BACKGROUND AND DESCRIPTION OF PRESENT-LAW

RULES AND PROPOSALS RELATING TO

CORPORATE INVERSION TRANSACTIONS

Scheduled for a Public Hearing

Before the

COMMITTEE ON WAYS AND MEANS

on June 6, 2002

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

June 5, 2002

JCX-52-02
i

CONTENTS

Page

INTRODUCTION .......................................................................................................................... 1

I. BACKGROUND AND PRESENT LAW ................................................................................... 2

II. DESCRIPTION OF INTRODUCED BILLS RELATING TO INVERSIONS......................... 5
1

INTRODUCTION

The House Committee on Ways and Means has scheduled a hearing on issues relating to 

corporate inversion transactions on June 6, 2002. This document,1 prepared by the staff of the 

Joint Committee on Taxation, provides a description of these transactions and relevant 

provisions of present law, as well as a description of introduced bills addressing these 

transactions.

 

1

 This document may be cited as follows: Joint Committee on Taxation, Background and 

Description of Present-Law Rules and Proposals Relating to Corporate Inversion Transactions

(JCX-52-02), June 5, 2002.
2

I. BACKGROUND AND PRESENT LAW

Determination of corporate residence

The U.S. tax treatment of a multinational corporate group depends significantly on 

whether the top-tier “parent” corporation of the group is domestic or foreign. For purposes of 

U.S. tax law, a corporation is treated as domestic if it is incorporated under the law of the United 

States or of any State. All other corporations (i.e., those incorporated under the laws of foreign 

countries) are treated as foreign. Thus, place of incorporation determines whether a corporation 

is treated as domestic or foreign for purposes of U.S. tax law, irrespective of other factors that 

might be thought to bear on a corporation’s “nationality,” such as the location of the

corporation’s management activities, employees, business assets, operations, or revenue sources, 

the exchanges on which the corporation’s stock is traded, or the residence of the corporation’s 

managers and shareholders.

U.S. taxation of domestic corporations

The United States employs a “worldwide” tax system, under which domestic corporations 

generally are taxed on all income, whether derived in the United States or abroad. In order to 

mitigate the double taxation that may arise from taxing the foreign-source income of a domestic 

corporation, a foreign tax credit for income taxes paid to foreign countries is provided to reduce 

or eliminate the U.S. tax owed on such income, subject to certain limitations. 

Income earned by a domestic parent corporation from foreign operations conducted by 

foreign corporate subsidiaries generally is subject to U.S. tax when the income is distributed as a 

dividend to the domestic corporation. Until such repatriation, the U.S. tax on such income is 

generally deferred. However, certain anti-deferral regimes may cause the domestic parent 

corporation to be taxed on a current basis in the United States with respect to certain categories 

of passive or highly mobile income earned by its foreign subsidiaries. The main anti-deferral

regimes in this context are the controlled foreign corporation rules of subpart F (sections 

951-964) and the passive foreign investment company rules (sections 1291-1298). A foreign tax 

credit is generally available to offset, in whole or in part, the U.S. tax owed on this foreignsource income, whether repatriated as an actual dividend or included under one of the antideferral regimes.

The U.S. “worldwide” system for taxing domestic corporations may be contrasted with 

the systems used in some countries that rely to a greater extent than the United States does on 

“territorial” principles. Under a territorial system, a country mitigates the double taxation of 

foreign-source income of resident corporations primarily through an exemption mechanism, as 

opposed to a credit mechanism. While a pure territorial system would exempt all foreign-source 

income from residence-country tax, in practice it is common for systems described as 

“territorial” to exempt only certain categories of income, to exempt either all or part of such 

income, and/or to provide various exceptions to reduce opportunities for tax avoidance.
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U.S. taxation of foreign corporations

The United States taxes foreign corporations only on income that has a sufficient nexus to 

the United States. Thus, a foreign corporation is generally subject to U.S. tax only on income 

that is “effectively connected” with the conduct of a trade or business in the United States. Such 

“effectively connected income” generally is taxed in the same manner and at the same rates as 

the income of a U.S. corporation. An applicable tax treaty may limit the imposition of U.S. tax 

on business operations of a foreign corporation to cases in which the business is conducted 

through a “permanent establishment” in the United States.

In addition, foreign corporations generally are subject to a gross-basis U.S. tax at a flat 

30-percent rate on the receipt of interest, dividends, rents, royalties, and certain similar types of 

income derived from U.S. sources, subject to certain exceptions. The tax generally is collected 

by means of withholding by the person making the payment. This tax may be reduced or 

eliminated under an applicable tax treaty. 

