Much ink has been spilt in the U.S. press recently on the topic of “inversion” transactions -- from Pfizer’s failed pursuit of AstraZeneca, to the $48 billion Medtronic/Covidien deal, to the more recent and creative Cosmo Technologies/Salix Pharmaceuticals, Mylan/Abbott and Burger King/Tim Hortons transactions. Advocates of inversions claim the deals seek to create shareholder value; detractors condemn them as unpatriotic and immoral. This article does not take sides in the debate but rather clarifies the basic elements of these transactions, which are sometimes misunderstood.

What Is an Inversion?

An inversion is the acquisition by a foreign corporation of a U.S. corporation (a U.S. Target). Although some reports describe inversion transactions as the takeover by a U.S. corporation of a foreign corporation, the opposite is actually the case as a technical matter. The confusion arises because the U.S. Target in an inversion transaction is often much larger than the foreign corporation, and other factors are present that suggest the U.S. Target is the acquirer. However, for the U.S. tax benefits from an inversion to be available, the foreign corporation must be the acquirer, even if it is the smaller company.

For an inversion transaction to “work” (that is, for the foreign acquiring corporation not to be taxed as a U.S. corporation), it is critical that the former shareholders of the U.S. Target own less than 80% of the shares of the foreign corporation following the transaction. Of course, the relevant rules are detailed and complex, and what is counted in the calculations can sometimes be counterintuitive, as described below.

Who Really Is Acquiring Whom?

From a purely commercial point of view, it is understandable to think of the U.S. Target as the acquirer. After all, the shareholders of the U.S. Target typically end up owning a significant majority of the equity of the combined company after the inversion. In most cases (though not all), the name of the combined entity will be the name of the U.S. Target. For instance, Medtronic plc will be the name of the parent entity created in the inversion transaction between the U.S. Target Medtronic and the foreign company Covidien plc. The operational headquarters of the combined businesses often remains in the United States, as is the case, for instance, in the AbbVie/Shire deal (Chicago) and the Cosmo Technologies/Salix Pharmaceuticals deal (Raleigh). The board of the combined company is usually composed mostly of members of the U.S. Target’s board, with a few additions from the foreign company, and the management team of the U.S. Target typically dominates the executive suite after closing. Finally, the U.S. Target is often the party proposing the transaction in the first place, sometimes in an obviously unsolicited manner.

Why Would a U.S. Corporation Wish to Be Acquired by a Foreign Company?

There are many reasons that a U.S. Target may wish to enter into an inversion transaction. Some reasons have nothing to do with tax, such as achieving or expanding an international platform or more readily accessing the international capital markets or simply expanding in search of growth. However, it is fair to say that reducing the U.S. tax burden (and, relatedly, deploying cash “trapped” outside the United States) is often a major, if not the primary, reason for an inversion. Private equity sponsors that own U.S. portfolio companies may want to take advantage of these benefits if they can find the right foreign partner, as 3G Capital, the majority owner of Burger King, has done with Tim Hortons.

The United States, at 35%, has the highest corporate tax rate of any OECD country. In contrast, the Irish and UK corporate income tax rates are 12.5% and 21%, respectively. The United States is also one of the only industrialized countries to tax the worldwide earnings of its corporations, including upon repatriation. Other countries have a “territorial” system under which the repatriation of earnings from offshore subsidiaries to the parent is exempt from taxation (either entirely or to a large extent). Although the U.S. grants a credit for foreign taxes paid by offshore subsidiaries, the credit system results in incremental U.S. taxes to the extent the foreign tax rate is lower than the U.S. rate. (For example, upon the repatriation of foreign earnings taxed locally at 10%, the U.S. will collect a 25% federal tax – the excess of 35% over 10%.) Moreover, under the United State’s extensive anti-deferral regimes, the U.S. often taxes foreign earnings even before they are repatriated. Adding further salt to the wound is the fact that the U.S. tax compliance burden is very high due to the formidable reporting requirements that the U.S. imposes on its multinationals.

Many U.S. Companies Do Not Actually Pay the Full 35% Tax Rate, So Why Do They Still Wish to Invert?

