Firms That Incorporate Abroad for Tax Purposes: Corporate "Inversions" and "Expatriation"
Firms That Incorporate Abroad for Tax Purposes:
Corporate “Inversions” and “Expatriation”
Updated March 11, 2008
Donald J. Marples
Specialist in Public Finance
Government and Finance Division
Firms That Incorporate Abroad for Tax Purposes:
Corporate “Inversions” and “Expatriation”
Over the past several years, reports indicate that an increasing number of U.S.
firms have altered their structure by substituting a foreign parent corporation for a
domestic one. Such “inversions” typically involve the creation of a new foreign
corporation in a country with low tax rates (a “tax haven”) that becomes the parent
of the firm’s foreign and U.S. component corporations. A chief motive for inversions
is apparently savings by firms on their U.S. corporate income tax. One source of
savings is tax on a firm’s foreign income: the United States taxes corporations
chartered in the United States on both U.S. and foreign income but taxes foreign-
chartered corporations only on their U.S.-source income. An inversion can thus
potentially reduce a firm’s U.S. taxes on foreign income. Other tax savings
apparently result from “earnings stripping,” or the shifting of U.S.-source income
from taxable U.S. components of the firm to the tax-exempt foreign parts.
In the long run, inversions may be accompanied by some increased level of U.S.
investment abroad; a firm that inverts reduces its tax burden on foreign investment.
However, any such shift may be small, and the recent corporate inversions do not
appear to be accompanied by substantive shifts of economic activity from the United
States. This leaves the impact of inversions on tax revenues as probably the leading
near-term economic effect. As a consequence, one policy issue inversions present
is that of tax equity: unless offset by spending cuts or larger budget deficits, the lost
revenue is made up with higher taxes on other U.S. taxpayers. Several bills
introduced in the 108th Congress appear to have had the revenue losses and tax equity
as their primary concern, and tax legislation aimed at restricting inversions was
included in the American Jobs Creation Act of 2004 (P.L. 108-357), an omnibus tax
bill addressing business and international tax issues. In 2006, additional tax
restrictions were proposed in the Senate-passed version of the Tax Increase
Prevention and Reconciliation Act (TIPRA; P.L. 109-222) but were not contained in
the final act. There are indications that the 110th Congress may look to the corporate
income tax as an area where revenue-raising measures might be found to offset tax
cuts provided elsewhere. In March 2007, the Senate passed a tax package that
included inversion provisions as part of H.R. 1591, a supplemental appropriations
bill. However, the measure was not included in the conference agreement on the bill.
Some have viewed inversions as symptomatic of a burden they believe the U.S.
tax system places on the international competitiveness of U.S. firms. A May 2002
U.S. Treasury report saw inversions as just one result of competitive problems posed
by U.S. taxes and called for a more general reexamination of the U.S. international
tax system. The report’s near-term recommendations for more stringent tax rules are
confined to changes aimed at protecting the domestic tax base rather than U.S. tax
revenue from foreign income. Recent policy discussions of the U.S. international tax
system have included calls by some for adoption of a “territorial” tax system, under
which U.S. taxes would no longer apply to foreign-source income. Inversions can
be viewed in this larger context; they have been described as “do-it-yourself”
territoriality and present many of the same policy issues. This report will be updated
as events in Congress and elsewhere occur.
In troduction ......................................................1
How Inversions Generate Tax Savings.................................3
Anatomy of an Inversion........................................3
The Basic Structure of U.S. International Taxation....................4
U.S. Tax Consequences of Inversions..............................5
Economic Effects of Inversions.......................................7
Investment and “Competitiveness”................................8
Alternative Policy Responses and Proposals.............................9
The House and Senate ETI Bills.............................10
The American Jobs Creation Act (AJCA; P.L. 108-357)..........11
2006 Budget Reconciliation Legislation (H.R. 4297).............12
2007 Senate Small Business Tax Bill.........................12
The May 2002 Treasury Report..................................13
Firms That Incorporate Abroad for
Tax Purposes: Corporate “Inversions”
News reports and articles in professional tax journals over the past several years
have drawn the attention of policymakers and the public to a phenomenon sometimes
called corporate “inversions” or “expatriations”: instances where firms that consist
of multiple corporations reorganize their structure so that the “parent” element of the
group is a foreign corporation rather than a corporation chartered in the United
States. A May 2002 study by the U.S. Treasury Department concluded that while
inversions are not new — the statutory framework making them possible has long
been in existence — there has been a “marked increase” in their frequency, size, and
visibility.2 A comprehensive list of firms that have inverted has not been compiled.
Some of the more high-profile inversions, however, include Ingersoll-Rand, Tyco,
the PXRE Group, Foster Wheeler, Nabors Industries, Coopers Industries, and Stanley
Works. (Stanley Works, however, subsequently announced that it would not
undertake its planned reorganization.) According to the U.S. Treasury Department,
the transactions are increasing in size, scope, and frequency.3
Firms engaged in the inversions cite a number of reasons for undertaking them,
including creating greater “operational flexibility,” improved cash management, and
an enhanced ability to access international capital markets.4 Prominent, if not
primary, however, is the role of taxes: each of the firms in the above list expects
significant tax savings from its reorganization.