Inversion transactions

Overview

Recent press reports and filings with the Securities and Exchange Commission (“SEC”) 

indicate that some U.S. corporations have reincorporated, or plan to reincorporate, as foreign 

corporations in low-tax jurisdictions such as Bermuda, thereby replacing the U.S. parent 

corporation of a multinational corporate group with a foreign parent corporation. These 

transactions, commonly referred to as “inversions,” place the corporate group in a position to 

derive two main U.S. tax benefits: (1) removing some or all of the group’s foreign operations and 

income from the U.S. taxing jurisdiction, thereby potentially achieving pure territorial tax 

treatment for the group with respect to the United States (i.e., with no limitations or exceptions 

such as those that are common under existing “territorial” tax systems); and (2) reducing the U.S. 

taxes that otherwise would be incurred on income from U.S. operations, through the use of 

various “earnings stripping” strategies (e.g., making excessive payments of deductible interest or 

royalties to a new foreign parent). 

Structure of inversion transactions and potential tax benefits

Inversion transactions may take many different forms, including stock inversions, asset 

inversions, and various combinations of and variations on the two. Most of the known 

transactions to date have been stock inversions. In one example of a stock inversion, a U.S. 

corporation forms a Bermuda corporation, which in turn forms a domestic merger subsidiary. 

The domestic merger subsidiary then merges into the U.S. corporation, with the U.S. corporation 

surviving, now as a subsidiary of the new Bermuda corporation. The U.S. corporation’s 

shareholders receive shares of the Bermuda corporation and are treated as having exchanged 

their U.S. corporation shares for the Bermuda corporation shares. (An asset inversion reaches a 

similar result, but through a direct merger of the top-tier U.S. corporation into a new Bermuda 

corporation, among other possible forms.)

An inversion may be accompanied or followed by further restructuring of the corporate 

group. For example, in the case of a stock inversion, in order to remove income from foreign 
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operations from the U.S. taxing jurisdiction, the U.S. corporation may transfer some or all of its 

foreign subsidiaries directly to the new foreign parent corporation or other related foreign 

corporations. Thus, the subpart F anti-deferral rules applicable to controlled foreign corporations 

no longer would apply to these foreign subsidiaries, and no U.S. tax would be imposed on any 

actual dividends paid by such foreign subsidiaries in the future to the new foreign parent. As a 

result, the corporate group may be able to obtain the equivalent of a pure territorial tax system, 

depending on which country of incorporation is chosen. Even absent a direct transfer of existing 

foreign subsidiaries to the new foreign parent, similar benefits may be derived in connection with 

foreign operations that might be established in the future, by initiating such operations under the 

new foreign parent instead of under a U.S. corporation.

In addition to removing foreign operations from the U.S. taxing jurisdiction, the 

corporate group may derive further advantage from the inverted structure by reducing U.S. tax 

on U.S.-source income through various “earnings stripping” or other transactions. This may 

include earnings stripping through payment by a U.S. corporation of deductible amounts such as 

interest, royalties, rents, or management service fees to the new foreign parent or other foreign 

affiliates. In this respect, the post-inversion structure enables the group to employ the same taxreduction strategies that are available to other multinational corporate groups with foreign 

parents and U.S. subsidiaries, subject to the same limitations. These limitations under present 

law include section 163(j), which limits the deductibility of certain interest paid to certain related 

parties, if the payor’s debt-equity ratio exceeds 1.5 to 1 and the payor’s net interest expense 

exceeds 50 percent of its “adjusted taxable income.” More generally, section 482 and the 

regulations thereunder require that all transactions between related parties be conducted on terms 

consistent with an “arm’s length” standard, and permit the Secretary of the Treasury to reallocate 

income and deductions among such parties if that standard is not met.

Potential tax costs of inversion transactions

Inversion transactions themselves may give rise to U.S. tax consequences at the 

shareholder and/or the corporate level, depending on the type of inversion. In stock inversions, 

the U.S. shareholders generally recognize gain (but not loss) under section 367(a), based on the 

difference between the fair market value of the foreign corporation shares received and the 

adjusted basis of the domestic corporation stock exchanged. To the extent that a corporation’s 

share value has declined, and/or it has many foreign or tax-exempt shareholders, the impact of 

this section 367(a) “toll charge” is reduced. The transfer of foreign subsidiaries or other assets to 

the foreign parent corporation also may give rise to U.S. tax consequences at the corporate level 

(e.g., gain recognition and earnings and profits inclusions under sections 1001, 311(b), 304, 367, 

1248 or other provisions). The tax on any income recognized as a result of these restructurings 

may be reduced or eliminated through the use of net operating losses, foreign tax credits, and 

other tax attributes. 

