Corporate Expats Consider More Than Tax Avoidance When Relocating Overseas

ANN ARBOR -- Although still relatively rare, U.S. companies increasingly continue to relocate their corporate headquarters to offshore tax havens such as Bermuda or the Cayman Islands-prompting recent congressional legislation to discourage the practice. The desire to avoid paying U.S. taxes on profits earned overseas, however, is not the only factor a firm considers when deciding to expatriate, say researchers at the University of Michigan and Harvard University.

Instead, the decision to invert the corporate structure—so that the foreign subsidiary becomes the parent company and the U.S. parent company becomes the subsidiary—is influenced by interest expense allocation rules associated with lost tax shields and the forced capital gains realization and consequent tax burden imposed on shareholders, according to professors James R. Hines Jr. of the U-M Business School and Mihir A. Desai of the Harvard Business School.

In their study of the causes and consequences of expatriation, which will appear in the National Tax Journal, Hines and Desai found that firms most likely to expatriate are large and/or have extensive foreign assets, considerable debt and low foreign tax rates.

"Since the U.S. system of taxing the worldwide incomes of American companies is particularly costly for firms with sizable interest expenses, as well as firms facing low foreign tax rates, this behavior is consistent with allocation rules playing an important role in the decision to give up U.S. identity," Hines says.

Stock price reactions to corporate inversion announcements is another determining factor in expatriation, the researchers say. They found that stock prices, on average, react positively to such news, with prices rising by an average of 1.7 percent over a five-day window centered on the announcement to expatriate (shares of inverting companies typically stand at just 88 percent of their average values of the previous year).

Stock price appreciation is greater for firms that have risen in value over the previous year—every 10 percent of prior share appreciation is associated with 1.1 percent greater market reaction to an inversion announcement—and whose shareholders, therefore, incur sizable capital gains liabilities when required to tender their shares (in exchanging them for new shares) as part of the inversion process, Hines and Desai say.

Likewise, firms that are heavily leveraged and which, therefore, lose the ability to claim foreign tax credits they would need if American-owned, exhibit positive price reactions upon inversion, they add.

"The fact that embedded shareholder capital gains discourage inversions suggests a natural counterweight to the rush to expatriate, one that supplements any costs associated with being subject to the corporate laws of new host countries, and the public relations impact of abandoning the United States," Desai says.

In all, the study shows that firms consider the forced capital gains realization and consequent capital gains tax burden imposed on shareholders in deciding whether or not to expatriate.

"The U.S. principle of taxing the worldwide incomes of American companies, together with the various quirky features of the system, means that many American companies would benefit from having foreign rather than American identity for tax purposes," Hines says.