The tax structure that permits tax savings through inversions has long been a
part of the U.S. tax system. The question then arises: why now? One plausible
explanation is the decline in the stock market that followed the bull market of the
1990s. As described in more detail below, an inversion is accompanied by a required
payment of tax by individual shareholders on capital gains. The capital gains tax may
1 This report was originally written by David L. Brumbaugh, Specialist in Public Finance.
2 U.S. Department of the Treasury, Office of Tax Policy, Corporate Inversion Transactions:
Tax Policy Implications (Washington: May, 2002), p. 1.
3 BNA Daily Tax Report, May 13, 2002, p. G-10.
4 These reasons are cited by Stanley Works in a February 8, 2002, press release. See also
the November 2, 2001 proxy statement by Ingersoll-Rand, which cites “a variety of potential
business, financial and strategic benefits.” The statement is available on the IR website at
[ h t t p : / / www.s h a r e hol de r . c o m/ i r / e dga r .c f m? Pa ge = 2] .
thus serve as a brake on inversions. Lower stock prices, however, may mean that
capital gains are smaller and capital gains taxes less onerous. Another suggestion has
been that increased globalization of markets has exposed U.S. firms to more
competitive pressures, leading them to more avidly pursue tax-saving strategies. And
yet another reason is simply momentum: firms may have been reluctant to
incorporate abroad for fear of public relations damage. Once several firms undertook
reorganizations, the damage potential may have been perceived to have fallen, and
other firms followed.5
The corporate inversions apparently involve little, if any, shifts in actual
economic activity from the United States abroad, at least in the near term. (See,
however, the section below on “Policy Issues” for a discussion of possible long-run
effects.) Bermuda and the Cayman Islands are the location of many of the newly
created parent corporations — jurisdictions that have no corporate income tax but
that do have highly developed legal, institutional, and communications
infrastructures. But the actual headquarters of inverted firms typically remain in the
United States, and an inversion does not apparently involve the outflow of capital
from the United States abroad or the shifting of corporate jobs to foreign locations.
Instead, the chief near-term economic impact of inversions is on U.S. federal tax
revenues, which are reduced by the reorganizations, and concern has been expressed
about the potential erosion of the U.S. corporate tax base.6 This has also led some
to draw conclusions about their impact on tax equity: unless federal spending is cut
or the deficit is increased, the reduction in tax revenue must be made up by tax
increases on other taxpayers.7 Some policymakers have sought a remedy within the
existing U.S. system for taxing international transactions. As discussed below in the
section on alternative policy responses and proposals, the 107th and 108th Congresses
have considered a variety of proposals aimed at stemming the growth of inversions.
The proposals range from re-imposing U.S. taxes in a manner that would undo the
5 For an analysis of the reasons firms undertake inversions, see Mihir A. Desai and James
R. Hines, Jr., “Expectations and Expatriations: Tracing the Causes and Consequences of
Corporate Inversions,” National Tax Journal, vol. 55, September 2002, pp. 409-439.
6 One commentator maintains that they may result in a “significant” erosion in the corporate
income tax base, and terms them “the most significant policy question the Congress and the
U.S. Treasury Department face regarding the federal corporate income tax.” Samuel C.
Thompson, Jr., “Section 367: A ‘Wimp’ for Inversions and a ‘Bully’ for Real Cross-Border
Acquisitions,” Tax Notes, vol. 94, March 18, 2002, p. 1506. Another analyst, however,
maintains that “corporate inversions are not a threat to the U.S. tax system.” Willard B.
Taylor, “Corporate Expatriation — Why Not?”, Taxes, vol. 78, March 2002, pp. 146-152.
The U.S. Treasury Department has expressed concern over tax-base erosion, but only in
connection with the ability of inverted firms to shift U.S.-source income to the foreign
parent corporation. U.S. Department of the Treasury, Office of Tax Policy, Corporate
Inversion Transactions: Tax Policy Implications, May 2002, p. 2. Available online at
[ h t t p : / / www.treas.gov/ p r e ss/ r e l eases/ docs/ i n ve r s i on.pdf ?IMAGE.X =33\&IMAGE.Y=12] .
7 For example, columnist Robert Trigaux of the St. Petersburg Times compares the tax
savings by inverting firms with liabilities of individual taxpayers, and asks: “If more
companies head offshore, guess who’s going to be stuck with the bills?” Robert Trigaux,
“Maybe Evading Taxes Isn’t Such a Great Idea,” St. Petersburg Times, March 10, 2002, p.
effect of the inversion to more incremental approaches, such as denying the
applicability of foreign tax credits and net operating losses to one-time U.S. “toll”
taxes that may be triggered by an inversion. The latter, more incremental approach
was taken by the enacted version of the American Jobs Creation Act of 2004 (P.L.
Others view inversions as symptomatic of more general problems with the U.S.
tax system that have become evident as the world economy has become more
integrated. Rather than disallowing inversions, they recommend a more general
reevaluation of the tax code “that drives them to do such a thing.”8 The U.S.
Treasury Department views inversions as evidence of competitive problems with the
U.S. tax system. The Administration initiated a study of inversions in February, 2002
and issued a preliminary report in May 2002. The report stated that a near-term
response to inversions should ensure that inversions “cannot be used to reduce
inappropriately the U.S. tax on income from U.S. operations”, and thus makes
several proposals designed to protect U.S. tax revenues generated by U.S. income.9
In keeping with its concern for competitiveness, however, the report does not propose
more stringent rules for foreign-source income and calls for a reexamination of the
U.S. international tax system.
Inversions have thus been discussed in terms of tax equity and competitiveness.
A more detailed look at their implications for the U.S. tax system in general is
presented below in the section entitled “Policy Issues.” First, however, it is useful
to look at the mechanics of inversions and how they generate tax savings.