In asset inversions, the U.S. corporation generally recognizes gain (but not loss) under 

section 367(a) as though it had sold all of its assets, but the shareholders generally do not 

recognize gain or loss, assuming the transaction meets the requirements of a reorganization under 

section 368.
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II. DESCRIPTION OF INTRODUCED BILLS RELATING TO INVERSIONS

H.R. 3857

H.R. 3857 was introduced in the House of Representatives by Mr. McInnis on March 6, 

2002. This bill would deny the intended tax benefits of certain inversion transactions by 

deeming the top-tier foreign corporation to be a domestic corporation for all purposes of the 

Code. This bill would apply if, immediately after a transaction in which a domestic corporation 

transfers property to a foreign corporation, more than 80 percent of the stock (by vote or value) 

of the foreign corporation is held by the former shareholders of the domestic corporation. In 

addition, this 80-percent test would be lowered to 50 percent if: (1) the stock of the foreign 

corporation is traded on a U.S. exchange, (2) less than 10 percent of the corporation’s gross 

income is derived from activities in the corporation’s country of incorporation, and (3) less than 

10 percent of the corporation’s employees are permanently located in such country.

The bill would apply to transactions occurring after December 31, 2001. 

H.R. 3884

H.R. 3884, the “Corporate Patriot Enforcement Act of 2002,” was introduced in the 

House of Representatives by Mr. Neal on March 6, 2002. This bill would deny the intended tax 

benefits of “corporate expatriation transactions” by deeming the top-tier foreign corporation to 

be a domestic corporation for all purposes of the Code. A “corporate expatriation transaction” 

would be any transaction in which: (1) a U.S. corporation becomes a subsidiary of a “nominally 

foreign corporation” or otherwise transfers substantially all of its properties to such a 

corporation; and (2) the former shareholders of the U.S. corporation hold more than 80 percent 

(by vote or value) of the stock of the “nominally foreign corporation” immediately after the 

transaction. In addition, this 80-percent test would be lowered to 50 percent in cases in which: 

(1) the “nominally foreign corporation” does not have substantial business activities in the 

corporation’s country of incorporation (compared to the total business activities of the 

corporation and all companies connected to it by a chain of 50 percent or greater ownership), and 

(2) the stock of the corporation is traded principally in a U.S. public market. 

The bill also would apply to certain partnership transactions. Specifically, the proposal 

would apply to transactions in which a “nominally foreign corporation” acquires substantially all 

of the properties constituting a trade or business of a domestic partnership, if after the acquisition 

more than 80 percent of the stock of the entity is held by former partners of the partnership, the 

“substantial business activities” test is not met, and the corporation’s stock is traded principally 

in a U.S. public market.

The bill generally would be effective for transactions completed after September 11, 

2001. The bill also would apply to transactions completed on or before September 11, 2001, but 

only for taxable years beginning after December 31, 2003. 

H.R. 3922

H.R. 3922, the “Save America’s Jobs Act of 2002,” was introduced in the House of 

Representatives by Mr. Maloney on March 11, 2002. This bill is the same as H.R. 3884, except 
6

that this bill also includes a provision that would lower corporate tax rates from year to year in 

such a way as to make the provision revenue-neutral, based on estimates to be provided by the 

Secretary of the Treasury.

H.R. 4756

H.R. 4756, the “Uncle Sam Wants You Act of 2002,” was introduced in the House of 

Representatives by Mrs. Johnson on May 16, 2002. This bill provides the same definitions and 

sanctions as H.R. 3884, but this bill also includes a sunset provision, pursuant to which the 

provisions of the bill would not apply to transactions beginning after December 31, 2003. Thus, 

the bill would effectively impose a moratorium on inversion transactions.

S. 2050

S. 2050 was introduced in the Senate by Senators Wellstone and Dayton on March 21, 

2002. This bill would deny the intended tax benefits of certain inversion transactions by 

deeming the top-tier foreign corporation to be a domestic corporation for all purposes of the 

Code. The transactions covered would be those in which property is transferred by a domestic 

corporation to a foreign corporation, or stock in a domestic corporation is transferred to a foreign 

corporation, if the former shareholders of the domestic corporation hold more than 50 percent of 

the stock of the foreign corporation immediately after the transaction. The bill would authorize 

the Secretary of the Treasury to provide by regulation that the provision not apply in cases in 

which the foreign corporation was engaged in the conduct of an active trade or business that was 

substantial relative to the trades or businesses of the domestic corporation immediately before 

the inversion transaction.

The bill would be effective for taxable years beginning after December 31, 2002, 

regardless of when the inversion transaction occurs.

S. 2119

S. 2119, the “Reversing the Expatriation of Profits Offshore Act,” was introduced in the 

Senate by Senators Grassley and Baucus on April 11, 2002. This bill would define two different 

types of corporate inversion transactions and establish a different set of consequences for each 

type. The bill also would apply to certain partnership transactions. 

