Vol. 5, No. 1

Each edition of Tax Matters consists of free-flowing responses by three tax practitioners to a question regarding a current issue in tax law and policy. Tax Matters commentaries provide insightful perspectives on a broad range of topics, making important contributions to the dialogue within the tax bar about cutting-edge issues. Although the commentaries are certainly of interest to the academic community, they are primarily directed toward tax professionals and their clients.

United States taxation of worldwide income combined with a high corporate tax rate disadvantages US-headed multinational groups compared with groups with the same income mix but a non-US parent. The disadvantage has become more pronounced in recent years as more countries move to territorial systems and lower rates.

US groups have a strong tax incentive to restructure—including by foreign mergers—so their parent is non-US.  They then will never owe US tax on foreign source income earned in subsidiaries of the non-US parent, and so may be able to outbid US competitors for foreign acquisitions.  Corporate inversions also enable conversion of US-source income into untaxed foreign-source income through deductible payments to foreign affiliates.  Moreover, US dividend withholding tax no longer applies.

Congress and the Treasury have reacted several times to limit inversions.  Section 367(a) regulations finalized in 1996 tax US shareholders on gain if together they end up with more than half the shares of the new foreign parent.  Enacted in 2004, section 7874 generally treats the new parent as domestic if at least 80% of its shares are held by former shareholders of the inverting domestic corporation by reason of having held its shares, unless the group has substantial business activities in the new foreign parent’s home country.  Last year temporary regulations narrowly construed this exception.

Foreign mergers continue to occur notwithstanding section 7874, however, including Perrigo/Elan (Ireland) (announced July 29) and Actavis/Warner Chilcott (Ireland) (announced May 20).  Reports of expected tax savings have renewed focus on the policy issues inversions present.  Why are they of more concern than decisions to incorporate a new business abroad?  To what extent do expected savings arise from deductible related party payments?  What do inversions say about whether the United States can sustain a system increasingly out of step with a world of territorial, low-rate systems?  Why do inversions reduce effective tax rates if US groups already can permanently defer tax—and book tax expense—on reinvested business income of foreign subsidiaries? What practical effect has section 7874 had?  Should tax planners advise more US-headed multinational groups to merge or restructure, planning around section 7874, so that they have a non-US parent? What if any non-US tax constraints limit inversions?

By Robert Scarborough, Lecturer in Law, Columbia Law School


Inversions: A UK Perspective | Peter Clements

Considering Corporate Inversions | Andrew Short

Inversions: The American Experience | Eric Sensenbrenner


Inversions: A UK Perspective
Peter Clements
Partner, Freshfields Bruckhaus Deringer LLP

Until recently the U.K., like the U.S., operated a worldwide basis of taxation. Overseas profits of operating subsidiaries were taxed upon repatriation in the form of taxed dividends, and the controlled foreign company (CFC) rules, the equivalent to Sub-part F, taxed many passive profits earned abroad on an accruals basis. The profits and losses of foreign branches were taxed (or relieved) in the same manner as U.K. profits, subject to double taxation relief.

However, the U.K. regime has changed markedly in the last few years. The result is a much more territorial tax system – and one that seems to be proving attractive to business.



The U.K.’s tax regime has always had a number of attractive features for multinational groups, including the absence of a dividend withholding tax, generous relief for financing costs, and an extensive tax treaty network. Against this was the existence of the CFC regime and the historic lack of an exemption for foreign dividends. Nevertheless, the UK held its own against other major economies overall.

In the years leading up to 2007/2008, however, the balance started to shift. A gradual annual tightening of the CFC rules was followed in 2007 by a proposal from the Labour Government to implement major changes that threatened to bring almost all passive income earned abroad into the U.K. tax net unless it was taxed at rates close to the U.K. tax rate (then 30%) – like Sub-part F, but without the benefit of any deferral mechanisms.

For many, this represented a tipping point, and a number of high profile U.K. companies took steps to move their tax domicile abroad. WPP, the giant advertising group, announced in 2008 that it had moved its tax domicile to Ireland – as did Henderson Group, United Business Media, and Shire, the pharmaceutical group. Ineos, the fourth-largest chemicals company in the world, moved to Switzerland a few years later. By late 2009 this trickle risked becoming a flood – with the Financial Times reporting that more than half of companies had considered leaving the U.K.[2], including a number of FTSE heavyweights.

