CORPORATE INVERSIONS are leading to more hand wringing and possible government action in Washington.

European and Asian companies with US subsidiaries are starting to pay attention because of the potential for any fix to affect them as well.

A corporate inversion is where a US corporation with substantial foreign operations inverts its ownership structure to put a foreign parent company on top with the aim of keeping future earnings from its overseas businesses outside the US tax net. The foreign parent may also “strip” earnings from the US subsidiary by capitalizing the subsidiary with debt so that earnings can be pulled out of the United States as deductible interest on the debt.

Congress amended the US tax code in 2004 to make it painful for US companies to invert. Most inversions today involve a merger of a US corporation with a foreign corporation. The shareholders of the US company retain less than 80% of the shares of the combined enterprise. If they retain 80% or more, then the IRS will treat the foreign parent as a US corporation, subjecting it to tax in the United States on its worldwide earnings. A merger done properly allows the merged company to incorporate in a third country with lower taxes. Ireland and the United Kingdom have been popular destinations.

Senator Carl Levin (D.-Michigan) and Rep. Sander Levin (D.-Michigan) introduced bills in the Senate and House to reduce the 80% threshold for treatment as a US corporation to 50%. The bills have a retroactive effective date of May 8, 2014. Alternatively, the foreign parent would be treated as a US corporation if it remains managed and controlled from the US and at least 25% of its employees, employee compensation or assets are located in or derived from the United States. Neither bill is expected currently to be enacted because of opposition from Republicans, who control the House. A bill must pass both houses of Congress to become law.

Republicans believe that the only effective deterrent to inversions is to reduce US corporate tax rates. The US tax rate has remained unchanged at 35% since 1986. In 1986, the rate was in the middle of the pack among peer group countries. Today other countries’ rates are between 20% and 30%.

Martin Sullivan, an economist who writes for Tax Notes magazine, argues that reducing tax rates will not stop inversions and that the US needs to move to a territorial tax regime where US and foreign corporations are treated the same.

US multinational corporations have $1.95 trillion parked in offshore holding companies. The earnings cannot come back to the United States without being taxed. A key driver in many inversions is greater flexibility where to invest offshore earnings without subjecting them to US tax. Many US companies are also becoming more international in scope and are earning an increasing share of their income outside the United States.

Democrats are expected to introduce another round of bills in September to reduce the amount of earnings stripping that the United States will tolerate.

The US Treasury is also exploring whether it can tighten any US tax rules to discourage inversions without waiting for Congress to act.

Senator Charles Schumer (D.-New York) described a proposal in mid-August to make earnings stripping more difficult that he plans to introduce in bill form in September. The US does not allow interest payments by US corporations to foreign related parties to reduce the adjusted taxable income of the US corporation by more than 50%. The limit applies only if the US corporation has more than three parts debt to two parts equity. Any interest that cannot be deducted can be carried forward until a year when there is room within this formula to deduct it. If the US subsidiary has an “excess limitation,” meaning it could have deducted more interest in a year, then the excess limitation can be carried forward for up to three years.

Schumer would bar US corporations from using interest paid to related parties to reduce income by more than 25% and apply this limit regardless of how much debt a US corporation has in relation to equity. He would not allow any excess limitation or disallowed interest deductions to be carried forward to a later year. These rules would apply only to inverted companies. The reason the bill language has not been released yet is he is still working on a definition of inverted company. More punitively, he would require inverted companies to ask the IRS in advance for approval for the terms of transactions with related parties for the next 10 years after the inversion.

Schumer said at a July 22 Senate hearing on inversions that his proposal would provide a retroactive fix. “Any company that did an inversion six months ago, a year ago, five years ago will lose this deduction,” he said, calling it “a prospective policy action to counter past and future inversion activity.”

Rep. Sander Levin released a separate draft earnings stripping bill in early August and is collecting comments through September 5. Levin is the ranking Democrat on the House tax-writing committee. His bill is similar to the Schumer proposal, but would not be limited to inverted companies and it would allow disallowed interest deductions to be carried forward for up to five years. The bill would be effective in tax years ending after it is enacted.

Senator Ron Wyden (D.-Oregon), the chairman of the Senate tax-writing committee, said he and Orrin Hatch (R.-Utah), the senior Republican on his committee, are talking about a proposal that Wyden hopes to put to a vote in the committee in September. Wyden said the fact that merger agreements now make it a condition to closing that the US government has not taken action to stop inversions belies the claim that the transactions have nothing to do with taxes. Hatch said he is open to a short-term fix, but any fix must move the US toward a territorial tax system in which companies are taxed only on their income from US sources, be revenue neutral and not be retroactive. Even if Hatch were to go along, there does not appear to be any path forward through the House.

