What Is an Inverted Corporation & Its Tax Implications?
Understand the corporate restructuring strategy of an inversion, its effect on global tax liability, and the specific U.S. tax code provisions that govern it.
A corporate inversion is a strategic restructuring used by a U.S.-based multinational company to lower its global tax obligations. The process involves changing its legal domicile to a country with a more favorable tax system by making the U.S. company a subsidiary of a new foreign parent corporation.
While the company’s legal address changes, its core operations and management often remain in the United States. The primary driver for this maneuver is potential tax savings, which can enhance shareholder value. This practice is a legal method of tax reduction and is distinct from illegal tax evasion.
The Mechanics of a Corporate Inversion
The most common method to achieve an inversion is through a merger with a foreign entity, where a U.S. corporation merges with a smaller foreign company in a low-tax jurisdiction. The transaction is structured so the foreign entity legally becomes the parent of the combined group.
The original U.S. corporation then continues its operations, but now as a subsidiary of the new foreign parent. The shares of the former U.S. company are exchanged for shares in the new foreign parent, and the U.S. entity is dissolved as the top-level corporation. This change in structure alters how its foreign earnings are treated under U.S. tax law.
Primary Tax Implications of Inverting
Historically, inversions were driven by the U.S. “worldwide” tax system. The Tax Cuts and Jobs Act of 2017 shifted the U.S. to a modified “territorial” system, where dividends from foreign subsidiaries may be largely exempt from U.S. tax. However, anti-abuse rules were introduced to prevent companies from shifting profits to low-tax countries.
Tax considerations remain a driver for inversions under the new system. Rules designed to tax certain foreign income, such as the Global Intangible Low-Taxed Income (GILTI) and the Base Erosion and Anti-Abuse Tax (BEAT), can still subject a U.S.-parented company’s foreign profits to U.S. taxation. By changing its legal domicile, a company may navigate these provisions more effectively, though its U.S. subsidiary still pays U.S. taxes on domestic income.
The act of inverting triggers immediate tax consequences for the original U.S. shareholders. The exchange of U.S. shares for new foreign parent shares is treated as a taxable sale. Shareholders must recognize and pay capital gains tax on the difference between the market value of their new shares and their original cost basis, even if they have not sold the shares for cash.
U.S. Anti-Inversion Regulations
The U.S. government enacted rules to discourage corporate inversions, primarily within Internal Revenue Code Section 7874. This legislation does not prohibit inversions but imposes negative tax consequences if certain ownership thresholds are met. The rules are centered on the percentage of the new foreign parent company owned by the former shareholders of the U.S. company.
Two ownership tests form the core of the regulations. The first is the 80% test. If former shareholders of the U.S. company own 80% or more of the stock of the new foreign parent, the IRS disregards the inversion for tax purposes. The new foreign parent is then treated as a U.S. corporation, nullifying the intended tax benefits.
A second test applies if former U.S. shareholders own at least 60% but less than 80% of the new foreign parent. In this scenario, the company is respected as foreign but is labeled a “surrogate foreign corporation.” This status comes with adverse tax consequences for a 10-year period, such as restricting the use of tax attributes like net operating losses to offset U.S. tax on gains from the inversion.
Section 7874 includes an exception known as the “substantial business activities” test. The anti-inversion rules may not apply if the new foreign parent’s corporate group has substantial business operations in the country of incorporation. Treasury regulations define “substantial” as requiring at least 25% of the group’s employees, assets, and gross income to be located in the new home country. This exception distinguishes between tax-motivated inversions and business combinations where the foreign entity has a real operational footprint.