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June 16, 2014
News Analysis: What's Next in Inversion Land?
by Mindy Herzfeld

Full Text Published by Tax Analysts®

The U.S. government has made regular efforts since the 1990s to prevent companies from moving their business out of the United States. However, those efforts have been only partially successful as companies continue to seek lower corporate rates overseas. Even while lawmakers debate how to stop the current wave of inversions, the next set of transactions is already taking shape.
The Problem

The U.S. corporate income tax rate is much higher than corporate tax rates in most other countries. The United States is one of the last remaining countries to use a worldwide system. The combination of these two key attributes of the U.S. tax system penalizes U.S. multinationals relative to their foreign competitors and has encouraged a wave of inversions over the last 20 years that the IRS and Congress have been unable to stop.

Early Regulatory Responses

In one of the first highly public inversion transactions, U.S. cosmetics company Helen of Troy Ltd. reorganized into a Bermuda company in 1993. In response, the government issued Notice 94-46, 1994-1 C.B. 356, expressing concern that some restructurings were being undertaken "for tax-motivated purposes."

The Helen of Troy transaction involved a merger of a newly created U.S. subsidiary of a Bermuda company with the U.S. public company. In response to criticism that transactions like it could qualify as tax free to both the company and its shareholders, the IRS said in Notice 94-46 that it would modify the regulations under section 367(a). The new regulations would provide that the transfer of stock or securities of a domestic corporation by a U.S. person to a foreign corporation is taxable if all U.S. transferors own in the aggregate 50 percent or more of either the total voting power or the total value of the stock of the transferee corporation immediately after the exchange. Regulations (T.D. 8638) were issued in 1996 and were retroactive to 1994.

The regulations under section 367(a) curtailed inversion transactions until a depressed stock market or companies' balance sheets made it worthwhile for companies to undertake taxable inversion transactions.

Section 7874

A new wave of inversions began in the late 1990s. In response to highly publicized inversions involving Tyco International Ltd., Ingersoll-Rand PLC, and Nabors Industries Ltd., Congress enacted section 7874 as part of the American Jobs Creation Act of 2004. Like the regulations under section 367(a), section 7874 potentially taxes inverted companies and some shareholders upon an expatriation transaction. However, section 7874 can impose much higher penalties than section 367(a). If the other statutory requirements are met, and there is an 80 percent overlap between the shareholders of old USCo and New ForeignCo, New ForeignCo is treated as a domestic company under U.S. tax rules. In effect, the inversion has failed.

Despite the larger hammer in section 7874, the government did not withdraw the section 367(a) regulations. Today, two sets of rules aimed at preventing inversions remain on the books.

Section 7874 was designed to prevent transactions in which companies changed only a "filing cabinet and a mailbox" but nothing of substance in their business operations. It was not intended to curtail transactions in which there was a meaningful change in a company's ownership. Only after companies figured out a way to undertake inversions without being subject to section 7874's draconian penalties did the IRS try to expand its scope to prevent more substantive merger transactions.

Because section 7874 was enacted to stop paper transactions, a penalty is imposed only when there is a significant shareholder overlap between the historic U.S. company and the new inverted company. To get the targeted sets of transactions, lawmakers provided that shares issued in a public offering should not be counted in determining whether there had been an ownership change. For example, even if a domestic company merges into a foreign company in a transaction in which former shareholders of the USCo own less than 60 percent of New ForeignCo, an inversion transaction may still be deemed to occur if there has been an initial public offering of 25 percent of the shares of New ForeignCo in a related transaction.

Specifically, section 7874 provides that certain stock is disregarded in testing ownership when determining whether an inversion transaction has occurred. Among the types of disregarded stock is stock of the foreign corporation that is sold in a public offering related to the acquisition.

Because the statutory language of section 7874 referred only to public offerings, inversions of U.S. companies could take place in the context of private buyouts without being subject to the law.

The 2009 Fix

The government didn't like this result. The Obama administration and the IRS viewed private equity buyout transactions that used foreign companies as the acquisition vehicles as violating the intent of the statute, even when there was minimal shareholder overlap. Treasury released a notice announcing its intention to issue regulations interpreting the term "public offering" to include shares issued for cash, marketable securities, or any other property acquired in a transaction with a principal purpose of avoiding the purposes of section 7874 (Notice 2009-78, 2009-40 IRB 452).

The IRS issued regulations based on Notice 2009-78 in early 2014.

Arguably, this interpretation directly contradicts the legislative history. Prior versions of section 7874 referred to stock "which is sold in a public offering or private placement related to the acquisition" (S. 1637, S. Rep. No. 108-192 (Sept. 18, 2003)). The final statute had a more restrictive definition referring only to a public offering.

The Latest Wave of Inversions

This significant expansion of the original scope of section 7874 put a damper on inversion transactions for a while. However, a different type of transaction soon became more prevalent. Previous waves of transactions involved companies reincorporating into jurisdictions with no corporate income tax, such as Bermuda or the Cayman Islands. Now companies began to expatriate without falling within the section 7874 penalty by using the substantial business activities exception. To meet this exception, companies expatriated into jurisdictions with lower (but not zero) corporate tax rates in which they had substantial business activities. The insurance company AON PLC's move from Chicago to the United Kingdom is an example of this kind of inversion.

