What Is a Tax Inversion and Its Tax Consequences?

A corporate tax inversion is a strategic maneuver where a company relocates its legal domicile to a country with a lower tax rate to reduce its overall income tax burden. While a company’s operational headquarters and business activities often remain in the original country, the change in legal address alters its tax jurisdiction. The practice has been used by U.S. corporations seeking more favorable tax treatment on global earnings, prompting legislative action to address its impact on the domestic tax base.

The Mechanics of a Corporate Inversion

A corporate inversion is a restructuring transaction executed when a U.S.-based corporation merges with or acquires a smaller foreign company in a country with a more favorable tax system. Following the transaction, the U.S. company becomes a subsidiary of the foreign entity, and its shareholders exchange their stock for shares in the new foreign parent company. This process moves the corporation’s legal and tax residence out of the United States, even though its core operations and management may not physically move. The new corporate structure consists of a foreign parent company at the top, with the original U.S. corporation operating as a controlled subsidiary. This arrangement is sometimes called a “reverse merger” because the larger acquiring company subordinates itself to the smaller, foreign target for legal domicile purposes.

Tax Implications for the Inverting Corporation

The motivation for a corporation to execute an inversion is the reduction in its global tax liability. The Tax Cuts and Jobs Act of 2017 (TCJA) shifted the U.S. from a worldwide tax system to a territorial system. Before this change, American companies owed U.S. tax on all profits, regardless of where they were earned, though taxes on foreign income could be deferred. An inversion allowed a company to avoid this system for future foreign profits.

Under the current territorial system, a 100% deduction is allowed for the foreign-source portion of dividends from certain foreign corporations. An inversion can still offer benefits, such as gaining access to offshore cash reserves without incurring certain U.S. taxes.

Corporations also use inversions for “earnings stripping.” In this strategy, the U.S. subsidiary borrows from its new foreign parent and makes interest payments on the loan. These interest payments are tax-deductible in the U.S., reducing the subsidiary’s taxable income, while the interest income is taxed at the foreign parent’s lower home-country rate.

Tax Consequences for Shareholders

For shareholders of the original U.S. company, a corporate inversion is a taxable event. U.S. tax authorities treat the transaction as a taxable disposition of stock, meaning shareholders must recognize a capital gain or loss as if they had sold their shares. This tax liability arises even though shareholders receive new shares in the foreign parent company instead of cash. The taxable gain is calculated as the difference between the fair market value of the new foreign shares and the shareholder’s adjusted basis in their original U.S. company shares. This immediate tax impact can be a downside for taxable U.S. investors who have substantial unrealized gains in their stock.

U.S. Anti-Inversion Rules

The U.S. government has implemented anti-inversion rules, primarily in Section 7874 of the Internal Revenue Code, to remove the tax benefits of an inversion if certain conditions are met. The rules are triggered based on the level of ownership that the former U.S. company shareholders retain in the new foreign parent corporation.

There are two ownership thresholds. If former shareholders of the U.S. company own 80% or more of the new foreign parent’s stock, the foreign company is treated as a U.S. corporation for all U.S. tax purposes. This nullifies the entire tax benefit of the inversion.

A second threshold is set at 60% ownership. If former U.S. shareholders own at least 60% but less than 80% of the new foreign parent, the inversion is respected, but with penalties. The inverted U.S. corporation is restricted from using certain tax attributes, such as net operating losses, to offset any income or gain recognized from the transfer of assets during the inversion.

Impact of Recent Tax Legislation

The Tax Cuts and Jobs Act (TCJA) of 2017 altered the financial incentives for U.S. corporations to pursue tax inversions. The TCJA reduced the top U.S. federal corporate income tax rate from 35% to 21%, which narrowed the gap between U.S. tax rates and those in lower-tax jurisdictions, making the savings from an inversion less compelling.

The TCJA also introduced a tax on Global Intangible Low-Taxed Income (GILTI). This provision imposes a U.S. tax on a company’s foreign profits that exceed a 10% return on its tangible assets held in foreign countries, reducing the advantage of shifting profits offshore.

The law also created the Base Erosion and Anti-Abuse Tax (BEAT). BEAT is designed to prevent corporations from eroding the U.S. tax base by making deductible payments to foreign affiliates, directly targeting earnings stripping techniques. The BEAT tax rate is 10% through 2025 and is scheduled to increase to 12.5% in 2026. Together, the lower domestic rate, GILTI, and BEAT have diminished the tax motivations that once drove U.S. companies to invert.