How Inversions Generate Tax Savings
Anatomy of an Inversion
Although each corporate inversion has unique features, a common
reorganization is apparently a “triangular” stock transaction merger, where a new
foreign corporation is created that is chartered in a foreign country with low tax rates.
The new foreign entity creates a U.S.-chartered “merger subsidiary,” owned by the
new foreign corporation. The U.S. parent corporation is then merged into the
domestic merger subsidiary and becomes a subsidiary of the new foreign parent. For
stockholders of the U.S. corporation — for example, individuals, institutional
investors, and other firms — shares of the old U.S. parent automatically becomes
shares of the new foreign parent.10 Other forms of inversions are “asset transfers,”
where the domestic parent transfers its assets to a newly created foreign corporation,
8 House Ways and Means Committee Chairman William Thomas, as quoted in BNA Daily
Tax Report, April 16, 2002, p. G-7.
9 U.S. Department of the Treasury, Office of Tax Policy, Corporate Inversion Transactions:
Tax Policy Implications, May, 2002, p. 30.
10 This is the form taken by the recent Ingersoll-Rand inversion. See Lee A. Sheppard,
“Ingersoll-Rand’s Permanent Holiday,” Tax Notes International, January 14, 2002, pp. 107-
and “drop-down” transactions, where the domestic parent transfers its assets to a
foreign corporation, but the foreign corporation transfers some of those assets to a
The Basic Structure of U.S. International Taxation
To see how inversions such as these generate tax savings, it is useful first to
look at the general structure of the U.S. international tax system. In the international
context, the United States bases its tax jurisdiction on residence: it taxes corporations
chartered in the 50 states or the District of Columbia on their worldwide income,
foreign as well as domestic. At the same time, the United States generally exempts
corporations chartered in foreign countries from U.S. tax on their foreign-source
Under the residence system, a firm’s U.S. tax on foreign income depends on
how the firm’s foreign operations are organized, and a result of the system is a
feature known as the “deferral principle,” or simply “deferral.” Under deferral,
income that a U.S.-chartered corporation earns directly through a branch that is not
separately incorporated is generally taxed by the United States on a current basis
since the income is earned by a U.S. “resident.” In contrast, foreign income earned
through a separate foreign subsidiary corporation is generally not subject to U.S. tax
until it is remitted to the U.S. parent corporation as dividends or other income: it is
tax-deferred. Because of discounting,13 this deferral confers a tax benefit on income
earned in foreign countries with relatively low tax rates.
The system has several additional complicating features. One is the U.S. foreign
tax credit, which is designed to alleviate double-taxation where foreign countries tax
U.S. firms’ foreign income. Under its provisions, the United States permits its
taxpayers to credit foreign taxes they or their foreign subsidiaries pay against U.S.
taxes they would otherwise owe. The foreign tax credit is generally limited to
offsetting U.S. tax on foreign and not domestic income, but if a firm pays sufficient
foreign taxes, it may use the credit to eliminate its entire U.S. tax liability on foreign-
source income, whether U.S. pre-credit taxes are deferred or apply on a current basis.
Another important feature is a set of “anti-deferral” regimes that limit the
availability of deferral in some cases. The broadest and most important of these is
the tax code’s Subpart F provisions that were enacted in 1962 as a means to limit the
concentration of passive-investment income by firms in tax havens. Under Subpart
F, U.S. parent firms can in some cases be taxed on particular types of subsidiary
11 For a more detailed description of these categories and specific examples of each, see
Willard B. Taylor, “Corporate Expatriation — Why Not?” Taxes, vol. 78, March 2002, pp.
12 U.S. taxes generally do apply, however, to a foreign corporation’s income from the
conduct of a U.S. trade or business and on certain investment income earned in the United
13 Discounting is the fundamental economic principle that a given increment of funds — say,
a dollar — is more valuable the sooner an economic actor has control of it. For a firm, this
is because the sooner a dollar is received, the sooner it can be invested and earn a return.
income, even if it is not repatriated to the U.S. parent firm. Subpart F, however, only
applies where a foreign subsidiary is controlled (more than 50%-owned) by those
U.S. stockholders who own large blocs (at least 10%) of the subsidiary’s stock. The
type of income subject to Subpart F is generally income from passive investment and
certain types of income whose source is thought to be easily manipulated.
A second anti-deferral regime is the passive foreign investment company, or
PFIC rules. In contrast to Subpart F, the PFIC provisions apply to foreign
corporations that invest intensively in passive-type assets, regardless of the degree
or concentration of U.S. ownership and even to income that is not itself from passive
investment. Although the PFIC rules permit a deferral of U.S. tax in some cases, the
rules apply an interest charge to the delayed tax payment, thus negating the benefit
Before explaining how an inversion within this U.S. tax structure generates tax
savings, we first note that foreign taxes are not irrelevant. Foreign countries
frequently tax corporations chartered within their borders — as does the United
States. Thus, whatever U.S. tax savings an inversion generates could be offset if the
country where the new parent corporation is chartered were not to have corporate tax
rates lower than those of the United States. Indeed, Bermuda and the Cayman Islands
have been a frequent destination for recent inversions, and neither imposes a
corporate income tax.14
U.S. Tax Consequences of Inversions
Given the U.S. tax structure, inversions potentially provide tax savings in two
general ways: by reducing U.S. tax on foreign source income; and by reducing U.S.
tax on U.S. income that is shifted outside the United States in “earnings stripping”
or similar transactions. Where they occur, these tax savings are ongoing but only
save taxes at the corporate level under the corporate income tax. Inversions can
potentially trigger a one-time tax on gain that is required to be recognized when an
inversion occurs; the capital gains tax can apply to individual stockholders or at the
corporate level. Further, inversions may be unable to generate tax savings to firms
whose foreign tax credits have eliminated U.S. tax on foreign income.