It is correct that many U.S. multinationals do not have an effective tax rate anywhere near the nominal U.S. corporate rate due to a variety of tax planning strategies. For example, U.S. multinationals, particularly those in the pharma and technology areas, are often able to fund research and development from subsidiaries organized outside the United States. If the R&D leads to the creation of valuable intangibles, the foreign subsidiary that funded the research is entitled to reap some or all of the profits from the commercialization of the intangible. In this way, significant earnings may be kept offshore, and a lower effective U.S. tax rate may be achieved. (For example, Apple is reported to have a 7% global effective tax rate.) However, the benefit is merely one of deferral. If and when the U.S. parent wishes to access the earnings of its foreign subsidiaries (either by receiving a dividend of, or by borrowing, the foreign earnings), the U.S. parent must pay U.S. tax on the amount accessed.

When a U.S. Corporation Inverts, Does it Avoid All U.S. Income Taxes?

One persistent misconception is that U.S. multinationals do not have to pay U.S. income taxes once they invert. The truth is that a U.S. multinational that inverts must still pay U.S. income tax on the earnings derived from its U.S. operations and from its foreign operations that continue to be owned by a U.S. company. However, it is also true that inversions provide an opportunity to diminish the U.S. tax base, as described below.

What Are the Key U.S. Tax Benefits Derived From an Inversion?

There are two major U.S. tax benefits that can be achieved through an inversion. First, the U.S. Target can be leveraged with intercompany debt from the foreign acquirer in an inversion. The interest paid on the intercompany debt is generally deductible by the U.S. Target, which leads to a smaller U.S. tax base. Although the U.S. has “thin capitalization” rules, they are not very stringent, and significant earnings can be stripped from the United States in this manner. Second, future non-U.S. business expansion that otherwise would have taken place under the U.S. Target can be undertaken by the foreign acquirer. In this way, the U.S. is not able to tax future earnings from international expansion.

Do U.S. Shareholders of the U.S. Target Have to Pay Tax When They Exchange Their U.S. Target Shares for Shares of the Foreign Acquirer?

Many share-for-share exchanges involving a U.S. target and a U.S. acquirer are structured to be tax-free to U.S. shareholders. In an inversion, however, the acquirer is foreign, so the normal share-for-share tax rules do not apply. Generally, inversion transactions are taxable to U.S. shareholders of the U.S. Target, unless the equity value of the U.S. Target is equal to or smaller than the equity value of the foreign acquirer. If the U.S. Target is the bigger of the two companies, U.S. shareholders will be taxed when they exchange their U.S. Target shares for shares of the foreign acquirer (to the extent of any gains based on the fair market value of the shares received). If the transaction is a pure share-for-share exchange, U.S. shareholders who recognize gain would have “phantom income” and must satisfy their U.S. tax liability by using other resources or selling some of the shares of the foreign acquirer that they receive.

Has the U.S. Congress Done Anything to Curtail Inversions?

The Shareholders of the U.S. Target End Up Owning 80% or More of the Combined Company Post-Inversion. Congress enacted anti-inversion legislation in 2004. The legislation imposes a severe sanction in cases where the former shareholders of the U.S. Target end up owning 80% or more of the foreign acquirer as a result of the inversion. Specifically, the foreign acquirer is treated for U.S. tax purposes as if it were a U.S. corporation. If the foreign acquirer is treated as a U.S. corporation, none of the foregoing tax advantages can be achieved. Moreover, the foreign acquirer would become subject to U.S. corporate income tax on its worldwide earnings. The legislation unilaterally overrides all tax treaty obligations of the United States that would otherwise prohibit the U.S. Government from taxing the foreign acquirer. As a result, the 2004 legislation effectively shut down most inversion transactions where the 80% ownership threshold was reached or surpassed.

The Shareholders of the U.S. Target End Up Owning at Least 60% But Less Than 80% of the Combined Company Post-Inversion. The 2004 anti-inversion legislation also imposes two relatively mild sanctions in cases where the former shareholders of the U.S. Target end up owning at least 60% but less than 80% of the foreign acquirer as a result of the inversion.

First, in such a transaction, executive officers and directors of the U.S. Target are required to pay an excise tax on the value of their stock-based compensation, such as options and RSUs relating to shares of the U.S. Target. The theory is that the public shareholders are required to pay tax on their gains in an inversion deal where the 60% threshold is met, so insiders who orchestrate the inversion should not be allowed to escape tax on the value of their stock-based compensation that would otherwise roll over tax-free into equivalent interests in the foreign acquirer. There is an exception to the excise tax if the stock-based compensation is cashed out at or prior to the closing of the inversion. As a result, many inverting companies choose to accelerate vesting and then cash out stock-based compensation to protect employees and directors who would otherwise be subject to the excise tax. Other inverting companies often simply indemnify their employees and directors against the excise tax.

