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Excerpt from American Bar Association Tax Section Comments Regarding the Proposed Regulations under Section 7874, May 19, 2006:

• The principal tax benefit of an inversion transaction is that a foreign controlled corporate group can create tax avoidance opportunities by sheltering U.S. profits of the U.S. corporate group with deductible payments made to foreign related parties. Moreover, tax benefits are enhanced to the extent that foreign subsidiaries held by the U.S. group (and thereby subject to the U.S. subpart F rules) are restructured or their operations are otherwise transferred to related foreign corporations that are outside the scope of the U.S. subpart F regime because the new foreign parent’s widely held stock places it outside the definition of a controlled foreign corporation.
   
• Many inversions were subject to full taxation at the shareholder level (and sometimes at the corporate level) under prior law. The absence of gain or availability of losses or other income-sheltering tax attributes, however, often mitigated the tax cost in consummated transactions. Notwithstanding the “toll charge” on inversions under prior law, Congress concluded that corporate inversion transactions should be further deterred because of the significant opportunities to strip earnings out of the United States. Congress also believed that similar benefits could be achieved from inversion transactions involving U.S. businesses conducted in partnership form.
   
• . . . [S]ection 7874 operates to effectively disregard the inversion (i.e., in the case where former shareholders own at least 80 percent of the acquiring foreign corporation) or limit the benefits of an inversion (i.e., in the case where the former shareholders own less than 80 percent but at least 60 percent of the acquiring foreign corporation).

Excerpt from General Explanation of Tax Legislation Enacted in the 108^th Congress (JCS-5-05, May 2005):

U.S. tax treatment of inversion transactions

• A U.S. corporation may reincorporate in a foreign jurisdiction and thereby replace the U.S. parent corporation of a multinational corporate group with a foreign parent corporation. These transactions are commonly referred to as inversion transactions. 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 foreign 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 foreign corporation. The U.S. corporation's shareholders receive shares of the foreign corporation and are treated as having exchanged their U.S. corporation shares for the foreign corporation shares. An asset inversion reaches a similar result, but through a direct merger of the top-tier U.S. corporation into a new foreign corporation, among other possible forms. An inversion transaction 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 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 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 tax-reduction strategies that are available to other multinational corporate groups with foreign parents and U.S. subsidiaries, subject to the same limitations (e.g., secs. 163(j) and 482).
• Inversion transactions may give rise to immediate 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 secs. 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.

Reasons for Change

• The Congress believed that inversion transactions resulting in a minimal presence in a foreign country of incorporation were a means of avoiding U.S. tax and should be curtailed. In particular, these transactions permit corporations and other entities to continue to conduct business in the same manner as they did prior to the inversion, but with the result that the inverted entity avoids U.S. tax on foreign operations and may engage in earnings-stripping techniques to avoid U.S. tax on domestic operations. The Congress believed that corporate inversion transactions were a symptom of larger problems with our current system for taxing U.S.-based global businesses and were also indicative of the unfair advantages that our tax laws conveyed to foreign ownership.
   
• The Act addressed the underlying problems with the U.S. system of taxing U.S.-based global businesses, and this provision removes the incentives for entering into inversion transactions. The Congress believed that certain inversion transactions have little or no non-tax effect or purpose and should be disregarded for U.S. tax purposes. The Congress believed that other inversion transactions may have sufficient non-tax effect and purpose to be respected, but warrant that any applicable corporate-level "toll charges" for establishing the inverted structure not be offset by tax attributes such as net operating losses or foreign tax credits.

Excerpt from The Joint Committee on Taxation, JCX-52-02:

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 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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