DESCRIPTION OF PROPOSALS IN THE

"REVERSING THE EXPATRIATION

OF PROFITS OFFSHORE ACT"

Scheduled for a Markup

By the

SENATE COMMITTEE ON FINANCE

on June 13, 2002

Prepared by

the Staff of the

JOINT COMMITTEE ON TAXATION

June 11, 2002

JCX-55-02
i

CONTENTS

Page

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

A. Tax Treatment of Inversion Transactions........................................................................... 2

B. Reinsurance Agreements .................................................................................................... 7
1

INTRODUCTION

The Senate Committee on Finance has scheduled a markup on June 13, 2002, of S. 2119, 

the "Reversing the Expatriation of Profits Offshore Act", with certain modifications. This 

document1 prepared by the staff of the Joint Committee on Taxation, provides a description of S. 

2119 the "Reversing the Expatriation of Profits Offshore Act", as modified.

 

1

 This document may be cited as follows: Joint Committee on Taxation, Description of 

Proposals in the "Reversing the Expatriation of Profits Offshore Act," (JCX-55-02), June 11, 

2002.
2

A. Tax Treatment of Inversion Transactions

Present Law

Background

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. 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 F2 and the passive foreign investment company 

rules.3 A foreign tax credit is generally available to offset, in whole or in part, the U.S. tax owed 

on this foreign-source income, whether earned directly by the domestic corporation, repatriated 

as an actual dividend, or included under one of the anti-deferral regimes, subject to certain 

limitations.

In contrast, the United States taxes foreign corporations only on income that has a 

sufficient nexus to the United States. Place of incorporation determines whether a corporation is 

treated as domestic or foreign for purposes of U.S. tax law.

Inversion transactions

Some U.S. corporations have reincorporated as foreign corporations in low-tax 

jurisdictions, 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; 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). Inversion transactions may take many 

different forms, including stock inversions and asset inversions. 

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

group. For example, in order to remove income from foreign 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. 

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

corporate group may derive further advantage from the post-inversion structure by reducing U.S. 

 

2

 Secs. 951-964.

3

 Secs. 1291-1298.
3

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, subject to certain limitations under present law. These limitations include section 

163(j), which limits the deductibility of interest paid to 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 Treasury Secretary to reallocate income and deductions among such 

parties if that standard is not met.

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), 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 “toll charge” 

is reduced. 

The transfer by the U.S. corporation 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). 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) 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 tax-free reorganization under the Code.

Description of Proposal

In general

The proposal would define two different types of corporate inversion transactions and 

would establish a different set of consequences for each type. Certain partnership transactions 

also would be covered. 

Transactions involving at least 80 percent ownership

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 (by reason of holding stock in the U.S. corporation) 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 proposal would deny the intended tax 
4

benefits of this type of inversion by deeming the top-tier foreign corporation to be a domestic 

corporation for all purposes of the Code. 

In determining whether a transaction would meet the definition of an inversion under the 

proposal, stock held by members of the expanded affiliated group that includes the foreign 

incorporated entity would be disregarded. For example, if the former top-tier U.S. corporation 

receives stock of the foreign incorporated entity (e.g., “hook” stock), this stock would not be 

considered in determining whether the transaction meets the definition. Similarly, if a U.S. 

parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned 

controlled foreign corporation, the stock of the new foreign corporation would be disregarded, 

and the definition would not be met. Stock sold in a public offering related to the transaction at 

issue also would be disregarded for these purposes.

Transfers of properties or liabilities as part of a plan a principal purpose of which is to 

avoid the purposes of the proposal would be disregarded. In addition, the Treasury Secretary 

would be granted authority to issue regulations to prevent the avoidance of the purposes of the 

proposal, including avoidance through the use of related persons, pass-through or other 

noncorporate entities, or other intermediaries, and through transactions designed to qualify or 

disqualify a person as a related person or a member of an expanded affiliated group. Similarly, 

the Treasury Secretary would be granted authority to issue regulations treating certain non-stock 

instruments as stock, and certain stock as not stock, where necessary to carry out the purposes of 

the proposal. 

Transactions involving greater than 50 percent but less than 80 percent ownership

The second type of inversion covered by the proposal would be a transaction that would 

meet the definition of an inversion transaction described 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 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 strengthened. These 

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

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 tax attributes 

(e.g., net operating losses or foreign tax credits).

With respect to monitoring, the proposal would establish a new pre-filing procedure. 

