The future of tax inversion in the U.S. hangs in balance after it was disclosed that the U.S. government is considering a legislation to curb such inversions. This emerged just a few days after Burger King Worldwide Inc (NYSE: BKW) announced acquisition of Tim Hortons (NYSE: THI) in a deal that would see BK relocate its headquarters from Miami-Dade County, Florida, United States to Oakville, Ontario, Canada.

A tax inversion refers to reincorporating a company to another country to reduce taxes on the foreign income. An example is a corporate acquisition where a local-based company acquires a foreign rival and changes its tax address to the acquired entity’s home country to gain more favourable tax treatment. In the case of the U.S., companies have carried out tax inversions to countries such as Canada, Ireland and the U.K., as these countries have less burdensome corporate tax policies.
Recent Corporate Inversion Deals
Corporate inversions are a relatively new phenomenon that became commonplace in the 1990s as U.S. corporations looked to relocate to tax havens. More recently, corporate inversions in the form of mergers with entities in lower-tax jurisdictions have become increasingly prevalent. Since 1983, about 52 companies have inverted their operations but, surprisingly, 22 of these deals have occurred within the last six years. Here are some of the deals:

• In July, global medical device maker Medtronic (NYSE: MDT) and healthcare and medical supplies major Covidien Ltd. (NYSE: COV) struck a cash-and-stock buyout deal valued close to $43 billion. If the deal goes through, the Minneapolis-based Medtronic will relocate its headquarters to Ireland to cut its tax liabilities while accessing its $14 billion in cash, most of which are from its foreign operations. The deal is expected to be completed early next year.
• However, the deal that raised eyebrows is the one between AbbVie (NYSE: ABBV) and London-listed Shire Plc. TheNorth Chicago, Illinois-based AbbVieis the largest U.S. Company to have inverted its legal address for tax purposes. If the deal goes through as planned, relocation of its tax address to the U.K. will help AbbVie lower its tax rate in 2016 to 13% from its current rate of 22%.

Reasons Behind Corporate Inversions in the U.S.
A majority of the revenues for some U.S. multinationals comes from their operations abroad. Unfortunately, the U.S. income tax code imposes income tax on foreign business profits earned by American corporations. Subjecting foreign income to taxation when the earnings are brought back to the U.S. provides a strong incentive for U.S. companies to move their headquarters. While backers of the current U.S. system are quick to mention tax credits, it must be noted that these credits rarely compensate for the total taxes paid.

In comparison, tax treatment of foreign income in Canada depends on whether the income is active business income or passive income, and whether or not this income is earned in a country with which Canada has a tax treaty. If a country has an income tax treaty, or has signed a tax information exchange agreement (TIEA) with Canada, active business income from that country is considered “exempt surplus” and is not taxable. However, passive incomes, such as royalties, interest, etc., are outside “exempt surplus” and are taxable (NRCAN/CA, 2014).

For example, if a company inverts to Canada, the company reincorporates as a Canadian corporation and is now able to return its “foreign” profits to its shareholders, easily avoiding the double taxation. However, this will not be possible in the case of Burger King. The majority of BK’s income is passive income (it is a franchise that collects royalties and franchise fees), and it will not be able to fully benefit from the Canadian exempt surplus tax code since foreign passive income is taxable income.
Hedge Funds Are Anxious as Treasury Sets Sight on Inversions
Inverted deals have invoked the wrath of U.S. president Barack Obama, who criticized the “herd mentality” of companies seeking deals to escape the 35% U.S. corporate tax and described such companies as “corporate deserters.” On August 6, he announced that the Treasury Department would work on new rules to penalize these deserters and curb such deals in the future.

Obama’s announcement sent hedge funds into a frenzy, many of which were on a fishing expedition to get any clues on a looming crackdown on corporate tax inversion. As Bloomberg reports, fund managers were searching for any information possible – talking to tax lawyers and experts in order to avoid getting blindsided on trades due to any impending change regulations (Bloomberg, 2014).

In recent days, some of these questions have been answered as the White House announced new rules aimed at curbing the onslaught of tax inversion deals. For companies that invert by way of merger, the Treasury Department has implemented an 80% limit for ownership of the combined corporation by U.S. shareholders. Above this 80% threshold a company is still considered domestic by the tax authority. Given that Burger King owns approximately 51% of the combined stock, this deal is well within limits set by the Treasury Department. Nonetheless, legislation is being considered which would reduce the threshold from 80% to 50%. The administration is also focusing on combating a variety of techniques that companies can use to circumvent the current requirements.

What’s Really at Stake Due to Corporate Inversions
The U.S. Treasury already loses a lot when companies make foreign acquisitions, and it has contended with that. It has, however, shown no signs of relenting on the fight against overseas reincorporation of U.S. firms.

According to the Wall Street Journal, the U.S. might lose close to $20 billion a year if corporate inversions continue(Yahoo Finance, 2014). With at least 10 inversions yet to be finalized and more being negotiated, the Obama administration has dubbed these companies unpatriotic and is moving fast to tame the situation.

According to Jared Bernstein, it is unpatriotic the way these companies shed their American roots in order to take advantage of a tax cut overseas. However, it is acknowledged that there is some legitimacy that incentivizes a company to go abroad, given that the U.S. has a corporate tax code that is in some cases uncompetitive. He finds it especially disturbing when the companies involved generate earnings from federal programs such as Medicare.

Nonetheless, Burger King’s purchase of Tim Hortons appears to be driven by longer-term growth prospects rather than a simple beneficial tax strategy.