New Treasury Department Rules Limit the Benefit of Corporate Inversions

R. Nicholas Rabold, KLJ Editor-In-Chief[1]

For years, national debate on corporate taxation has centered on the matter of corporate inversions—the practice through which United States companies reincorporate overseas, usually through a merger with a smaller, foreign corporation, with the goal of reducing the company’s overall tax burden.[2] The number of annual inversions has significantly increased over the past decade, with a spike following the 2004 enactment of Section 7874[3] of the Internal Revenue Code, which was designed to discourage the tax minimization practices of some United States corporations.[4]

Much of the outcry revolving around corporate inversions relates to the expatriation of United States corporations and the consequent outflow of capital and tax revenue.[5] However, the real benefit of a corporate inversion does not derive simply from the international merger of a United States corporation and a smaller, foreign corporation.[6] Rather, the merger is merely the impetus. The true benefit of the inversion is derived from earnings stripping.[7]

For sake of example, assume Corporation A, a United States corporation, merges with a foreign corporation, Corporation B, thereby establishing a new corporate headquarters outside the United States—let’s say in Bermuda, a known tax haven.[8] Although the newly-formed Corporation AB has its corporate headquarters in Bermuda, it maintains United States operations through subsidiaries that continue to carry on the business scheme of the now-defunct Corporation A within the United States. Naturally, these United States subsidiaries of Corporation AB will remain subject to taxation by the IRS.[9]

But the entire purpose of the corporate inversion, of course, was to reduce the tax burden imposed by the United States Government, something not significantly accomplished by the merger of Corporations A and B alone because of the remaining, taxable subsidiary operations. Hence the role of earnings stripping.[10] In order to reduce taxes even further, Corporation AB arranges for its United States subsidiaries to heavily leverage their continuing operations through debt held by Corporation AB. The now-indebted United States subsidiaries of foreign, parent Corporation AB will pay tax-deductible interest on that debt to their foreign parent, through which their earnings are ‘stripped’ of their otherwise significant tax burden.[11] This use of such inversions is an ingenious method that allows corporations to protect their income from an otherwise sizable corporate tax burden.[12]

The November 2015 announcement of the planned merger between United States pharmaceutical giant Pfizer Inc. and the Irish pharmaceutical corporation Allergan PLC brought the matter of corporate inversions—and their concomitant tax consequences—to the center of national debate.[13] Although the debate aroused by the proposed merger is ongoing,[14] the deal itself was short lived. It was dead by April.[15] As for the cause? New Treasury Regulations.[16]

The new treasury regulations, released on April 4, 2016, have curbed the benefits of corporate inversions and limited their applicability. The U.S. Department of the Treasury’s press release on the subject notes that this was done by “disregarding foreign parent stock attributable to certain prior inversions or acquisitions of U.S. companies” under 26 U.S.C. § 7874 and “[t]argeting transactions that increase related-party debt that does not finance new investment in the United States” pursuant to 26 U.S.C. § 385.[17] The general effect of these new regulations is twofold.

First, the regulations limit the number of inversions that may escape the application of 26 U.S.C. § 7874 by disregarding stock held by a foreign acquiring company “attributable to assets acquired from an American company within three years prior to the signing date of the latest acquisition.”[18] This has the effect of stepping together[19] the acquisitions by the foreign parent, and then disregarding them in order to look to the overall substance of inverted transactions rather than their form[20] for purposes of determining whether the restrictions of 26 U.S.C. § 7874 apply.[21]

Second, pursuant to authority mandated by 26 U.S.C. § 385,[22] the regulations make “it more difficult for foreign-parented groups to quickly load up their U.S. subsidiaries with related-party debt following an inversion or foreign takeover, by treating as stock the instruments issued to a related corporation in a dividend or a limited class of economically similar transactions.”[23] Significantly, the new regulations “treat as stock an instrument that might otherwise be considered debt if it is issued by a subsidiary to its foreign parent in a shareholder dividend distribution.”[24] This prevents subsidiary corporations engaged in certain transactions from taking tax deductions on interest payments made to their foreign, parent corporation(s) under 26 U.S.C. § 163 and 26 U.S.C. § 67(b)(1) by treating what would otherwise be considered a debt instrument as equity.[25] This undermines the use of earnings stripping as a method of tax minimization.[26]

We know these new regulations, at minimum, were effective in preventing the Pfizer Inc.—Allergan PLC merger agreement.[27] But because these regulations are so new, it is not yet clear what their ultimate economic and tax implications will be. In any event, what is clear is that the Treasury has now taken a more aggressive stance on the outflow of capital and tax revenue from the United States, perhaps signaling the immediate future of tax reform on other matters.[28]