The U.S. response, when confronted with similar circumstances prior to 2004, was to introduce and then tighten draconian anti-inversion rules – effectively using a legislative ‘stick’ to ensure that U.S.-domiciled corporations were not tempted by the lower effective tax rates offered by overseas jurisdictions.

In contrast, the UK’s response was to start dangling the carrots.


The UK reforms

In truth, the Government may have been influenced in part by the fear that a blanket anti-inversion rule could not be implemented without the risk of taxpayer challenge based on the EU fundamental freedoms – a fetter to which the U.S. is not subject. In any event, whatever the reason, the official tone softened, and in July 2009 the first substantive legislative change was made with the introduction of a broad exemption for overseas dividends.

However, it was when the current Conservative-led coalition Government came to power in May 2010 that the transformation of the U.K. tax system really accelerated, with Chancellor George Osborne declaring his goal for the U.K. to have “the most competitive tax regime in the G20.” A period of consultation with business and professional bodies followed, culminating in a substantial reform of the U.K.’s CFC regime with effect from 1 January 2013. The rules are now intended to be targeted more narrowly at the kind of “wholly artificial” diversions of profits from the U.K. that the European Court described in the Cadbury Schweppes case (C-196/04). This complemented a corresponding (optional) exemption for profits of overseas branches of a U.K. resident company introduced in 2011. These measures, coupled with the dividend exemption, substantially completed the U.K.’s transition to a territorial basis of taxation – bringing it into line with many other European jurisdictions.

A parallel initiative was to slash the mainstream corporation tax rate. In 2010, the rate was 28% (still low by U.S. standards, of course). By 2015 it will be 20%, the joint-lowest in the G20. For profits deriving from patented products, the new “patent box” regime will bring the effective rate down to 10%. This makes the tax differential with countries like Ireland and Switzerland much narrower – which in turn makes the incentive to leave the U.K. significantly weaker.


The reaction

So has the “carrot” policy been a success? It is early days but the signs are positive. Some of the most high profile departures have announced their return, including WPP and Henderson. Additionally, new businesses are starting to see the attraction of a U.K. base. Aon, the global insurance broker, last year moved its headquarters from Chicago to the U.K. (its shareholders apparently taking the U.S. tax hit) and disclosed in an SEC filing that the U.K. territorial tax system would produce “significant value for shareholders” going forward. Indeed, research by FDI Markets found that 45 foreign companies recently moved their global or regional headquarters to London, up from just 25 in 2009.

Of course, UK headquarters do not themselves attract much investment or create much employment. But once a base is established, further growth may follow: Noble Corp cited the talented local workforce as one of the reasons for its recently announced relocation to the U.K. from Switzerland. And GlaxoSmithKline has pledged to invest £500m in the U.K., and to relocate key research jobs, as a direct result of the U.K.’s patent box regime and other tax reforms.

But it’s not all plain sailing. Even while striving to make the U.K. more attractive to multinationals, the Government clearly feels forced to respond to the current wave of popular hostility against perceived “unfair” or “immoral” tax minimization techniques of large companies. The result is a mixed political message, which risks undermining the positive effect of the reforms. An Ernst & Young survey recently reported that 67% of tax professionals believe that uncertainty created by the debate on tax “fairness” is now the main deterrent to investing in the U.K.[3]

Overall, however, most businesses acknowledge that the U.K. has taken a big step in the right direction. Perhaps the U.S. should take note.

The views expressed in this article are those of the author and do not necessarily reflect the views of Freshfields Bruckhaus Deringer LLP.

[1] Partner, Freshfields Bruckhaus Deringer LLP

[2] “Taxation risks business exodus” Financial Times, 7 December 2009.

[3] “Budget 2013: Keeping the UK open for business”, Ernst & Young, 20 March 2013.

  Considering Corporate Inversions
Andrew Short
Partner, Paul Hastings LLP. All views expressed herein are solely those of the author.

The United States taxes U.S. corporations on their worldwide income, at one of the highest corporate tax rates in the world. It is understandable that U.S. corporations with offshore operations strive for the advantages of the lower tax rates available to competitors in offshore jurisdictions where these corporations operate. Current U.S. tax law provides U.S. multinationals with a limited ability to structure offshore operations using foreign corporate subsidiaries to defer tax on active earnings so long as those earnings are reinvested offshore and not repatriated to the United States. U.S. multinationals spend significant time and incur significant expense trying to maximize the benefit of deferral. Deferral is only temporary, and ultimately the profits are taxed in the United States upon repatriation.

