An inversion transaction is one where a US company with substantial foreign operations turns its ownership structure upside down so that what was formerly a US parent company becomes a subsidiary of a new parent company in Bermuda or another tax haven.  In the process, the US company sheds all of its foreign subsidiaries. They become direct subsidiaries of the new parent company in Bermuda.  US companies in increasing numbers are doing inversions in order to reduce the amount of taxes they have to pay in the United States.

The US government may move to stop inversions.  Senators Max Baucus (D.-Montana) and Charles Grassley (R.-Iowa), the chairman and senior Republican on the Senate tax-writing committee, said they will introduce what they hope will be a bipartisan bill in April to put a halt to inversions.  Grassley derided US corporations that invert for having their “butts” in the United States but their hearts elsewhere.

Two bills introduced by eight members of the House tax-writing committee from both political parties in March would also put a halt to inversions.  One of the House bills is retroactive to inversions done after last September 11 and would overturn inversions done earlier starting in 2004.

A bill must pass both houses of Congress to become law.  Senate action is considered more likely; the chairman of the House tax-writing committee is lukewarm to action this year.

The Bush administration is doing a study of why inversions occur and promised to release an outline of any recommendations by late April with the full study to follow later.

The Internal Revenue Service is working in the meantime on amendments to its existing tax regulations that could broaden the circumstances in which a “toll charge” is collected at the US border on US companies that invert their ownership structures.  Any such change in the regulations would probably be prospective.  A “toll charge” is a tax that is collected when assets are moved outside the US tax net.  The tax is on the amount the assets have appreciated in value.  US law already imposes a toll charge, but perhaps not always in the right circumstances.

The Rush Offshore

US companies that have inverted in recent years include Foster Wheeler, Stanley Works, Tyco International, Coopers Industries, Seagate Technology and Fruit of the Loom.  Ingersoll-Rand said in a prospectus filed with the US Securities and Exchange Commission in November that an inversion it had underway would add $40 million a year to earnings, plus a one-time benefit to earnings in the fourth quarter of 2001 of $50 to $60 million.  Coopers Industries estimated that inverting would allow the company to reduce its effective tax rate from 35% to 20% and increase earnings by $55 million a year.

Global Grossing and Accenture, the former consulting arm of Arthur Andersen, incorporated their parent companies in Bermuda from the start.

US companies are driven to inversions in an effort to reduce US taxes on earnings from their offshore operations. The United States taxes American companies on worldwide earnings.  Foreign operations can usually be set up in a way that allows US taxes to be deferred for as long as the earnings remain offshore.  However, this makes the earnings unavailable for reinvestment in the United States without triggering US taxes.  In addition, US tax deferral is only possible on “active” income —not “passive” income.  Examples of passive income are dividends, interest, rents and royalties. The US looks through offshore subsidiaries of US corporations and taxes the US parent on any passive income it sees in the offshore ownership chain.

By inverting, the offshore operations move outside the US tax net altogether.

There is a cost to inverting.  The US shareholders are usually taxed on any appreciation in value of the shares they hold in the US company. Tax is triggered when shares in the US company are exchanged for shares in the new foreign parent company. There is also potentially a “toll charge” on the inverting US company when it transfers its foreign subsidiaries to the new foreign parent company, although this tax is usually avoided.

Inversions have been of greater interest recently with the dip in the US stock market.  Lower share prices make it an opportune time to invert because the US shareholders are less likely to have a gain on their shares.

Legislation

Eight members of the tax-writing committee in the House introduced two bills in March that would attack inversions by treating the new parent company set up in Bermuda or other tax haven as if it were a US corporation still subject to tax fully on its worldwide income.

Four Republicans on the House tax-writing committee — Scott McInnis (R.-Colorado), Amo Houghton (R.-New York), Nancy Johnson (R.-Connecticut) and Wes Watkins (R.-Oklahoma) — introduced one of the bills.  It would treat the new offshore parent company as a US company for tax purposes if more than 80% of the shares in the offshore parent remain owned — by vote or value — by former shareholders of the US company that is inverting.  However, the threshold would drop to 50% if three things are true about the new foreign parent.  First, its shares are publicly traded on a US stock exchange.  Second, less than 10% of its gross income is expected to come from the tax haven where it is incorporated. Third, fewer than 10% of its employees are based permanently in the tax haven. The McInnis bill would apply to inversions done after December 2001.

The other bill — introduced by Rep. Richard Neal (D.-Massachusetts) and cosponsored mainly by Democrats — takes a similar approach.  However, the lines in it are less clear.  Under the Neal bill, the new foreign parent company would be taxed in the US if it ends up with “substantially all” the assets of the inverted US company and former shareholders of the inverted US company own more than 80% of it.  A lower stock ownership threshold — 50% rather than 80% — would apply if the “principal market” where shares in the new foreign parent are traded is the US and the new foreign parent does not have “substantial business activities (when compared to the total business activities of the expanded affiliated group)” in the tax haven where it is organized.

The Neal bill would apply retroactively to inversions after last September 11.  It would also apply to earlier inversions, but not until 2004.

The full House voted down an amendment on March 13 that would have treated foreign parent companies created in inversion transactions as domestic for purposes of class action lawsuits.  The vote was 202 to 223. The amendment was offered by three Democrats — John Conyers (D.-Michigan), Sheila Jackson-Lee (D.-Texas) and Richard Neal (D.-Massachusetts).

Lee Sheppard, an influential columnist who is read by tax policymakers in Washington, criticized the approach taken by the House bills in a column in Tax Notes magazine on April 1.  Sheppard said, “[T]he drafters of the House bills are focusing on the result of inversion transactions, rather than examining the misguided residence rules and ineffectual outbound transaction rules that let the horse out of the barn in the first place.” She argued for adopting the British approach of treating a corporation as having a US residence for tax purposes if it is “managed and controlled” from the United States.  Adoption of this approach would have more far-reaching consequences since it might pull into the US tax net the offshore subsidiaries that US multinationals set up today in the Cayman Islands, Mauritius and other tax havens to hold their foreign investments in the hope of deferring US taxes on foreign earnings.

By Keith Martin and Samuel R. Kwon, in Washington