What Are the U.S. Anti-Inversion Rules?

A corporate inversion involves a U.S. company restructuring its corporate group so the ultimate parent corporation is a foreign entity, a move often made to lower its global tax liability. In response, the United States implemented anti-inversion rules under Internal Revenue Code Section 7874. These regulations do not prohibit inversions but create negative tax outcomes to make them less financially attractive. The rules are based on the ownership percentage that the former U.S. company’s shareholders retain in the new foreign parent, with consequences tied directly to this figure.

Defining an Expatriated Entity

For the anti-inversion rules to apply, a transaction must create an “expatriated entity.” This happens when a foreign corporation acquires a U.S. entity and is treated as a “surrogate foreign corporation.” Three conditions must be met for this classification to occur.

The first condition is that a foreign corporation acquires substantially all of the properties of a domestic corporation. This can happen through a stock or asset acquisition. The term “substantially all” is interpreted broadly to capture transactions that transfer the core assets of the U.S. business to the new foreign parent.

A second condition is the continuity of ownership test. This test requires that former shareholders of the U.S. corporation hold a certain percentage of stock in the new foreign parent “by reason of” their prior ownership. The specific ownership percentages that trigger the rules determine the severity of the tax consequences.

The final condition is that the expanded affiliated group (EAG) to which the new foreign parent belongs lacks substantial business activities in its country of incorporation. The EAG includes the foreign parent and all companies connected through a chain of more than 50% ownership. This condition helps distinguish tax-motivated inversions from legitimate business combinations.

Ownership Thresholds and Their Triggers

The anti-inversion rules are triggered by specific ownership levels that former U.S. company shareholders hold in the new foreign parent. There are two thresholds: one at 80% and another at 60%. The consequences of an inversion are directly tied to which of these thresholds is met or exceeded.

The 80% test is the more severe of the two. If former shareholders of the domestic corporation own 80% or more of the stock of the new foreign parent, the rules are at their most stringent. This high level of continued ownership suggests the transaction is a mere change in corporate form rather than a substantive business combination.

The 60% test applies when ownership is significant but less complete. If former U.S. shareholders own at least 60% but less than 80% of the new foreign parent’s stock, the transaction is an inversion with different tax consequences. In these cases, the new parent’s foreign status is respected, but other punitive tax measures are applied.

An element in calculating these percentages is the exclusion of “disqualified stock.” This is stock of the foreign parent not included in the denominator of the ownership fraction, which increases the ownership percentage of former U.S. shareholders. For example, stock issued in a public offering related to the acquisition is disqualified. This rule prevents companies from artificially diluting ownership to fall below the thresholds.

Tax Consequences of an Inversion

The tax outcomes of a corporate inversion are determined by the ownership threshold that is met. The consequences range from disregarding the foreign status of the new parent company to imposing targeted taxes that limit the transaction’s financial benefits.

When the 80% ownership threshold is met, the new foreign parent is treated as a U.S. domestic corporation for all tax purposes. Despite being incorporated abroad, the entity is subject to U.S. corporate income tax on its worldwide income. This outcome negates the intended tax advantages of reincorporating overseas.

If the ownership level is between 60% and 80%, the new foreign parent is respected as a foreign corporation and is generally not subject to U.S. tax on its foreign-source income. However, the “expatriated entity”—the acquired U.S. company—faces adverse tax treatment on gains from the transaction for 10 years following the inversion.

This adverse treatment centers on “inversion gain,” which is income or gain recognized by the U.S. entity from the transfer of its stock or properties. The rules prohibit using tax attributes, like net operating losses (NOLs) or tax credits, to offset the U.S. tax on this gain. This ensures the U.S. collects a tax toll on the transaction, making it more costly.

The Substantial Business Activities Exception

The anti-inversion rules include an exception for transactions with a legitimate business purpose. Even if the ownership thresholds are met, the rules will not apply if the expanded affiliated group (EAG) has “substantial business activities” in the foreign country of incorporation. This exception allows genuine business combinations to proceed without penalty.

To qualify for this exception, the EAG must satisfy a quantitative test. The substantial business activities test is met if at least 25% of the group’s employees, assets, and gross income are located or derived in the foreign country of the new parent. All three of these 25% requirements must be met for the exception to apply.

The employee test requires that at least 25% of the group’s employees by headcount and 25% of its total employee compensation are based in the foreign country. The asset test requires that the value of the group’s assets in the foreign country is at least 25% of the total value of its assets.

The group’s gross income test requires that at least 25% of its total gross income is derived from the foreign country during a one-year testing period. This income must come from customers or operations located within that jurisdiction. For this exception to apply, the foreign acquiring corporation must also be a tax resident in its country of incorporation, preventing incorporation in a low-tax jurisdiction while being managed from another.