However there are limits. It is often desirable from a corporate perspective for U.S. multinationals to operate in different regions of the world through different corporate chains. Existing planning opportunities make it difficult to transfer funds from one chain to another without incurring U.S. taxes. Deferral requires demonstrable business activity. The contemporary technologically advanced business model is not always consistent with the traditional notions of an active business enterprise and some offshore operations may fall short of the statutory activity requirement. Deferral also requires the foreign subsidiary to maintain employees in the offshore jurisdiction, comply with frequently onerous employment laws, and become subject to media criticism for moving jobs overseas.

Established U.S. multinationals must consider whether a corporate inversion, consisting of the expatriation of the domestic parent offshore and reestablishment in a lower tax jurisdiction, is an appropriate solution. The corporate inversion provides a clear path for the corporate group to pay taxes at a lower effective rate, and minimizes the U.S. tax planning associated with circulating profits within a corporate group. Planning for “permanent’ deferral through foreign subsidiaries is difficult whereas permanent exclusion is a fundamental benefit of corporate inversions. Subject to some limits, the inverted U.S. corporation can reduce taxable income by creating deductible interest and royalty payments, and transfer pricing techniques can be used to allocate profit attributable to “headquarters operations” offshore.

The incentive to expatriate also applies to owners of less well-established U.S. businesses. The United States provides start-up businesses with access to capital through angel investors and venture capitalists. The United States provides a stable legal system in which to operate. Perhaps most importantly the United States provides a pool of talent to develop the business successfully. Entrepreneurs initially may not consider the ultimate tax ramifications of establishing operations in the United States rather than offshore. Many soon realize that building a business through investing after-tax profits based on a 35% rate (or 39.5% for non-incorporated businesses) is substantially more difficult than building one based on after tax proceeds at the lower rates available in offshore jurisdictions. Although it may not be feasible for an entrepreneur to initially establish offshore operations, once the entrepreneur has gained some footing, and the tax bill becomes too high, thoughts of inversion arise.

Congress has made inverting more difficult by introducing Section 367, which limits tax-free reorganizations with foreign corporations, and Section 7874, which either requires inverted entities to pay U.S. taxes on a specified portion of their overall gain, or, if substantial U.S. ownership remains, treats inverted entities as U.S. corporations. Nonetheless U.S. businesses have continued to invert. There are methods to avoid the statutory restrictions and penalties for inversions, including by acquiring an existing business. Moreover, especially for the newer businesses, the tax costs of the existing penalty may not be prohibitive if inversion is considered before there is substantial untaxed appreciation.

Successful inversions move revenues and the associated tax revenue, as well as the jobs that are particularly scarce in today’s economy, offshore. Significant time and effort is devoted to tax planning for the business which takes away resources that could be used to grow the business itself. Business acquisitions may be undertaken more for tax purposes than for business purposes. Finally, the overall conversation in the media and business groups about the competitiveness of the U.S. tax system leads the global community to wonder if the United States is a good business environment.

One way to reverse the incentive is to adopt a territorial system of taxation. Under a territorial system, U.S. tax is imposed only on earnings from U.S. operations. Many major world economies tax based on the territorial tax system to facilitate the global flow of capital. Adopting a territorial system will allow domestic firms to repatriate their profits tax-free and return to a level playing field with their foreign competition. In turn, there will be less of an incentive for U.S. multinationals to change their tax residency and corporate inversions would no longer be a significant problem in the United States.


Inversions: The American Experience
Eric Sensenbrenner
Partner, Skadden, Arps, Meagher & Flom LLP. All views expressed herein are solely those of the author.


The American experience with corporate inversions has been one of iteration, that has seen periodic waves of expatriation activity followed by (sometimes swift) legislative and regulatory changes designed to curtail these transactions, only to be followed by yet another wave of new types of expatriation transactions, as the market reacts to the shifting legal landscape. The legal framework governing these transactions has both evolved in response to transactions occurring in the marketplace, and played a role in shaping subsequent generations of inversion transactions. We are currently witnessing one of these waves, involving combination transactions with smaller foreign merger partners, which have become the dominant form of inversion transaction today, largely as a result of changes made in June 2012 to the substantial business activities test under section 7874.