Under this procedure, the taxpayer would be required annually to submit an application to the 

IRS for an agreement that all return positions to be taken by the taxpayer with respect to relatedparty transactions comply with all relevant provisions of the Code, including sections 482, 845, 

163(j), and 267(a)(3). The Treasury Secretary would be given the authority to specify the form, 
5

content, and supporting information required for this application, as well as the timing for its 

submission.

The IRS would be required to take one of the following three actions within 90 days of 

receiving a complete application from a taxpayer: (1) conclude an agreement with the taxpayer 

that the return positions to be taken with respect to related-party transactions comply with all 

relevant provisions of the Code; (2) advise the taxpayer that the IRS is satisfied that the 

application was made in good faith and substantially complies with the requirements set forth by 

the Treasury Secretary for such an application, but that the IRS reserves substantive judgment as 

to the tax treatment of the relevant transactions pending the normal audit process; or (3) advise 

the taxpayer that the IRS has concluded that the application was not made in good faith or does 

not substantially comply with the requirements set forth by the Treasury Secretary.

In the case of a compliance failure described in (3) above (and in cases in which the 

taxpayer fails to submit an application), the following sanctions would apply: (1) no deductions 

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

permitted; (2) any transfers or licenses of intangible property to related foreign parties would be 

disregarded; and (3) any cost-sharing arrangements would not be respected for the taxable year 

for which the application was required.

If the IRS fails to act on the taxpayer’s application within 90 days of receiving it, then the 

taxpayer would be treated as having submitted an application that substantially complies with the 

above-referenced requirements. Thus, the deduction-disallowance and other sanctions described 

above would not apply, but the IRS could examine the transactions at issue under the normal 

audit process. The IRS would be authorized to request that the taxpayer extend this 90-day 

deadline in cases in which the IRS believes that such an extension might help the parties to reach 

an agreement. 

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

certain interest paid to foreign related parties, would be strengthened 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.

Partnership transactions

Under the proposal, 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 (by reason of holding their partnership interests), 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.
6

Effective Date

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 inversion transactions meeting the 50-percent test 

that are completed after 1996. The measures set forth in the second prong also would apply to 

inversion transactions completed after 1996 that would have met the 80-percent test but for the 

March 20, 2002, effective date of the first prong. 
7

B. Reinsurance Agreements

Present Law

In the case of a reinsurance agreement between two or more related persons, present law 

provides the Treasury Secretary with authority to allocate among the parties or recharacterize 

income (whether investment income, premium or otherwise), deductions, assets, reserves, credits 

and any other items related to the reinsurance agreement, or make any other adjustment, in order 

to reflect the proper source and character of the items for each party.4 For this purpose, related 

persons are defined as in section 482. Thus, persons are related if they are organizations, trades 

or businesses (whether or not incorporated, whether or not organized in the United States, and 

whether or not affiliated) that are owned or controlled directly or indirectly by the same interests. 

The provision may apply to a contract even if one of the related parties is not a domestic 

company.5 In addition, the provision also permits such allocation, recharacterization, or other 

adjustments in a case in which one of the parties to a reinsurance agreement is, with respect to 

any contract covered by the agreement, in effect an agent of another party to the agreement, or a 

conduit between related persons. 

Description of Proposal

The proposal would modify the rules of section 845, relating to authority for the Treasury 

Secretary to allocate among the parties to a reinsurance agreement, recharacterize items, or make 

any other adjustment, in order to reflect the proper source and character of the items for each 

party. The proposal would authorize such allocation, recharacterization, or other adjustment, in 

order to reflect the proper source, character or amount of the item. It is intended that this 

authority6 be exercised in a manner similar to the authority under section 482 for the Treasury 

Secretary to make adjustments between related parties, including in situations in which the 

related persons (or agents or conduits) are engaged in cross-border transactions that require 

allocation, recharacterization, or other adjustments in order to reflect the proper source, character 

or amount of the item or items.

Effective Date

The provision would be effective for any risk reinsured after April 11, 2002.

 

4

 Sec. 845(a).

5

 See S. Rep. No. 97-494, "Tax Equity and Fiscal Responsibility Act of 1982," July 12, 

1982, 337 (describing provisions relating to the repeal of modified coinsurance provisions).

6

 The authority to allocate, recharacterize or make other adjustments was granted in 

connection with the repeal of provisions relating to modified coinsurance transactions.