreign income is being taxed both abroad and in the country of incorporation. Companies undertaking a corporate inversion usually select a country which has a lower tax rate than their home country.

Key Takeaways

  • Corporate inversion, also known as tax inversion, involves a domestic company moving its headquarters or base of operations overseas.
  • The destination company will have a lower tax rate and usually a more favorable regulatory environment than the domestic country, thus lowering the corporation's effective tax rate on a net basis.
  • While legal, the practice has come under fire as a loophole that artificially lowers corporate taxes and keeps U.S. dollars overseas.

What Is Corporate Inversion?

How Corporate Inversions Work

Corporate inversion is one of the many strategies companies employ to reduce their tax burden. A company can reincorporate abroad by having a foreign company purchase its current operations. The foreign company then owns the assets and the old corporation is dissolved. The business, while remaining the same in its daily activities, is now domiciled effectively in the new country. Companies may also buy or merge with a foreign business and use that entity as their new headquarters. Despite the new corporate structure, it is not uncommon for the U.S. operations of the company to continue and for jobs and business lines to remain unchanged.

From a profitability and competitiveness standpoint, corporate inversions represent a smart business move because they lower the tax burden on a company's operations. However, this is not to say that corporate inversions are cost-free. When a company goes through a corporate inversion, it ends up contributing less taxes to the nation where it was originally founded. This, of course, lowers the revenue the government has for services. Many critics of corporate inversions point out that companies often benefit from broader societal factors, such as a well educated workforce, but quickly look for ways to avoid or minimize contributions as soon as they have other options.

Example of a Corporate Inversion

For example, consider a manufacturing company that incorporated itself in the United States in the 1950s. For years, most of its revenue came from U.S. sales, but recently, the percentage of foreign sales has increased. Income from abroad is taxed in the United States, and U.S. tax credits do not cover all taxes which the company must pay elsewhere. As the percentage of sales coming from foreign operations grows relative to domestic operations, the company pays more in U.S. taxes because of where it is domiciled. In addition, its U.S. income is taxed at a high domestic rate. 

If the business incorporates abroad, it can bypass paying higher U.S. taxes on income not generated in the United States. The company would advance to a corporate inversion to achieve this aim. There are other potential advantages to corporate inversions, including the possibility of more attractive financing options, but the primary benefit is no longer having to pay U.S. taxes on foreign income.

Criticism of Corporate Inversions

Corporate inversion is a legal strategy and is not considered tax evasion as long as it does not involve misrepresenting information on a tax return or undertaking illegal activities to hide profits. However, there has been controversy surrounding the ethics of the companies that opt for corporate inversions. Many U.S. companies have been called out for leaving the country, as with Burger King's move to Canada in 2014 through a merger with the Canadian coffee and doughnut chain, Tim Hortons.

The controversy came to a head in 2015, when Pfizer Inc. announced it would move to Ireland as part of a merger with Allergan PLC, setting up one of the largest ever corporate inversions. This announcement was met by widespread outrage in political circles and new rules were set by the U.S. Department of the Treasury and the Internal Revenue Service that made the deal—and most large corporate inversions—much less attractive. In 2016, Pfizer Inc. called the deal off.

A year later, the Tax Cuts and Jobs Act of 2017 addressed much of the tax disparity that was driving corporate inversions, slowing the use of this tax strategy. As of 2020, the new U.S. corporate tax rate has put corporate inversion on the back burner for multinationals calling the U.S. home. The practice remains legal and corporate inversions can still take place, but the strategy is not as popular as it was in the previous two decades when the tax savings were more significant.

Article Sources
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  1. Businesswire. "Pfizer and Allergan to Combine."

  2. The White House: Obama Administration. "The Corporate Inversions Tax Loophole: What You Need to Know."

  3. Pfizer. "Pfizer Announces Termination of Proposed Combination with Allergan."

  4. University of New Hampshire. "Relationships Between Corporate Inversions and the Tax Cuts & Jobs Act."

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