Despite each new legal and regulatory regime of increasingly strict rules discouraging inversions, the appetite of U.S. multinationals to be organized under a foreign-parented structure remains unabated, and that should not be surprising. In contrast to foreign competitors organized in countries with territorial tax systems, and who can effectively base-erode their U.S. operations without significant limitation, U.S.-based multinationals are at a significant disadvantage. Until Congress addresses the fundamental structure of the U.S. system of taxing international income and the systemic biases that favor such foreign-parented structures, we should expect such transactions to continue.


Foreign Mergers as the Dominant Form of Inversion Today

The foreign merger has emerged as the dominant form of inversion transaction today, not so much by design, as by default. Any cross-border combination transaction effected today must navigate the rules of both section 367(a) and section 7874. Although similar in their aims, the focus of these two provisions is somewhat different, and in their consequences, dramatically so. On a certain level, both of these regimes could be viewed as essentially effecting a purposive test, attempting to ascertain whether the subject transaction is being undertaken for business reasons that dictate the chosen structure or jurisdiction of reincorporation, or instead reflect a tax motivation.

Regulations under section 367(a) permit a transaction to be tax-free to U.S. shareholders of the U.S. company only where, among other requirements, they receive no more than 50% of the foreign company stock and the foreign company is at least equal, or greater, in value. This regime could be seen as setting up a presumption that the natural form of business combination transaction involves the larger company acquiring the smaller one, and the decision to depart from that form implies a tax motive. However, as was seen in the inversions that occurred in the early part of the last decade, shareholder-level taxation was seldom an impediment, due to the large degree of institutional shareholding, and existing market conditions.

Recognizing that shareholder taxation was not stemming the tide of inversions, in 2004 Congress acted, this time focusing squarely on single-company inversions into jurisdictions where the corporate group lacked substantial business activity. Under section 7874(b), where there is the requisite 80% or greater continuity by former shareholders of the U.S. company and the group does not conduct substantial business activities in its jurisdiction of organization, the foreign parent company is treated as a domestic corporation. Like the 367(a) regulations, this regime too can be seen as essentially a purposive test, drawing a distinction between inversions (defined at the 80% continuity threshold) into jurisdictions where there are substantial business activities (presumptively for business reasons) and those where there are not substantial business activities (presumptively tax motivated).

For several years following the enactment of section 7874, and two sets of Temporary Treasury Regulations, the focus of the inversion transactions was on satisfying the substantial business activities test. Inversions that formerly had been undertaken into jurisdictions such as Bermuda and the Cayman Islands were now replaced by inversions into jurisdictions such as the Netherlands and the United Kingdom, which not coincidentally around the same time had substantially revised its domestic tax laws to become a far more attractive holding company jurisdiction. The government response came in June of 2012, in the form of a new set of Temporary Regulations that render the substantial business activities exception unavailable for all but a few companies with a strong concentration of activities in a single foreign country.

In the wake of these recent changes the foreign merger transaction has emerged, involving business combinations between U.S. companies and generally smaller (but more than 25% of the size of the U.S. company) foreign companies, sometimes under a holding company formed in a third, more attractive jurisdiction. Because these transactions rely on the shareholders of the U.S. company receiving less than 80% of the stock of the foreign parent and not on the presence of substantial business activities, U.S. companies once again are afforded their choice of jurisdiction. This type of foreign merger transaction sets up a curious paradigm, where “foreignness” itself becomes a valuable attribute that commands a premium in the marketplace, and raises interesting questions in the context of a transaction that relies on the shareholders of the foreign company receiving more than 20% of the stock.



That inversions of one sort or another continue, despite repeated attempts to quash them, only highlights the benefits of a foreign-parented structure. The approach to-date, by focusing on curtailing the ability of U.S. companies to invert, instead of the underlying features of the U.S. tax system that disadvantage U.S.-based multinationals relative to their foreign-parented competitors, has only led to new, and different forms of inversions. Fundamentally, the decision of where to incorporate is driven by the same considerations, whether that decision is exercised in the context of starting a business, determining which company will be the acquirer in a cross-border business combination, or in a standalone inversion. Until the fundamental structure of the U.S. system of taxing international income is addressed, that decision will favor foreign-parented structures, and experience has shown that such transactions are likely to continue despite ever-restrictive anti-inversion regimes.