Corporate Inversion: Exploring the Political and Economic Phenomenon

In a practice called "corporate inversion," American companies fleeing high corporate tax rates seek to reincorporate overseas.

Photo by Alan Cleaver (Flickr)

BY: Henry Raper, Guest Contributor 

Editor’s Note: The Campbell Law Observer has partnered with Judge Paul C. Ridgeway, Resident Superior Court Judge of the 10th Judicial District, to provide students from his International Business Litigation and Arbitration seminar the opportunity to have their research papers published with the CLO.  The following article is one of many guest contributions from Campbell Law students to be published over the upcoming semester.

What is a Corporate Inversion?

Hank Raper

Henry Raper

Corporate inversions have recently become a highly publicized and politically polarizing issue impacting international taxation and multinational corporations.  Since the late 1990s, corporate inversions have become increasingly popular as a way to subvert the United States corporate income tax rate (PDF) of 39.1 percent.1  Corporations also claim inversions allow them increased “operational flexibility.”2

The reason for the rising frequency of corporate inversions is based upon competition in the global marketplace.  If an American corporation is competing with a foreign corporation in the same industry and the foreign corporation pays a zero percent corporate income tax rate, then the American corporation is economically disadvantaged.  By not having to pay corporate income taxes as American corporations, foreign corporations are able to expand and develop their business to the detriment of American competitors.

The most typical method for a corporate inversion is a stock inversion.  A stock inversion is when a domestic corporation, a corporation incorporated within the United States, also operates within other countries.  There are three steps involved in accomplishing a stock inversion.  First, the domestic corporation creates a foreign corporation in a country with a low or non-existent corporate income tax rate, such as Bermuda or the Cayman Islands.  Second, the foreign corporation is used to create a “domestic subsidiary corporation” in order to facilitate the corporate inversion.  Finally, the foreign corporation merges with the domestic subsidiary corporation within the United States.  This allows the foreign corporation to assume all the characteristics of an American corporation, but with foreign control, foreign place of incorporation, and a dramatically reduced or even zero percent corporate income tax rate.

“In sum, the corporate structure is basically turned upside down, with the newly-created foreign corporation becoming the parent (organized outside the United States so that it is a ‘foreign’ corporation), and the former domestic parent becoming a U.S. subsidiary of a foreign corporation.”  A corporate inversion mandates a revamping of corporate bylaws, but no changes occur in daily functions and operations of the corporation.  It may even be difficult to notice a difference in a corporation’s activity following an inversion, as even the headquarters may still be located within the United States.  Many corporate inversions are often referred to as “mailbox inversions” since the most significant change is the corporation shifting its place of incorporation to a foreign country to reduce its overall corporate tax rate.

Support for Corporate Inversion

The United States Chamber of Commerce advocates for the use of corporate inversions as a method to “maximize profitability and stock value” to shareholders.  The Chamber of Commerce also notes corporate inversions are legal under current federal law and are the “free exercise of prudent business decision-making.”  Furthermore, former Majority Leader of the United States House of Representatives, Dick Armey, believes corporate inversions are akin to American businesses choosing Delaware as its place of incorporation to benefit from their corporate friendly tax laws.

Corporations are also use inversion to avoid of significant regulatory costs in the United States.  Examples of high regulatory costs include the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act.3  Sarbanes-Oxley creates “the Public Company Accounting Oversight Board, standards for auditor independence, certification of financial statements and internal controls, new regulations for security analysts, and whistleblower protections.”  By inverting, corporations navigate around Sarbanes-Oxley and avoid complying with the regulations it creates.  Additionally, Dodd-Frank “creates the Bureau of Consumer Financial Protection, undertakes mortgage reform, creates an orderly liquidation authority for financial institutions, requires derivatives to be cleared over clearinghouses, and enhances regulation of credit rating agencies.”  As with Sarbanes-Oxley, many of these reforms implemented through Dodd-Frank may be avoided by a corporation going through the inversion process.

Criticism of Corporate Inversions

Those opposed to corporate inversions have described the practice as: ‘immoral,’ an ‘unpatriotic tax dodge,’ and ‘a bad example of corporate tax cheating.’”  Perhaps the greatest reason to oppose corporate inversion is that it reduces the American tax base at the expense of other individual and corporate taxpayers.  In other words, in order to sustain current revenues into the federal treasury, American taxpayers are obligated to pay more taxes while corporate inverters obtain a tax savings.  The practice is ultimately costing the United States billions of dollars every year.  Based on figures compiled by the nonpartisan Joint Commission on Taxation, the federal coffers will miss out on $19.46 billion over the next decade if the laws surrounding corporate inversions are not changed.

