Order Code RL31444
Report for Congress
Received through the CRS Web
Firms That Incorporate Abroad for Tax Purposes:
Corporate “Inversions” and “Expatriation”
Updated January 30, 2003
David L. Brumbaugh
Specialist in Public Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Firms That Incorporate Abroad for Tax Purposes:
Corporate “Inversions” and “Expatriation”
Summary
Recent 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 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.
corporations. A chief motive for inversions is apparently taxes: the inversions can
save firms substantial amounts of corporate-level U.S. income taxes. One source of
tax savings is U.S. 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. By locating
its parent firm in a low-tax foreign country, an inverting firm can avoid U.S. taxes.
An additional source of tax saving is apparently “earnings stripping,” or the shifting
of U.S.-source income from taxable U.S. components of the firm to the tax-exempt
foreign parts by means of tax-deductible interest payments.
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 new 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 to locations offshore. 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 107th Congress appear
to have the revenue losses and tax equity as their primary concern and generally
would re-impose U.S. taxes when inversions occur. The Homeland Security Act
passed in November 2002, included a provision preventing the new Homeland
Security Department from contracting with “inverted” corporations. However, the
bill contains relatively broad conditions under which the prohibition can be waived.
Inversions have been viewed by some as symptomatic of a burden they believe
the U.S. tax system places on the competitive position of U.S. firms in the global
marketplace. A May 2002 report issued by the U.S. Treasury Department sees
inversions as just one result of competitive problems posed by U.S. taxes.
Accordingly, that report calls for a more general reexamination of the U.S.
international tax system, with an eye towards competitiveness. 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 not
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. Indeed, 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 in certain respects. This report will be updated as events in
Congress and elsewhere occur.

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
How Inversions Generate Tax Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Anatomy of an Inversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
The Basic Structure of U.S. International Taxation . . . . . . . . . . . . . . . . . . . . 3
U.S. Tax Consequences of Inversions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Economic Effects of Inversions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Tax Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Investment and “Competitiveness” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Alternative Policy Responses and Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Congressional Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Other Approaches . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
The May 2002 Treasury Report . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

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Firms That Incorporate Abroad for
Tax Purposes: Corporate “Inversions”
and “Expatriation”
Introduction

Recent news reports and articles in professional tax journals have drawn the
attention of policymakers and the public to a phenomenon sometimes called
corporate “inversions” or “expatriation” – 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. According to press reports, reorganizations that have recently occurred or
have been planned include those of Ingersoll-Rand, Tyco, the PXRE Group, Foster
Wheeler, Nabors Industries, Coopers Industries, and Stanley Works. (Stanley Works,
however, announced on August 1 that it would not undertake its planned
reorganization.) According to the U.S. Treasury Department, the transactions are
increasing in size, scope, and frequency.1
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.2 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? A rigorous study
has not been conducted, but several suggested reasons have been offered. One
plausible reason is the recent decline in the stock market. As described in more detail
below, an inversion is accompanied by a required payment of tax on capital gains;
lower stock prices 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.
1 BNA Daily Tax Report, May 13, 2002, p. G-10.
2 These reasons are cited by Stanley Works in a February 8, 2002 press release. The release
is available at the firm’s website at [http://www.stanleyworks.com/index.htm]. 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:
[http://www.ingersoll-rand.com/proxy.pdf].

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Once several firms undertook reorganizations, the damage potential may have been
perceived to have fallen, and other firms followed.
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
which do have a 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.3 This has 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.4 Some policymakers have sought a remedy in incremental
changes to the U.S. system for taxing international transactions. As discussed below
in the section on alternative policy responses and proposals, a set of bills introduced
in the 107th Congress would seek to stem inversions by re-imposing U.S. taxes when
they occur.
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.”5 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
3 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, Mar. 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, Mar. 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
[http://www.treas.gov/press/releases/docs/inversion.pdf?IMAGE.X=33\&IMAGE.Y=12].
4 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, Mar. 10, 2002, p.
1H.
5 House Ways and Means Committee Chairman William Thomas, as quoted in BNA Daily
Tax Report, Apr. 16, 2002, p. G-7.