To see how these results occur, we look at the straightforward example of a firm
that is initially “uninverted”; the firm includes a U.S.-chartered parent corporation
that is publicly owned and traded on U.S. stock exchanges. The parent corporation
earns foreign income through foreign subsidiaries. Under current law, as long as a
firm has a dearth of foreign tax credits, at least some U.S. tax burden applies to the
firm’s foreign income. Some of the income may be taxed on a current basis either
through Subpart F or the PFIC provisions. And while other foreign income may be
tax-deferred, it is nonetheless ultimately taxed when it is repatriated. At the
14 As an illustration, Ingersoll-Rand reported to its shareholders that the firm’s payments to
Bermuda will be limited to a fixed annual fee whose current amount is $27,825. In
addition, Bermuda’s Minister of Finance has assured Ingersoll-Rand that even if Bermuda
enacts an income tax, it will not apply such a tax to Ingersoll-Rand until 2016. See the
proxy statement posted at [http://www.shareholder.com/ir/edgar.cfm?Page=2].
stockholder level, shareholders who are private individuals generally pay individual
income tax on dividends from the U.S. parent corporation and on capital gains when
the stock is sold. However, some shareholders may hold their stock in tax free
vehicles — for example, individual retirement accounts (IRAs) — while other
shareholders — for example pension funds — may be tax exempt.
Now, suppose the firm inverts, so that the both the former U.S. parent
corporation and the foreign subsidiaries become subsidiary to a new foreign parent
corporation. First, since the conglomerate’s foreign income is now earned by a
foreign-chartered corporation, U.S. corporate-level tax on the foreign income that
was either deferred or currently paid under the anti-deferral regimes is eliminated.
Thus, one source of tax saving is U.S. tax on foreign income.
Inverted firms may also employ earnings stripping to reduce U.S. tax on
domestic income. Earnings stripping shifts U.S.-source income from a U.S.
corporation to a foreign parent by means of transactions between the related parts of
the firm. While the transactions can take a variety of forms, a prototypical earnings
stripping transaction involves a foreign parent lending funds to a domestic subsidiary;
the subsidiary is able to deduct interest payments to its parent from its U.S. taxable
income, thereby reducing its U.S. tax liability. According to the Treasury report on
inversions, “a feature common to many inversions is the presence of substantial
indebtedness from the former U.S. group to the new foreign parent or one of its
foreign subsidiaries.”15 Foreign corporations are generally subject to a U.S.
“withholding tax” on U.S.-source interest received from related U.S. corporations;
the withholding tax rate is generally 30%. However, the withholding tax is in many
cases reduced or eliminated by tax-treaty provisions. Thus, if an earnings-stripping
transaction is structured so that interest payments are made to a related lender in a
treaty country, the tax can be avoided.
Provisions designed to limit earnings stripping by foreign firms investing in the
United States were enacted with the Omnibus Budget Reconciliation Act of 1989
(P.L. 101-239). The provisions deny deductions for interest payments to related
corporations, but apply only after a certain threshold of interest payments and level
of debt-finance is exceeded.16
As noted above, although inversions can generate ongoing tax savings at the
corporate level under the corporate income tax, they may generate taxes at the
shareholder level, under the individual income tax. One source of new taxes may be
capital gains: Section 367 of the tax code and Treasury regulations issued under that
section impose capital gains tax on transfers of stock by U.S. stockholders to foreign
corporations. Thus, for a shareholder of an inverted firm’s domestic parent, any
appreciation that occurred from the time of purchase to the time of the inversion is
15 U.S. Department of the Treasury, Office of Tax Policy, Corporate Inversion
Transactions: Tax Policy Implications, p. 22.
16 For further information on the earnings stripping provisions, see Aaron A. Rubenstein and
Todd Tuckner, “Financing U.S. Investments After the Revenue Reconciliation Act of 1993,”
Tax Adviser, vol. 25, February 1994, pp. 111-117.
generally subject to capital gains tax.17 The purpose of the provision is to prevent
capital gains from flowing out of U.S. tax jurisdiction without being subject to U.S.
tax at some point.18
The triggering of capital gains tax suggests a divergence of interests among an
inverting firm’s stockholders, with those of taxable shareholders differing from those
whose stock is not taxed (e.g., pension funds and those with holdings in IRAs).
Indeed, lawsuits were filed by some Ingersoll-Rand shareholders that sought to block
the firm’s inversion, although stockholders subsequently voted overwhelmingly to
approve the reorganization and the lawsuits were settled.19 For its part, Stanley
Works has pointed out that only 40% of its shares are in taxable accounts.20
The anti-deferral regimes may also be a factor at the shareholder level.
Inversions commonly result in stockholders at large owning the new foreign parent
corporation. Subpart F, with its thresholds requiring control and concentration of
ownership, are not likely to be a factor. The PFIC rules, however, may be more
likely to apply. If a foreign parent passes the PFIC passive-investment and income
thresholds, individual stockholders may be subject to the PFIC regime where they
previously were not.21
Economic Effects of Inversions
As noted above, the chief near-term economic effect of inversions is to reduce
U.S. tax revenue.22 If the U.S. government has a fixed revenue requirement,
17 For a detailed description of Section 367, see Vikram A. Gosain, “Working With the New
Section 367 Rules After the Final Regs. And TRA ‘97,” Journal of Taxation, vol. 87,
November 1997, pp. 310-314.