Effect on Shareholders

A corporate inversion also impacts shareholders.  Shareholders of the “former domestic parent” acquire shares in the foreign corporation for their old shares, but must pay taxes on the transaction.  First, shareholders are required to agree to the inversion and second, must pay capital gains taxes for their shares.  The shareholders are then awarded new shares in the foreign corporation in exchange for their shares in the old domestic corporation proportionate to their interest percentage.  Each step in this process requires disclosure to shareholders what the impact to them will be in accordance with Securities and Exchange Commission regulations.  It is the taxation assessed to shareholders that most stands in the way of corporations making the decision to invert.

Although there are shareholder disclosure requirements established by the Securities and Exchange Commission, shareholders often do not realize the full implications of approving an inversion.  Using Bermuda as an example, there are several issues for shareholders if a corporate inversion is approved.  First, laws are not accessible since decisions of courts are not compiled and reported publicly.  Second, there are virtually no limitations to insider trading.  Third, a shareholder vote is not required before a corporation undertakes major transactions. Fourth, there are limitations to derivative suits by shareholders.  Finally, judgments for money damages in the United States are difficult to enforce in Bermuda because the two countries have not signed an agreement to enforce each other’s judgments.

The reason for these changes in shareholder rights following an inversion is the “internal affairs” doctrine.4  According to the United States Supreme Court, the internal affairs doctrine does not allow more than one country to regulate the internal affairs of a corporation.  This may include relationships between “the corporation and its current officers, directors, and shareholders” as well as “the adoption and amendment of bylaws, the holding of directors’ and shareholders’ meetings, and the determination of methods of voting.”  Thus, following an inversion, shareholders rights are dramatically reduced with the possibility shareholders will not have an adequate remedy against the corporation once an inversion is approved.


The structure of American international taxation dates back to the 1960s, when the United States economy contained the majority of multinational investment.  However, this structure has gradually become more strained over the past fifty years.  In the United States, a corporation is considered to be domestic or foreign based on the place of incorporation rule.  If a corporation is classified as domestic by incorporating within one of the fifty American states, then it must pay corporate income taxes on its worldwide income.  Foreign corporations, on the other hand, often apply different standards than place of incorporation in determining taxation.

Worldwide Taxation

A worldwide taxation system is utilized by the United States; whereby, domestic corporations must pay corporate income taxes on all income earned worldwide rather than the income only earned within the borders of the United States.  However, foreign corporations only pay corporate income taxes on income with a “sufficient nexus” to the United States. For foreign corporations, American taxation only applies to income “effectively connected” with the “conduct of a trade or business” in the United States.  According to Martin Regalia, Vice President and Chief Economist for the United States Chamber of Commerce, “The foreign operations of a domestic corporation are thus subject to a burden not borne by local, foreign competitors.”  However, to counter the reduced corporate income tax rate that foreign corporations pay relative to domestic corporations, the United States grants a tax credit “up to the total tax owed on foreign income.”

Territorial Taxation

Outside the United States, most nations apply a tax system known as territorial taxation.  Under this system, corporations pay tax on where the income is earned rather than by place of incorporation, the system used by the United States.  In an effort to stop inversions, the Heritage Foundation has recommended the United States adopt a territorial tax system, moving away from worldwide taxation.  The Heritage Foundation argues this change will diminish the need for corporations to invert due to territorial taxation making domestic corporations more competitive globally.  Countering the recommendation by The Heritage Foundation to switch to a territorial tax system, the Brookings Institute challenges this position by arguing a territorial system promotes tax avoidance and even states, “going to a territorial system as a response to corporate inversions is like choosing to reduce the crime rate by legalizing certain crimes.”

Tax Deferral & Avoidance

The repatriation rule  “allows U.S. corporations to defer the payment of tax on foreign income earned by a separate foreign subsidiary corporation until the funds are repatriated, or remitted to the United States as dividends or other income.”  As a result, the repatriation rule has allowed nearly two trillion dollars to stay overseas and avoid American taxation.  One of the best arguments for ending the repatriation rule is tax fairness so all shareholders pay corporate taxes at a minimum of what the rate is in the United States.  By making this change, shareholders of foreign businesses will not be advantaged in taxation over shareholders of domestic corporations.

Subpart F of the Internal Revenue Code was enacted in 1962 to prevent corporations from deferring taxes in Bermuda or a comparable low tax country.  When shareholders in the United States own more than fifty percent of the stock in a foreign corporation, then the foreign corporation is considered to be a “controlled foreign corporation.”  In handling a controlled foreign corporation, American shareholders must disclose their pro rata share in their tax return of any income, hence designated as Subpart F.  Income gained by the controlled foreign corporation considered to be Subpart F includes “highly mobile passive income, such as interest, dividends, and royalties.”  Income not sufficiently connected to the foreign country where the foreign corporation is incorporated is also considered Subpart F income.  Subpart F income is not “active business income with a sufficient connection to the foreign country in which the foreign subsidiary is incorporated.”