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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.6
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.7 Other forms of inversions are “asset transfers,”
where the domestic parent transfers its assets to a newly created foreign corporation,
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
domestic subsidiary.8
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
6 U.S. Department of the Treasury, Office of Tax Policy, Corporate Inversion
Transactions: Tax Policy Implications, May, 2002, p. 30.
7 This is the form taken by the recent Ingersoll-Rand inversion. See: Lee A. Sheppard,
“Ingersoll-Rand’s Permanent Holiday,” Tax Notes International, Jan. 14, 2002, pp. 107-111.
8 For a more detailed description of these categories and specific examples of each, see:
Willard B. Taylor, “Corporate Expatriation – Why Not?”, Taxes, vol. 78, Mar. 2002, pp.
146-152.

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corporations chartered in foreign countries from U.S. tax on their foreign-source
income.9
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,10 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
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
of deferral.
9 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 States.
10 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.

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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.11
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
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.
11 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.ingersoll-rand.com/proxy.pdf].

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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.”12 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.13
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
generally subject to capital gains tax.14 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.15
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
12 U.S. Department of the Treasury, Office of Tax Policy, Corporate Inversion
Transactions: Tax Policy Implications, p. 22.
13 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, Feb., 1994, pp. 111-117.
14 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, Nov.
1997, pp. 310-314.
15 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.

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the firm’s inversion, although stockholders subsequently voted overwhelmingly to
approve the reorganization and the lawsuits were settled.16 For its part, Stanley
Works has pointed out that only 40% of its shares are in taxable accounts.17
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.18
Economic Effects of Inversions

Tax Equity
As noted above, the chief near-term economic effect of inversions is to reduce
U.S. tax revenue.19 If the U.S. government has a fixed revenue requirement,
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
assailed them.
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
16 Pamela Sebastian Ridge, “Economy Hinders Progress of Ingersoll-Rand Revamping,” The
Wall Street Journal, Dec. 26, 2001, p. B3.
17 John M. Moran, “Stanley Tax Plan Could be Double-Edged Sword,” Hartford
Courant, Feb. 9, 2002, p. E1.
18 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 web site at
[http://www.ingersoll-rand.com/proxy.pdf].
19 The Joint Committee on Taxation has estimated that H.R. 3884, a bill aimed at limiting
inversions, would increase federal tax revenues by $4 billion over 10 years. BNA Daily
Tax Report, June 3, 2002, p. G-1.

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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 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

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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 and foreign sources. Their
proposals – including a set of bills introduced (but not passed) in the 107th Congress
– that proposed 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. system may be in
order. The recent Treasury Department report, for example, recommends more
stringent treatment of U.S.-, but not foreign-source income, and calls for a
reexamination of the U.S. system of taxing foreign income.
Congressional Proposals
A number of bills were introduced in the 107th Congress that addressed
inversions. Most contained provisions that defined an inversion and imposed more
stringent tax treatment when the defined inversion threshold is met. None of the
inversion bills that proposed altered tax rules were adopted before the 107th Congress
adjourned, although, as described below, restrictions on Department of Homeland
Security contracts with inverted firms were adopted.
Looking at the tax bills first, S. 2050 (Sen. Wellstone) treated a foreign parent
corporation as an “inverted domestic corporation,” and tax it under the same rules
that apply to domestic corporations, thereby subjecting its foreign earnings to U.S.
tax as though the inversion had not occurred. A foreign corporation would be
considered inverted under the bill if a domestic corporation’s property or stock is
transferred to it and immediately after the transfer more than 50% of the foreign
parent’s stock is owned by the domestic corporation’s shareholders. The bill was
retroactive, applying its tax rules to all such corporations after December 31, 2002,
regardless of when the inversion occurred.

