In a corporate inversion, a U.S. corporation (typically the parent of an affiliated group) becomes a wholly owned subsidiary of a foreign corporation (through a merger into the foreign corporation’s U.S. subsidiary) or transfers its assets to the foreign corporation, but at the same time keeps most of its operations in the United States. Inversions are especially popular these days for pharmaceutical and biotechnology companies, where most of the value of the company is found in intangible assets.

The Internal Revenue Code provides two primary incentives for these types of transactions: (1) U.S. corporations are subject to federal income tax on their worldwide income, and (2) U.S. corporations are able to defer from U.S. federal income tax certain categories of income from foreign operations until the income is repatriated to the United States in the form of a dividend.

While an inversion transaction is typically a taxable transaction under Section 367(a), if the transaction is otherwise respected, U.S. federal income tax can be deferred on foreign operation until repatriated, and there are opportunities to reduce the taxable income of the U.S. operations by making deductible payments of interest, royalties and other fees to the foreign parent.

Under Section 7874, a foreign corporation is treated as a U.S. corporation for all purposes of the Code where, under a plan or series of related transactions:

  1. The foreign corporation completes, after March 4, 2003, the direct or indirect acquisition of substantially all the properties held directly or indirectly by a U.S. corporation;
  2. Shareholders of the U.S. corporation obtain 80% or more of the foreign corporation’s stock (by vote or value) by reason of holding their U.S. shares; and
  3. The foreign corporation and corporations connected to it by a 50% chain of ownership (the “expanded affiliated group”) does not have substantial business activities in the foreign corporation’s country of incorporation or organization when compared to the total business activities of the group. For this purpose, substantial business activities requires the expanded affiliated group to have at least 25 percent of (i) the group employees; (ii) group assets; and (iii) group income in the foreign country of incorporation.

The same rule applies where a domestic partnership transfers substantially all the properties of a trade or business to a foreign corporation and the same stock ownership and absence of business activities tests are met.

Where, however, the inversion transaction satisfies the above three tests, except that the domestic corporation’s shareholders (or a domestic partnership’s partners) obtain at least 60% but less than 80% of the foreign corporation’s stock, the foreign corporation is a “surrogate foreign corporation” respected as a foreign corporation. The inversion gain recognized by the “expatriated entity,” however, is taxable in full with no reduction or offset for losses, credits or other tax attributes. Also, for ten years after the expatriation transaction is completed, the expatriated entity’s gain on transfers or licenses to the surrogate foreign corporation or to a “foreign related person” is taxable without offset (with an exception for inventory and like property).

2012 Regulations Aimed at Discouraging Inversions were Ineffective  

Historically, most inversion transactions were merely internal restructurings where the new foreign parent had little substance in its country of incorporation. In 2012, however, final regulations were issued that moved away from a “facts and circumstances” business activities test and introduced the new 25 percent safe harbor tests discussed above. It was assumed that these changes would make it much more difficult for inverted companies to satisfy the business activities test and therefore discourage U.S. companies from inverting.

What has happened, however, is that U.S. companies have resorted to simply acquiring smaller foreign companies (typically at large premiums, in effect paying for the future tax savings) to satisfy the business activities test. (For example, last May, New Jersey based Actavis PLC agreed to acquire Ireland’s Warner Chilcott at a 34% premium over its then existing stock price). Most of these companies have been located in low-tax jurisdictions such as Ireland, which has a 12.5 percent corporate income tax rate, or, in the case of the failed Pfizer-Astra Zeneca deal, the U.K., which has favorable regime for the taxation of income derived from patents.

Further Legislation Likely to be Part of Overall Tax Reform

Shortly after new proposed legislation was introduced a few weeks ago that was designed to shut down inversion transactions completely, U.S. medical device maker Medtronic announced that it is taking over competitor Covidien and moving its tax residence to Ireland. Although this deal bears many similarities to the failed Pfizer takeover attempt of Astra Zeneca last month, Medtronic’s main tax motivation supposedly is to gain access to cash trapped overseas. According to a Covidien press release, the combined company will have its principal executive offices in Ireland, “where both companies have a longstanding presence.” Medtronic will, however, continue to have its operational headquarters in Minneapolis.

The timing of the Medtronic announcement seems to indicate that U.S. companies do not believe that further legislation will be enacted any time soon. In fact, it is generally believed that Congress is of the view that corporate inversions are a symptom of a broken, uncompetitive tax system, and that the system should be reformed so that the United States is a more attractive place to do business.