18 U.S. Congress, Joint Committee on Taxation, General Explanation of the Revenue
Provisions of the Deficit Reduction Act of 1984, joint committee print, 98th Cong., 2nd sess.
(Washington: GPO, 1984), p. 427.
19 Pamela Sebastian Ridge, “Economy Hinders Progress of Ingersoll-Rand Revamping,” The
Wall Street Journal, December 26, 2001, p. B3.
20 John M. Moran, “Stanley Tax Plan Could be Double-Edged Sword,” Hartford Courant,
February 9, 2002, p. E1.
21 In the Ingersoll-Rand (IR) reorganization, its domestic corporations received “class B”
non-voting stock amounting to 45% of the value of all the new Bermuda parent’s shares.
IR’s proxy statement states that IR does not expect its new Bermuda corporation to be
classified as a CFC. However, the statement mentions the possibility that the Internal
Revenue Service may classify the class B stock as voting stock, which could trigger the
application of Subpart F. The statement also states that IR does not expect the Bermuda
parent to be classified as a PFIC. The statement is available on the IR website at
[ h t t p : / / www.s h a r e hol de r . c o m/ i r / e dga r .c f m? Pa ge = 14] .
22 The Joint Committee on Taxation has estimated that H.R. 3884, a bill aimed at limiting
inversions’ revenue loss has implications for fairness: the lost revenue is made up by
higher taxes elsewhere, either on other corporations and businesses, or on individual
taxpayers. Equity is one of the chief grounds on which inversions’ critics have
Economic theory, however, points out that equity is a difficult concept to apply
in the case of the corporate income tax. To begin, corporations are not people but
agglomerations of stockholders, employees, creditors, and managers, each of whom
has his own particular income and wealth characteristics. It is therefore not very
informative to compare the tax burden of a corporation with that of an individual, no
matter how eye-catching the comparison may be. To make equity comparisons even
more difficult, the ultimate repository of the tax’s burden is difficult to determine
with any certainty. In the short run, the burden of corporate income tax (or the
benefit of its reduction, as with inversions) likely falls on the corporate stockholders.
In the long run, however, economic analysis suggests that market adjustments and
behavioral reactions to the tax result in its burden being spread beyond corporate
stockholders to all owners of capital. Thus, inversions may reduce the tax burden on
capital in general relative to the burden on labor income. And to the extent capital
income is associated with individuals with higher incomes, inversions may reduce
the progressivity of the tax system.
Investment and “Competitiveness”
In the short run, inversions probably have little impact on real economic activity.
Firms undertaking inversions have indicated that they are only changes in legal
structure and substantive headquarters functions will continue to be conducted in the
United States. At the same time, however, inversions do reduce the corporate tax
burden on foreign-source income relative to that on domestic income. An inverted
firm may face a lower overall tax rate on investment in low-tax countries than it does
on investment in the United States. As a consequence, a more long-run result may
be for inverted firms to shift some amount of investment and business operations
from the United States to locations where foreign income taxes are low.
What are the implications of this possible impact on investment flows? In
assessing the impact of taxes on investment, economic analysis focuses on economic
efficiency and, ultimately, on economic welfare. According to traditional economic
theory, taxes best promote economic efficiency when they are least distorting of
investment decisions; when taxes do not distort investment decisions, investment is
generally employed in its most productive location. As a consequence, economic
welfare is maximized. Economic theory also holds that taxes are least distorting of
the location of investment when the tax burden on investment is the same in every
location. In the international context, taxes do not distort investment location when
the tax burden on foreign source income is the same as that on domestic income. (In
tax parlance, a tax policy that promotes equal taxation of foreign and domestic
investment is a policy of “capital export neutrality.”) Since inversions reduce the tax
inversions, would increase federal tax revenues by $4 billion over 10 years. BNA Daily Tax
Report, June 3, 2002, p. G-1.
burden on foreign income compared to domestic income, their availability likely
nudges the U.S. tax system away from capital export neutrality with a corresponding
loss in economic efficiency and economic welfare.
But any loss in economic efficiency that may result from inversions is not likely
to be large, because features of the U.S. tax system that exist quite apart from
inversions already reduce the tax burden on foreign investment. The ability of firms
to defer U.S. tax on subsidiary earnings in low-tax countries reduces the tax burden
on foreign investment as do certain U.S. foreign tax credit rules. While inversions
likely do reduce the tax burden on foreign income by granting a permanent tax
exemption rather than just a deferral of tax, it is likely their incremental change in the
tax burden is not enormous.
While capital export neutrality is thought by economists to maximize world
economic welfare, business leaders and others have emphasized the importance of
taxes’ impact on U.S. competitiveness and the ability of U.S. firms to compete in
world markets. This analysis recommends a policy sometimes called “capital import
neutrality” under which the United States would not tax income from foreign
business operations, and would limit its tax jurisdiction to U.S.-source income. For
example, several European countries operate “territorial” tax systems that do not
apply home-country taxes to foreign income; it is argued that the United States
should likewise adopt a territorial system to place its firms on the same tax footing
as firms from territorial countries.
