What is a tax inversion?

It involves a US company acquiring a foreign -based company and relocating its headquarters to where the company it has bought is incorporated.

The US company thus moves its domicile outsider the US, although typically its operations and management remain there.

It is called an “inversion” because the company outside the US is typically smaller - though is generally at least 25-30 per cent of the size of the acquirer.

Cutting the tax bill is a key motivation , as the deal can allow the acquiring company to dramatically reduce tax on earnings outside the US. For this to work, the company being merged with – effectively acquired – must be in a lower tax jurisdiction such as Ireland or the Netherlands.

The Pfizer/Allergan deal is being dubbed a “ super inversion” because of the size of the deal and the fact that Allergan - the Irish domiciled company being acquired - will hold 44 per cent of the total equity of the merged entity.The fact that the overseas-based company owns over 40 per cent means Pfizer will avoid a number of new rules brought in recently, aiming to stop US firms buying much smaller overseas competitors in these tax deals.

How does this work?

It is based on two key factors in the US tax code. The first is that the headline US rate of corporation tax, at 35 per cent, is among the highest among major economies. The second is that, unlike most countries, the US taxes its companies on worldwide earnings. Most countries levy corporate tax on profits earned in their jurisdiction. However the US levies companies on worldwide profits, though it does exempt foreign earnings when they are not repatriated to the US. After an inversion, a big US company still pays US tax on the profits earned in the US, but the tax paid on its non-US earnings can fall significantly.

Pfizer’s effective tax rates on its profits could fall from 25 per cent to below 20 per cent in the short term, once the Allergan deal is completed , and some analysts predict it could fall substantially further in the years ahead.

How does inversion lead to such big tax gains?

As well as the lower rate on income earned outside the US, inversions also allow companies to legally avoid tax via inter-company transactions. The most common is when the US arm borrows money from what is now its foreign parent and then sends large interest payments back overseas. This reduced profits declared in the US and increases the profits declared in the lower tax jurisdiction abroad. The US had been expected to crack down on this so called “earnings strippings” , but so far it hasn’t.

For shareholders of US companies, the inversion deal involves giving away some equity in the company in the hope that the resulting tax gains will more than make up for it.

Where does Ireland come in?

Rules introduced in recent years mean inversions no longer work with firms operating in tax havens such as the Caymans. However they are still legal with Ireland, which has a low tax 12.5 per cent regime rather than the “ no tax” regime as in many havens. Particularly in the pharma sector, deals with companies resident in Ireland have thus become popular, such as the takeover last year by Medtronic of Irish domiciled Covidien.

Why does the US allow this?

Good question. It has become an issue in the US presidential campaign – and there have been changes to tighten the rules over the years.

However the US corporate lobby is strong and threats over the years to change the system have generally been watered down or forgotten.