The first type of inversion would be a transaction in which, pursuant to a plan or a series 

of related transactions: (1) a U.S. corporation becomes a subsidiary of a foreign-incorporated 

entity or otherwise transfers substantially all of its properties to such an entity; (2) the former 

shareholders of the U.S. corporation hold 80 percent or more (by vote or value) of the stock of 

the foreign-incorporated entity after the transaction; and (3) the foreign-incorporated entity, 

considered together with all companies connected to it by a chain of 50 percent or greater 

ownership (i.e., the “expanded affiliated group”), does not have substantial business activities in 

the entity’s country of incorporation, compared to the total business activities of the group. The 

bill would deny the intended tax benefits of this type of inversion by deeming the top-tier foreign 

corporation to be a domestic corporation for all purposes of the Code. 
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The second type of inversion covered by the proposal would be a transaction similar to 

the inversion transaction defined above, except that the 80-percent ownership threshold is not 

met. In such a case, if a greater-than-50-percent ownership threshold is met, then a second set of 

rules would apply to the inversion. Under these rules, the inversion transaction would be 

respected (i.e., the foreign corporation would be treated as foreign), but: (1) any applicable 

corporate-level “toll charges” for establishing the inverted structure would be strengthened; (2) 

the Internal Revenue Service (“IRS”) would be given expanded power to monitor related-party 

transactions that may be used to reduce U.S. tax on U.S.-source income going forward; and (3) 

section 163(j), relating to “earnings stripping” through related-party debt, would be tightened. 

These measures generally would apply for a 10-year period following the inversion. 

Specifically, any applicable corporate-level “toll charge” imposed under sections 304, 

311(b), 367, 1001, 1248, or any other provision with respect to the transfer of controlled foreign 

corporation stock or other assets by a U.S. corporation as part of the inversion transaction or after 

such transaction to a related foreign person would be taxable, without offset by any other tax 

attributes (e.g., net operating losses or foreign tax credits). No similar measures would apply to 

any shareholder-level toll charges imposed under section 367(a). 

In addition, the bill would establish a “pre-approval” process, under which no deductions 

or additions to basis or cost of goods sold for payments to foreign related parties would be 

permitted unless the taxpayer concludes an annual “pre-approval agreement” with the IRS, to 

ensure that all related-party transactions comply with all relevant provisions of the Code, 

including sections 482, 845, 163(j), and 267(a)(3). Similarly, the transfer or license of intangible 

property from a U.S. corporation to a related foreign corporation would be disregarded, and costsharing arrangements would not be respected, unless such an agreement is concluded. The 

confidentiality and disclosure rules normally applicable to advance pricing agreements (“APAs”) 

would apply to all pre-approval agreements entered into pursuant to the proposal, and the 

parameters for the IRS’s required annual APA report would be amended to require a summary 

section for inversion transactions. 

The “earnings stripping” rules of section 163(j), which deny or defer deductions for 

certain interest paid to foreign related parties, would be tightened as to inverted corporations. 

With respect to such corporations, the proposal would eliminate the debt-equity threshold 

generally applicable under that provision and reduce the 50 percent thresholds for “excess 

interest expense” and “excess limitation” to 25 percent. 

Under the bill, both types of inversion transactions are defined to include certain 

partnership transactions. Specifically, both prongs of the proposal would apply to transactions in 

which a foreign-incorporated entity acquires substantially all of the properties constituting a 

trade or business of a domestic partnership, if after the acquisition at least 80 percent (or more 

than 50 percent but less than 80 percent, as the case may be) of the stock of the entity is held by 

former partners of the partnership, and the “substantial business activities” test is not met. For 

purposes of determining whether these definitions are met, all partnerships that are under 

common control within the meaning of section 482 would be treated as one partnership, except 

as provided otherwise in regulations. In addition, in situations in which the strengthened “toll 

charge” provisions would apply, those provisions would apply at the partner level.
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The bill also would modify the rules of section 845, relating to authority for the Secretary 

of the Treasury to allocate income, deductions and other items among related persons in the case 

of a reinsurance agreement, to permit allocation if needed to reflect the proper source, character 

or amount of the item. This provision would not be limited to taxpayers engaged in inversion 

transactions. 

The first prong of the proposal would apply to inversion transactions meeting the 80-

percent test that are completed after March 20, 2002. The second prong of the proposal, limiting 

the benefits of other inversions, would apply to all inversion transactions meeting the 50-percent 

test, regardless of when completed. The measures set forth in the second prong also would apply 

to inversion transactions that would have met the 80-percent test but for the March 20, 2002, 

effective date of the first prong. The reinsurance provision would be effective for any risk

reinsured after April 11, 2002.