The availability of corporate inversions introduces an element of capital import
neutrality into the U.S. system. Supporters of capital import neutrality are likely to
view inversions in a more positive light than supporters of capital export neutrality;
capital import neutrality recommends an exemption for foreign income and
inversions accomplish that for inverted firms. And as noted above, some
policymakers have suggested that inversions may signal a need for tax changes that
would make the U.S. tax system more “competitive.”
Alternative Policy Responses and Proposals
Proposed policy responses to inversions vary widely, depending on what is
viewed as their chief threat. For example, those that are chiefly concerned about the
revenue and tax equity results of inversions make little distinction between
inversions’ loss of tax revenue from U.S. source-income, on the one hand, and
foreign-source income, on the other. Their proposals seek to re-impose U.S. taxes
on firms when inversions occur. In contrast, others view inversions as symptomatic
of a competitive burden imposed by the U.S. tax system, and have suggested more
general reforms of the U.S. method of taxing foreign-source income may be in order.
The 2002 Treasury Department report, for example, recommended more stringent
treatment of U.S.-, but not foreign-source income — for example, more effective
measures of limiting earnings-stripping — and called for a general reexamination of
the U.S. system of taxing foreign income.
The House and Senate ETI Bills. A number of bills were introduced in theth
108 Congress that addressed inversions. Prominent among these were two broad
business tax bills passed in 2004 by the Senate and House — S. 1637 and H.R. 4520,
respectively — that had as a primary focus the controversy over the U.S.
extraterritorial income exclusion (ETI) tax benefit for exporting. Both bills proposed
to repeal the ETI benefit and proposed a variety of tax cuts both for domestic and
overseas investment. The bills contained many overlapping provisions but also
contained differences, including some in the area of inversions. The differences
between the bills were resolved in October by a conference committee, and the
conference committee version of H.R. 4520 was enacted as the American Jobs
Creation Act of 2004 (P.L. 108-357).
S. 1637 (Senator Grassley) was approved by the Senate Finance Committee on
October 1, 2003, and included several inversion-related provisions among a variety
of revenue-raising proposals designed to offset the cost of the bill’s investment tax23
benefits. S. 1637 proposed to impose two new tax regimes on inversions,
depending on ownership thresholds and on when the inversions occurred. Under the
first regime, S. 1637 would have taxed a foreign parent corporation like a domestic
corporation if it passed a continuity-of-ownership threshold, thus nullifying much of
the tax benefit an inversion can generate. The test would be met if at least 80% of
the foreign corporation is owned by the former shareholders of a domestic
corporation or partnership that had transferred substantially all of its property to the
foreign parent. The threshold also required the foreign parent and its affiliates not
have “substantial business activities” in the country of incorporation, and applied
only to inversions that occur after March 20, 2002.
S. 1637’s second regime was based on a 50% ownership test and would
potentially have applied whether the inversion occured before or after March 20,
2002. (The second set of rules would not apply, however, to post-March 20
inversions subject to the bill’s first regime.) The second regime would act as a type
of toll tax on the shifting of the firm’s foreign subsidiaries from the former U.S.
parent to the new foreign parent. The tax would apply the highest corporate tax rate
(or the highest individual tax rate, in the case of partnerships) to stock received by
the former domestic parent from the new foreign parent in exchange for ownership
of the firm’s foreign subsidiary corporations. Neither foreign tax credits nor net
operating losses would be permitted to offset the tax.
An additional provision of S. 1637 proposed to impose an excise tax on stock
options related to inversions, thus addressing an area in which the interests of
corporate officers with respect to inversions might diverge from those of
stockholders. (See the discussion of capital gains taxes at the shareholder level,
above on pages 6-7.) Under the provision, officers, directors, and 10% owners of
23 The inversion proposals were similar to those contained in the Senate-passed version of
the May, 2003 tax-cut bill (JGTRRA, the Jobs and Growth Tax Relief and Reconciliation
Act; P.L. 108-27), but which were not included in the conference committee bill.
inverted firms would be subject to a 20% excise tax on compensation that is directly
linked to the value of an inverting corporation’s stock. Such compensation would
include stock, certain stock options (generally nonqualified stock options), and other
stock-based compensation. For stock options, the tax would apply to the value of the
option at the time of the inversion, determined by an option-pricing model specified
by the Treasury Department. The excise tax would apply, however, only when the
inversion in question triggers recognition of shareholder-level capital gains. The bill
also contained provisions that would extend current law’s earnings-stripping
restrictions on the deductibility of interest paid to related corporations (see pages 5-6,
above) to partnerships and S corporations. The restrictions currently apply only to
According to estimates by the Joint Committee on Taxation, S. 1637’s inversion
provisions would have increased tax revenue by $2.6 billion over 10 years.
The House passed H.R. 4520 (Representative Thomas) on June 17, 2004. Like
S. 1637, H.R. 4520 included more stringent treatment of inversions in conjunction
with a broad set of unrelated provisions that would repeal ETI while enacting other
investment tax benefits. The House bill’s inversion provisions, however, were
generally narrower than those of the Senate bill. (Note however, that a temporary
inversion provision comparable in scope to that of S. 1637 was included in H.R. 6,
the House-passed energy bill, as described below.) Under current law, the transfer
of foreign subsidiaries or other assets from a U.S. parent corporation to a new foreign
parent corporation may give rise to corporate-level tax (sometimes referred to as
“toll charges”) under several different tax code provisions. However, “tax attributes”
such as foreign tax credits or net operating losses (if available) may offset the tax.