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H.R. 3884 (Rep. Neal) was similar to S. 2050, except that it had a two-tiered
ownership threshold. The threshold was more than 50% ownership if the foreign
parent does not have “substantial” business activities in the country of origin and its
stock is publicly traded in the United States; the threshold was more than 80%
ownership otherwise. The bill’s rules applied in all tax years to inversions occurring
after September 11, 2001. Inversions occurring before that date were covered by the
rules beginning with tax year 2004. Mr. Neal stated that the Joint Tax Committee
estimated H.R. 3884 would increase federal tax revenue by $4 billion over 10 years.20
H.R. 4756 (Rep. Nancy Johnson) contained the same provisions as H.R. 3884
except its provisions would have been temporary, thus imposing what the bill termed
a “moratorium” on tax-motivated inversions. The bill’s provisions did not apply to
inversions occurring after 2003. H.R. 3922 (Rep. Maloney) contained the same
provisions as H.R. 3884, with one addition: it reduced the statutory tax rate that
applied to U.S. corporations in general by an amount whose revenue loss offset any
revenue gain from the bill’s inversion provisions.
H.R. 3857 (Rep. McInnis) was similar to H.R. 3884, except its two-tier test was
more detailed. The 50% threshold applied if the foreign corporation’s stock was
publicly traded in the United States, less than 10% of its gross income was from
activities in the country of organization, and less than 10% of its employees were
employed in the country of organization. The bill would have applied to transactions
occurring after December 31, 2001.
H.R. 4993 (Rep. Doggett) sought to limit the efficacy of earnings stripping by
denying treaty-mandated withholding tax reductions to payments made to treaty-
country corporations that are not predominantly owned by residents of the treaty
country. Thus, for example, the full 30% U.S. withholding tax rate would have
applied to payments to a newly formed foreign parent corporation inversion
transaction (assuming the parent’s stockholders are not residents of the treaty
country.
H.R. 5095 was introduced on July 11, 2002, by Chairman William Thomas of
the House Ways and Means Committee. A summary of the bill at the Committee’s
web site states inversions are one result of what the summary terms an
“uncompetitive” tax code.21 H.R. 5095 thus coupled a number of provisions directly
aimed at inversions with a range of tax reductions for U.S. business operations
abroad.22 The bill’s inversion provision consisted of a 3-year inversion
“moratorium,” provisions aimed at limiting earnings stripping, provisions applying
to capital gains on transfers associated with inversions, and provisions applying to
stock options associated with inversions.
20 BNA Daily Tax Report, June 3, 2002, p. G-1.
21 [http://waysandmeans.house.gov/fullcomm/107cong/hr5095/hr5095summary.htm]
22 The bill also repeals the Extraterritorial Income (ETI) tax benefit for exporting, thereby
attempting to defuse a long-running controversy over the benefit with the European Union.