Subsidiaries of a foreign parent corporation have also been used to take on massive amounts of debt to be owed to the foreign parent.  The reason being the foreign parent corporation may claim “large interest payments” from the subsidiary as deductions on their corporate income tax rate.  Other actions include, “manipulation of royalties, management fees, administrative fees, and transfer prices,” which moves income away from American taxation and saves the foreign parent corporation money.  These activities are called “earnings stripping.”

Congressional and Regulatory Response

The most significant action taken by Congress to prevent or limit the use of corporate inversions is the American Jobs Creation Act of 2004 (“Jobs Act”).  The Jobs Act targets corporations that are inverting in order to reduce their overall tax rate to the United States while continuing to operate in the United States.5  One example is Section 4985 of the Internal Revenue Code.  This section imposes an excise tax on shareholders for any gain on stock resulting from a corporate inversion.  For major shareholders, officers, and directors of the inverted corporation, they will be assessed a capital gains tax rate at the maximum level.  Furthermore, Section 4985 now stops tax deductions for executive compensation.

The most vital part of the Jobs Act to halt and reduce corporate inversions is Internal Revenue Code Section 7874.  Section 7874 addresses corporate inversions for two separate classes on inversions, eighty percent and sixty percent.  Eighty percent inversions are stripped of their benefits from inverting and are treated as domestic corporations and must pay taxes at the worldwide rate assessed to all corporations incorporated within the United States.  Inversions are determined to be eighty percent inversions by applying a three-part test.  First, the foreign parent organization obtains “substantially all of the properties held directly or indirectly” by a domestic corporation.  Second, stockholders in the United States own a minimum of eighty percent of the foreign parent’s stock through a transaction where they owned eighty percent of a domestic corporation’s stock.  Third, the foreign parent company and its subsidiaries do not have “substantial business activities” inside the foreign country of incorporation.

Sixty percent inversions are not required to pay worldwide taxation as is expected from eighty percent inversions.  Instead, there are tax penalties for corporations classified as sixty percent inversions.  In determining whether a corporation is a sixty percent inversion, the same test for eighty percent inversions is applied, except the second part of the test is changed to sixty percent rather than eighty percent.  In order to penalize sixty percent corporations following an inversion, Section 7874 of the Jobs Act taxes corporations at the maximum rate for any inversion gains realized for ten years.

Although Congress has taken beneficial action against corporate inversions through the Jobs Act, there are concerns with some aspects of the legislation.  The most noticeable is the failure to define the phrase “substantial business activities” in the third part of the test.  It is not clear whether this phrase encompasses the relocation of a particular department to a foreign country or something miniscule such as the location of shareholders’ meetings.  The failure of Congress to define “substantial business activities” opens the door to corporations exploiting this gap in the Jobs Act.  Fortunately, the Jobs Act granted the Secretary of the Treasury the power to install new regulations to address the frequency of corporate inversions.

Since the Jobs Act was passed in 2004 and Section 7874 was created to reduce corporate inversions, the Secretary of the Treasury has possessed the power to enact regulations to address the practice.  Recently, the Obama Administration put forward new regulations to address new concerns around corporate inversion that have arisen since 2004.  On September 22, 2014, the Department of the Treasury put out a press release announcing new regulations regarding eighty percent corporate inversions.  First, eighty percent incorporations are now blocked from inflating the value of the foreign acquiring corporation so that it appears to be a seventy-nine percent corporation through the use of passive assets.  Through this practice, corporations are able to circumvent the eighty percent rule where the corporation must pay worldwide taxation and only have to pay the penalties under the sixty percent rule.  This new regulation will apply if at least fifty percent of the foreign acquiring corporation is composed of passive assets.  However, financial institutions are exempt from this new regulation.  Second, prior to inverting, corporations may pay out large dividends known as “skinny-down” dividends in order to shrink the size of the corporation to avoid the eighty percent rule.  New regulations will prevent this from occurring in the future, with corporations inverting after passing out large dividends being treated as eighty percent corporations for purposes of Section 7874.


The issue of corporate inversions has become increasing more volatile in the 21st century.  Tensions are amplified by different interest groups advocating for various solutions to the problem such as territorial taxation (The Heritage Foundation) to attacking the same proposal (Brookings Institute).  Other entities have even argued that corporate inversions should not be addressed (United States Chamber of Commerce).  Certainly, corporate inversions will be an issue Congress and federal regulators will need to revisit on a continuing basis for the foreseeable future.  As new laws and regulations are passed and imposed on corporate inverters, new methods of evasion and avoidance of these rules will be uncovered.  Most assuredly, corporations will work diligently to find new ways to avoid taxation in order to gain an edge against their competition in their respective industry.

Henry Raper is a 3L student and will graduate from Campbell Law School in May 2015. He may be reached by email at he*********@em***.edu.