Second, in the “at least 60% but less than 80%” scenario, gains arising on the transfer by the inverting U.S. company to a related foreign company of appreciated property during the ten-year period following the inversion cannot be reduced by net operating losses or similar tax attributes. Congress’s intention was to prevent a U.S. inverted company from transferring its appreciated foreign subsidiaries to its foreign parent without paying a current toll charge.

Only a Very Narrow Exception Applies. A narrow exception applies in the above scenarios (even in the case where the 80% threshold is met): no sanctions will apply if the foreign acquirer conducts significant business operations in its country of organization. However, Treasury Regulations define “significant business operations” in a way such that very few corporations will qualify for this exception to the sanctions outlined above.

The 2004 Legislation Does Not Effectively Prevent All Inversions. Why Does Congress or the U.S. Treasury Department Not Do More?

The Congress may consider additional actions to prevent inversions. Representative Sander Levin and Senator Carl Levin (the two are brothers) have introduced legislation that would curtail most inversions by, among other things, lowering the threshold for the severe sanction (treatment as a U.S. corporation) to “more than 50%” from 80%. The law would be retroactive to inversions occurring after May 8, 2014. However, the Levin bills have thus far not received wide endorsement. Some in Congress believe that inversions are a symptom of a broken corporate income tax system; they argue that the issue of inversions should be addressed through comprehensive corporate income tax reform such as shifting to a territorial system, the system used in most other developed countries. The Administration has taken the position that legislation should be enacted immediately to deter inversions while Congress works on comprehensive corporate income tax reform.

Congress’s creativity in deterring inversion transactions is not limited to lowering the threshold ownership requirements. For instance, one recent bill threatens to prohibit the U.S, federal government from contracting with companies that have undergone inversions (as well as with other companies that have subcontracted business to the inverted companies). Another legislative proposal would strengthen the rules against earnings stripping and penalize the borrowing of funds by the parent of an inverted group from foreign subsidiaries of the U.S. Target.

Because Congress has thus far not enacted any of the recent proposals, the Treasury Department recently announced that it would try to deter inversions by issuing tax regulations that would make it costly for foreign acquirers in inversions to access the earnings that a U.S. Target holds offshore in foreign subsidiaries. The new regulations would apply to transactions that close on or after September 22, 2014.

Are There Traps for Private Equity in the Current Anti-Inversion Statute?

The 2004 anti-inversion statute and related regulations are written broadly and sweep in transactions that should never be thought of as inversions. For example, in one common fact pattern, a private equity fund that is acquiring a U.S. Target with international operations contributes cash to a newly-formed foreign acquisition vehicle, which then buys all of the shares of a U.S. Target for cash, other than shares held by management. Management of the U.S. Target is permitted to roll its shares into shares of the foreign holding company in exchange for, say, 5% of the shares of the foreign holding company. Under Treasury regulations issued in January of 2014, the 95% of the shares of the foreign holding company owned by the private equity fund are disregarded because they are issued in exchange for a cash contribution. (Don’t ask.) For purposes of the anti-inversion statute, the only shares taken into account are management’s shares. Because those shares constitute 100% of the only regarded shares, the 80% threshold is exceeded, and the foreign holding company is treated as a U.S. corporation subject to unlimited U.S. taxation on its worldwide income.

Do Inversions Present Special Opportunities for Private Equity?

A private equity fund that owns a foreign portfolio company of adequate size may hold the “ticket” for a U.S. Target to effect an inversion. If the deal is sensible from a commercial perspective and the foreign portfolio company is worth more than one-quarter of the value of the U.S. Target (measured by equity value), the foreign portfolio company can serve as the acquirer of the U.S. Target, provided that the shareholders of the foreign portfolio company end up with more than 20% of the shares of the combined company. Because the commercial and tax benefits of an inversion are generally significant, the owner of the foreign company can often extract a premium (in the form of a favorable exchange ratio) in exchange for its willingness to participate in the inversion.

There is no tax law requirement that the private equity fund remain invested in the combined company. For example, in a recent inversion transaction, the private equity investor sold its shares of the foreign portfolio company for cash in a pre-arranged private placement, which closed just prior to effecting the inversion transaction.


Many in Congress and the Administration would like to curtail inversions further. Retroactive legislation has been introduced and the Treasury Department has given notice of new anti-inversion regulations. Because predicting the outcome of government initiatives in an election year is always treacherous, it is clear that there will be a premium placed on creativity in structuring inversion deals going forward.