President Obama said in early August that the US Treasury Department is looking at what regulatory measures can be taken to stop inversions without waiting for Congress. The Treasury had said earlier that there is not much it can do without legislation. The Treasury search is expected to take at least into September.

Many tax experts are skeptical about whether Treasury can take meaningful action on its own in part because Congress already drew clear lines in the tax code for earnings stripping and corporate inversions.

However, Stephen Shay, a Harvard law professor who has had two tours as the senior international tax official at Treasury, suggested several ways the Treasury can limit inversions in a widely-read article in Tax Notes magazine on July 28. Shay suggested using section 385 of the US tax code, a 45-year-old provision that gives the IRS broad authority to draw lines between debt and equity, to reclassify as equity some debt on which earnings are being stripping by inverted companies. He would reclassify debt into equity to the extent a US corporation’s debt-equity ratio after an inversion exceeds a three-year historical average amount of debt for the larger group now headed by a foreign parent or, if less, if the foreign parent is using interest on debt to strip more than 25% of the average income of the US corporation for the past three years.

Shay also called attention to other tax code sections that the Treasury could invoke to prevent offshore subsidiaries of former US companies from making “hopscotch” loans to lend parked offshore earnings to the new foreign parent, bypassing the former US parent. The foreign parent then either relends the money to what is now its US subsidiary or makes a capital contribution to the US subsidiary. Shay acknowledged that it is easier for Treasury to tax foreign earnings moving to the US as back-to-back loans than as capital contributions from a foreign parent.

Any regulatory action by Treasury could limit benefits to companies that have already inverted. However, it could also complicate any future moves to address inversions in Congress since Congress would not be credited with having brought in more revenue, thereby reducing the attraction of an anti-inversion bill as a “pay for” for other tax changes that Republicans want to enact.

The US government is awarding more than $1 billion a year in federal business to more than a dozen expatriated US companies, according to research by Bloomberg. Clauses have been added in the House to the 2015 appropriations bills for energy, water, defense, transportation and housing and urban development to bar the federal government from awarding contracts to inverted companies, but the clauses would only bar such contracts for US companies that inverted by moving to Bermuda or the Cayman Islands. Rep. Rosa DeLauro (D.-Connecticut) is the principal advocate behind these provisions. The most recent rider to the energy and water appropriations bill passed the House by 221-200 in July. DeLauro said she will try to expand the ban in the future to all inverted companies. However, it is unclear whether any such ban will make it into a final spending bill, especially since the Senate has so far failed to pass any appropriations measures for 2015. Government agencies usually end up operating under a continuing resolution authorizing them to continue spending at the same level as the year before.

Democrats, led by Senators Carl Levin and Richard Durbin (D.-Illinois) in the Senate and Reps. DeLauro, Levin and Lloyd Doggett (D.-Texas) in the House, introduced a bill in late July to deny federal contracts to inverted companies. The bill would treat companies as inverted for this purpose if the combined entity created by merger is owned 50% or more by shareholders of the former US company.

Meanwhile, investment bankers are starting to talk about “spinversions,” where a large diverse company distributes part of its business to shareholders in a tax-free spinoff and combines it with a foreign entity. This would expand the pool of potential merger partners. In order to have a valid tax-free spinoff, shareholders of the US company must retain more than 50% of the merged entity. However, they would have to stop short of 80% to avoid having the merged company taxed like a US corporation. There must also be a valid business reason for the spinoff other than reducing US taxes.

The intense focus on inversions has caused several companies to pull back from potential such transactions. Mark Cuban, owner the Dallas Mavericks basketball team and star of a widely-watched US television program called Shark Tank, tweeted in late July: “If I own stock in your company and you move offshore for tax reasons I’m selling your stock.” He complained in a subsequent tweet that inverting companies are shifting the burden of helping pay for the US military and other government services to other US companies and citizens.

Inversions could play into the debate whether to extend production tax credits for renewable energy facilities at year end as well as affect the odds that the next Congress will take up major corporate tax reform. Any effort to add an anti-inversion provision to the extenders bill would complicate passing that bill. Failure to do anything this year will increase the odds that the next Congress will have to take up corporate tax reform.