H.R. 4520 proposed to deny the applicability of tax attributes in the case of
Like the Senate bill, the House bill contained a provision that applied an excise
tax on stock options related to inverted corporations. The applicable rate of the tax,
however, would be 15% rather the 20% rate imposed by S. 1637.
Unlike S. 1637, the House-passed bill did not contain restrictions on interest
deductions aimed at limiting earnings stripping. In this respect, it is distinct from the
2003 Ways and Means Committee bill (H.R. 2896), which did contain earnings
According to Joint Committee on Taxation estimates, the House bill’s inversion
and earnings stripping provisions would together increase tax revenue by an
estimated $488 million over fiscal years (FY) 2004-2014.
The American Jobs Creation Act (AJCA; P.L. 108-357). Like the
Senate bill, the conference agreement on H.R. 4520 adopted two alternative tax
regimes applicable to inversions; which one applies depends on continuity-of-
ownership thresholds. The new rules applied to inversions occurring after March 4,
2003. The new law provides that when a new foreign parent is at least 80% owned
by the former parent’s stockholders, the new law treats the foreign parent as a
domestic corporation, thus generally denying to the firm the tax benefits of the
inversion. The second regime applies when there is at least 60% continuity of
ownership but less than 80%. In the latter case, the new foreign parent is not taxed
like a domestic corporation, but (in a manner similar to the House bill) any toll taxes
that apply to transfers of assets to the new entity are not permitted to be offset by
foreign tax credits or net operating losses.
The conference agreement provides an excise tax on stock options, as did both
the House and Senate bills. The rate of the tax, however, will be the maximum
capital gains tax rate for an individual: 15% through 2008 and 20% thereafter.
According to JCT estimates, the conference agreement’s inversion provisions
will increase tax revenue by $937 million over 10 years.
Contracting Restrictions. Several bills not directly pertaining to taxes have
contained anti-inversion provisions. In the 107th Congress, Section 835 of the
Homeland Security Act (P.L. 107-296) contained restrictions on the agency’s
contracting with inverted corporations. The measure that was approved contained
broader waiver conditions than those in the earlier House or Senate bills and
provided that the prohibition can be waived in the interests of homeland security, to
prevent the loss of jobs, or to prevent the government from incurring higher costs.
In the 108th Congress, the Senate returned to the procurement restrictions issue.
On January 23, 2003, the Senate approved an omnibus appropriations bill (H.J.Res.
2) that would tighten the enacted waiver conditions by making a waiver of the
contracting restrictions possible only if the Secretary of Homeland Security certifies
that it is essential to national security. The provision was included in section 101 of
division L of the conference committee version of the bill that became P.L. 108-7.
2006 Budget Reconciliation Legislation (H.R. 4297). Additional tax
legislation aimed at restricting inversions was included as one of several revenue-
raising “offsets” in the version of budget reconciliation legislation passed by the
Senate in November, 2005. The proposal would have applied restrictions to
inversions occurring after March 20, 2002, rather than those occurring after March
threshold that applies to AJCA’s second inversion regime to a 50% continuity-of-
ownership threshold, thus expanding the scope of AJCA’s restrictions. The proposal
would also have tightened the tax code’s earnings-stripping restrictions (see above)
in the case of inverting firms. The Senate proposal was not contained in the final
version of reconciliation legislation enacted in May 2006 (Tax Increase Prevention
and Reconciliation Act; P.L. 109-222).
2007 Senate Small Business Tax Bill. On January 17, 2007, the Senate
Finance Committee approved S. 349, containing a package of tax benefits for small
business along with a set of revenue-raising measures designed to offset part of the
tax benefits’ revenue loss. The bill included expanded restrictions on inversions, a
scaled-back version of the 2005 proposals described above, as one of the revenue-
raisers. The provisions were subsequently included in H.R. 2, the minimum wage
bill passed by the full Senate in February, and in H.R. 1591, the supplemental
appropriations bill approved by the Senate in March. The inversion measure was not,
however, included in the conference agreement reached on H.R. 1591, nor was it in
the small business tax package that Congress ultimately passed as H.R. 2206 (P.L.
The Senate inversion provision generally applied a part of AJCA’s anti-
inversion regime, which are the provisions applicable to firms meeting the 80%-or-
greater test, to inversions occurring up to (approximately) a year earlier than the
effective date specified by AJCA. As described above, AJCA’s provisions apply to
inversions occurring after March 4, 2003. With some modifications, the Senate
measure also applied the AJCA provisions to inversions occurring after March 20,
2002. The modifications were apparently designed to limit the retroactivity of the
expanded date. Under their terms, the tax regime that AJCA applied to 80%
inversions — treatment of the new offshore parent as a domestic corporation — do
not apply until the first year after tax years beginning in 2006.
An approach to inversions that is similar to those contained in the legislative
proposals would modify the “anti-deferral” regimes contained in subpart F or the
PFIC provisions. These proposals have not, however, been introduced as legislation.