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The moratorium provisions – in a manner similar to other inversion bills –
treated an inverted foreign parent as a domestic corporation; the ownership threshold
the bill applied was 80% ownership of the new foreign parent by former shareholders
of the inverted domestic corporation. The bill’s treatment would only have applied,
however, to inversions occurring after March 20, 2002, and before March 21, 2005.
The bill’s earnings stripping provisions revamped the manner in which interest
deductions to related corporations were disallowed and the conditions under which
the disallowance applied. The bill’s transfer provisions prevented foreign tax credits
or net operating losses from shielding from tax gain recognized on transfers of
property to a new foreign parent (for example, the transfer of the stock of other
foreign subsidiaries to the foreign parent). Finally, the bill imposed a 20% excise tax
on stock options held by executives of inverting firms. (In contrast to capital gains
recognized by stockholders of inverting firms, stock options are not taxed under
current law when an inversion occurs.)
On June 18, 2002, the Senate Finance Committee approved S. 2119 (Sen.
Grassley), a bill intended to limit inversions and provide tax-revenue savings that
would offset revenue losses from another bill providing tax reductions linked to
charitable giving (S. 1924). For Senate floor consideration, the measures were
combined as an amended version of H.R. 7, the Community Solutions Act. The
Joint Committee on Taxation estimated that S. 2119 would increase federal tax
revenues by $628 million over 5 years and $2.1 billion over 10 years. The bill would
have imposed two new tax regimes on inversions, depending on ownership
thresholds and when the inversions occur. Under the first regime – like the bills
previously described – S. 2119 would have taxed a foreign parent like a domestic
corporation if it passed an ownership threshold. In this case, the test was met if at
least 80% of the foreign corporation was 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 to have “substantial business activities” in the country of incorporation,
and applied only to inversions that occur after March 20, 2002.
S. 2119’s second regime was based on a 50% ownership test and would have
potentially applied whether the inversion occurred before or after March 20, 2002.
(The second set of rules did not apply, however, to post-March 20 inversions subject
to the bill’s first regime.) The second regime would have acted 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 applied 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
were permitted to offset the tax.
Additional rules designed to limit earnings stripping would have applied under
the 50%-ownership regime. Under the bill, a domestic subsidiary in an inversion
arrangement was required to enter into an agreement with the Internal Revenue
Service that would govern the allocation of deductible costs and the particulars of
other transactions between the subsidiary and foreign parent. The agreement would
be designed to ensure that the deductions accurately reflect the respective incomes
of the related firms. Failure to enter such an arrangement would result in the

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disallowance of any deductions resulting from transactions between the related
corporations. Also, the bill would have reduced for inverted firms the debt-finance
threshold that triggers the tax code’s earnings stripping rules.
On July 26, 2002, the House approved an anti-inversion provision as an
amendment to H.R. 5005, a bill whose principal provisions related to homeland
security. Under the amendment, foreign firms chartered in countries identified by the
bill as tax havens were prohibited from conducting business with the proposed
Department of Homeland Security if the principal public market for trading of the
corporation’s stock is in the United States.23 The amendment provided a waiver of
the restriction if the President certifies that it is necessary to protect national security.
On July 31, the Senate approved a similar inversion provision as an amendment to
H.R. 5010, the defense appropriations bill.
Section 835 of the Homeland Security bill that was enacted (P.L. 07-296)
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 President certifies to Congress that it is
essential to national security.
Other Approaches
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
foreign income.24
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
23 The identified countries are Barbados, Bermuda, British Virgin Islands, Cayman Islands,
Bahamas, Cyprus, Gibralter, Isle of Man, Liechtenstein, Monaco, the Seychelles.
24 Samuel C. Thompson, Jr., “Section 367: A ‘Wimp’ for Inversions and a ‘Bully’ for Real
Cross-Border Acquisitions,” Tax Notes, vol. 94, Mar. 18, 2002, p. 1506; and Jim Ditkoff,
“Closing the Bermuda Loophole: An Easier Approach Than the REPO Bill,” BNA Daily
Tax Report, Apr. 26, 2002, p. J-1.

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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
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 notes that earnings stripping is not confined to
inversions, but can occur within foreign-controlled groups in general. The report’s
concern with the practice is 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 concludes that “the
prevalent use of foreign related-party debt in inversion transactions is evidence that
these rules should be revisited.” The report lists a number of specific ways the rules
could be tightened.27 The report also suggests 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
is broader than just inversions. The report views inversions as being one aspect of
a more general result of the U.S. tax system. The report’s analysis concludes 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 views not only inversions, but a growing number of acquisitions of U.S. firms
by foreign companies as possible symptoms of the disadvantage.30
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.
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.

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As a result of its concern for competitiveness, the Treasury report stops 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 states:
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 the
long run.31
As a more general response, the report recommends 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 is 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 appears more closely akin to
the capital import neutrality perspective described above.
Conclusions
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 the
exemption from U.S. tax of a firm’s foreign income.33 Accordingly, the debate over
31 Ibid., p. 2.
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
(continued...)

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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.
33 (...continued)
business operations.

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