[1] J.D. expected May 2017.
[2] Andrew Soergel, Ask an Economist: What the Heck is a Corporate Inversion?, U.S. companies are increasingly moving abroad to avoid corporate earnings taxes, U.S. News & World Report (Feb. 16, 2016, 6:00 AM),; see also Office of Tax Policy, Corporate Inversion Transactions: Tax Policy Implications, U.S. Dept. of the Treasury (May, 2002), (defining a corporate inversion).
[3] 26 U.S.C. § 7874 (intending to place a limit on the benefits derived from a corporate inversion, the statute provides the taxable income of an expatriated entity for any taxable year shall in no event be less than the inversion gain of the entity for the taxable year).
[4] U.S. Rep. Sander M. Levin, Inversions, U.S. House of Representatives Committee On Weighs and Means,
[5] Steven Davidoff Solomon, Corporate Inversions Aren’t the Half of It, N.Y. Times: Dealbook (Feb. 9, 2016),
[6] It is notable here that inbound corporate acquisitions, where the foreign corporation is larger than the United States corporation and acts as the acquirer, are not contemplated by 26 U.S.C. § 7874 and therefore escape the application of that Code provision. But this is part of what the new regulations addressed by this blog post seek to address. Fact Sheet: Treasury Issues Inversion Regulations and Proposed Earnings Stripping Regulations, U.S. Dept. of the Treasury (Apr. 4, 2016),
[7] Id.
[8] See 26 U.S.C. § 368 (stipulating Type A, B, and C corporate reorganizations).
[9] See generally 26 U.S.C. § 61.
[10] Solomon, supra note 5.
[11] 26 U.S.C. § 67(b)(1) (providing regular, itemized deductions for amounts paid as interest on debt); see also 26 U.S.C. § 163.
[12] See Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934) (Hand, J. Learned), aff’d sub nom. Gregory v. Helvering, 293 U.S. 465 (1935) (holding “[a]ny one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”).
[13] Johnathan D. Rockoff and Dana Mattioli, Pfizer, Allergan Agree on Historic Merger Deal: Deal, valued at more than $150 billion, would create world’s biggest drug maker, Wall St. J. (Nov. 22, 2015),; see also Jackie Calmes, Pfizer-Allergan Merger Reignites Tax Reform Discussion, N.Y. Times (Nov. 23, 2016)
[14] Diana Furchtgott-Roth, Free Pfizer! Why Inversions Are Good for the U.S., N.Y. Times (Apr. 7, 2016),
[15] Johnathan D. Rockoff, Liz Hoffman, and Richard Rubin, Pfizer Walks Away From Allergan Deal: Obama administration took aim at the deal that would have moved the biggest U.S. drug company to Ireland to lower its taxes, Wall St. J. (Apr. 6, 2016),
[16] Michael J. de la Merced and Leslie Picker, Pfizer and Allergan Are Said to End Merger as Tax Rules Tighten, N.Y. Times (Apr. 5, 2016),
[17] Fact Sheet: Treasury Issues Inversion Regulations and Proposed Earnings Stripping Regulations, U.S. Dept. of the Treasury (Apr. 4, 2016),
[18] Id.; see also supra note 6.
[19]See Estate of Stranahan v. Commissioner, 472 F.2d 867 (6th Cir. 1973) (recognizing the principle of stepped transactions).[20]This is consistent with historical tax policy. See Gregory v. Helvering, 293 U.S. 465 (1935) (holding the substance of a transaction, not the form, determines the tax consequences of said transaction).
[21] See Victor Fleischer, On Inversions, the Treasury Department Drops the Gloves, N.Y. Times (Apr. 5, 2016),
[22] 26 U.S.C. § 385(a) provides “[t]he Secretary is authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness…”
[23] Fact Sheet: Treasury Issues Inversion Regulations and Proposed Earnings Stripping Regulations, U.S. Dept. of the Treasury (Apr. 4, 2016),
[24] Id.
[25] Id.
[26] See Fleischer, supra note 21.
[27] See Rockoff, supra note 15.
[28] See, e.g., Gretchen Morgenson, Ending Tax Break for Ultrawealthy May Not Take Act of Congress, N.Y. Times (May 6, 2016),

*Featured Image by Frits Ahlefeldt, licensed under (CC BY-ND 3.0).