As with the legislative proposals, these suggestions would identify reorganizations
that qualify as inversions and apply their tax rules in such situations. The subpart F
or PFIC rules would be modified so that the stockholders of foreign-chartered
inverted parent corporations would be subject to U.S. tax on at least some of its
In contrast to the proposals that would apply only when inversions occur,
another suggested approach would modify the tax code’s concept of residence. Such
an approach would be more fundamental, and might be viewed as treating the cause
rather than the symptoms. One analyst has pointed out that the residence test applied
by the British tax system looks beyond the place of incorporation and generally
establishes a firm’s residence as the country from which the firm is centrally
managed and controlled. Such a system would appear to avoid some potential
administrative problems inherent in attempting to identify inversions by means of
thresholds, as do the legislative proposals. On the other hand, the British system has
apparently encountered difficulties in identifying the substantive location of
management and control: control can in some cases be established in tax havens
simply by conducting pro forma board meetings there.25
The May 2002 Treasury Report
The Treasury Department’s May 2002 report voiced three principal concerns:
that the earnings-stripping opportunities from inversion may erode the part of the
24 Samuel C. Thompson, Jr., “Section 367: A ‘Wimp’ for Inversions and a ‘Bully’ for Real
Cross-Border Acquisitions,” Tax Notes, vol. 94, March 18, 2002, p. 1506; and Jim Ditkoff,
“Closing the Bermuda Loophole: An Easier Approach Than the REPO Bill,” BNA Daily
Tax Report, April 26, 2002, p. J-1.
25 For a discussion of the British system and how it compares to U.S. legislative proposals,
see Lee A. Sheppard, “Preventing Corporate Inversions,” pp. 10-11.
U.S. tax base consisting of U.S.-source income; that the current tax system may give
foreign-controlled firms a competitive advantage; and that inversions “reduce
confidence in the fairness of the tax system.”26
The Treasury Department report noted that earnings stripping is not confined to
inversions, but can occur within foreign-controlled groups in general. The report’s
concern with the practice was reflected in a number of proposals aimed at restraining
the practice. As described above, the tax code already places limitations on interest
deductions when certain thresholds are exceeded; the Treasury concluded that “the
prevalent use of foreign related-party debt in inversion transactions is evidence that
these rules should be revisited.” The report listed a number of specific ways the rules
could be tightened.27 The report also suggested that “further work is needed” in
income-shifting areas apart from related-party debt, specifically, the tax system’s
transfer pricing rules in the area of intangible assets.28
As with earnings stripping, the Treasury report’s concern for competitiveness
was broader than just inversions. The report viewed inversions as being one aspect
of a more general result of the U.S. tax system. The report’s analysis concluded that
the U.S. system places U.S.-controlled and headquartered firms in general at a
disadvantage relative to foreign-controlled firms, a disadvantage that is believed to
occur because the United States taxes the worldwide income of its corporations while
some foreign countries use “territorial” systems that exempt foreign income.29 The
report viewed not only inversions, but a growing number of acquisitions of U.S.
firms by foreign companies as possible symptoms of the disadvantage.30
As a result of its concern for competitiveness, the Treasury report stopped short
of proposals that would negate the tax savings on foreign-source as well as domestic-
source income, a contrast with bills listed above. Instead, the report stated:
the policy response to the recent corporate inversion activity should be broad
enough to address the underlying differences in the tax treatment of U.S.-based
companies and foreign-based-companies, without regard to how foreign-based
status is achieved. Measures designed simply to halt inversion activity may
address these transactions in the short run, but there is a serious risk that
measures targeted too narrowly would have the unintended effect of encouraging
a shift to other forms of transactions to the detriment of the U.S. economy in the31
26 U.S. Department of the Treasury, Office of Tax Policy, Corporate Inversion
Transactions: Tax Policy Implications, May 2002, p. 21.
27 Ibid., pp. 21-25.
28 Ibid., p. 26.
29 Two examples of countries with “territorial” systems are France and the Netherlands.
30 Ibid., p. 19.
31 Ibid., p. 2.
As a more general response, the report recommended evaluating the merits of
exempting foreign-source business income and re-evaluating the usefulness of the
anti-deferral regimes and limitations on the foreign tax credit.32
The report was generally confined to describing the current legal framework and
presenting policy options; it does not present a rigorous economic analysis of
inversions or the broader impact of U.S. taxes in the international context. With its
focus, however, on protecting the domestic rather than foreign U.S. tax base and its
concern with competitiveness, the report’s perspective appeared more closely akin
to the capital import neutrality perspective described above.
The apparent recent increase in corporate inversions has aroused concern in its
own right. The spectacle of U.S. corporations engaging in “expatriation” in a tax-
saving technique not available to most individual taxpayers may, in the words of the
Treasury Department, “reduce confidence in the fairness of the tax system.” But
inversions can be viewed in a broader context. Recent tax policy debate has tended
to focus on the international economy, sparked in part by the European Union’s
successful challenge of the U.S. Foreign Sales Corporation export tax benefit, and
in part by the perceived new challenges posed by an increasingly integrated world
economy. Some observers and policymakers have suggested that the time is right to
consider fundamental reform of the U.S. tax system; one approach might be to adopt
a territorial tax system under which the United States would exempt foreign business
income from tax.
Inversions present many of the same policy issues as would be presented by
adoption of a territorial system. The end result of an inversion, after all, is the33
exemption from U.S. tax of a firm’s foreign income. Accordingly, the debate over
the respective merits of capital import neutrality and capital export neutrality occur
in much the same manner over inversions as they occur in a debate over territoriality.
And the administrative problems inversions present in protecting the U.S. domestic
tax base — the problems presented by earnings stripping and income shifting
transactions — would be presented by a territorial tax system. Thus, if the question
of adopting a territorial tax system moves to the fore of the tax policy debate, the
debate over inversions may have provided a preview.
32 Ibid., p. 29.
33 However, an inversion exempts all foreign income from U.S. tax, including income from
passive investment. Some territorial tax proposals would only exempt income from active