Once again Treasury and the IRS tried to stop the inversions. Temporary regulations issued in June 2012 interpreted the substantial business activities exception to require at least 25 percent of each of the group employees, group assets, and group income to be located or derived in the relevant foreign country.

The 2012 temporary regulations severely curtailed the ability of any company to reincorporate overseas using the substantial business activities exception. Few U.S. multinationals have 25 percent of their sales taking place in any single jurisdiction outside the United States.


There is one type of inversion transaction that the statute has not shut down and that the 2009 notice appeared to approve. It involves a substantive merger between a U.S. company and a foreign company in which the shareholders of the domestic company hold less than 80 percent (or 60 percent) of the shares of the new entity after the transaction.

Unlike the single reincorporations of the late 1990s, these merger transactions are real business combinations. As such, they could result in a double whammy for U.S. taxpayers. For example, in trying to appease U.K. government officials in connection with its failed bid for AstraZeneca PLC, Pfizer Inc. committed to plans for retaining research functions in the United Kingdom. Job cuts in a post-merger company would likely have happened in the United States. In causing U.S. companies to pursue and undertake mergers with companies headquartered outside the United States, the corporate tax rate and the legislative and regulatory rules have created an incentive for them to move not just paper, but real business activities.

The Latest Proposed Fix

The latest proposal from President Obama and Democratic lawmakers would tighten the rules still further by increasing the ownership stake that must be held by new shareholders to 50 percent. Bills (S. 2360 and H.R. 4679) introduced by Sen. Carl Levin, D-Mich., and his brother, House Ways and Means Committee ranking minority member Sander M. Levin, D-Mich., would amend the rules of section 7874 so that it would apply, regardless of the change in ownership, if the management and control of the company after the transaction is located, directly or indirectly, primarily within the United States, and the group has significant business activities in the United States. The change would make even substantive merger transactions much harder to do. However, companies determined to leave will still have options.

Joint Ventures

On May 7 Mondelez International Inc. announced its intention to enter into a joint venture with D.E Master Blenders 1753 NV to form a pure coffee company. The parent company of the joint venture would be organized in the Netherlands. The deal provides an example of one type of transaction that would continue to be viable even if new legislation is enacted. Mondelez will receive a 49 percent equity stake in the combined company, along with $5 billion in cash.

Restricting its ownership stake to under 50 percent will allow Mondelez to stay within the section 367(a) regulatory test (reg. section 1.367(a)-3(c)). It should prevent any earnings of the joint venture from being considered subpart F income. By transferring this significant business to a foreign corporation, Mondelez has allowed much of the earnings from the coffee business to remain outside the U.S. tax net. Depending on the type of equity received in the exchange, it may be able to shelter future asset value growth as well.

The Mondelez deal would not violate even the more restrictive ownership tests in the Levins' legislation unless the coffee business could be considered substantially all of the properties of Mondelez.

Subsidiary Acquisition

On May 6 Bayer AG announced its intention to acquire Merck & Co. Inc.'s consumer business in a $14 billion deal. The transaction would not fall under the classic definition of an inversion as the parent company, Merck, will still be a domestic company. However, in transferring a business valued at $14 billion out of the United States, the Merck-Bayer deal still represents a significant expatriation of a large domestic business. Merck appears to have structured the transaction to require current recognition of tax (at least for financial statement purposes), as the materials state that after-tax proceeds from the transaction will be between $8 billion and $9 billion.

At the same time, Merck and Bayer announced a plan to jointly develop and commercialize certain cardiovascular assets. Neither company has provided any details of the effort, but it's likely that it would result in a shift in the intangible value of the cardiovascular assets to a location outside the United States.

Like the Mondelez transaction, the Bayer-Merck transaction should not cause any foreign company to be treated as a domestic company under the Levins' bills.


Vodafone recently announced plans to move its research and product development center from Silicon Valley to London( The move represents another option for companies that want to escape U.S. taxation. Proposed amendments to section 7874 would be unable to prevent companies from moving valuable people and assets out to develop intangibles in jurisdictions that will tax the revenue stream at a lower rate.

Spinoffs and Inversions

At the 2014 Berkshire Hathaway shareholder meeting, Warren Buffett was asked about a potential breakup of his company. It would not happen unless by breaking it up he could "detax" the whole thing, he said. Buffett's response indicates a way in which Berkshire Hathaway might be broken up. If it were split into pieces small enough to make viable merger partners under section 7874, Buffett could achieve de-taxation.

In March a Reuters article said that there are "100 newly listed mid-large cap companies due on the market in the next 12 months via a Spinoff transaction." Each of these smaller, stripped-down companies potentially represents a better merger partner that can be combined with a foreign company without violating current section 7874 rules. For example, Kimberly-Clark Corp. is spinning off its healthcare business into a sector of the market that is rife with takeover attempts. Rules under section 355(e) would generally impose a two-year moratorium on acquisition or merger talks from the date of the spinoff.

Businesses must compete on costs in order to survive. Further tightening section 7874 will not be the end of the inversion story.

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