[Senate Report 107-188]
[From the U.S. Government Publishing Office]



                                                       Calendar No. 465
107th Congress                                                   Report
                                 SENATE
 2d Session                                                     107-188

======================================================================



 
           REVERSING THE EXPATRIATION OF PROFITS OFFSHORE ACT

                                _______
                                

                 June 28, 2002.--Ordered to be printed

                                _______
                                

   Mr. Baucus, from the Committee on Finance, submitted the following

                              R E P O R T

                         [To accompany S. 2119]

    The Committee on Finance, to which was referred the bill 
(S. 2119) to amend the Internal Revenue Code of 1986 to provide 
for the tax treatment of inverted corporate entities and of 
transactions with such entities, and for other purposes, 
reports favorably thereon with an amendment and recommends that 
the bill as amended do pass.

                                CONTENTS

                                                                   Page
 I. Legislative Background............................................1
II. Explanation of the Bill...........................................2
    A. Tax Treatment of Inversion Transactions........................2
    B. Reinsurance Agreements.........................................7
III.Budget Effects of the Bill........................................9

    A. Committee Estimates............................................9
    B. Budget Authority and Tax Expenditures.........................11
    C. Consultation with Congressional Budget Office.................11
IV. Votes of the Committee...........................................11
 V. Regulatory Impact and Other Matters..............................11
    A. Regulatory Impact.............................................11
    B. Unfunded Mandates Statement...................................12
    C. Tax Complexity Analysis.......................................12
VI. Changes in Existing Law Made by the Bill as Reported.............12

                       I. LEGISLATIVE BACKGROUND

    At a hearing on March 21, 2002, notice was given that the 
Senate Committee on Finance intended to take action to curtail 
the benefits of inversion transactions. On June 13, 2002, the 
Committee began to mark up S. 2119 (the ``Reversing the 
Expatriation of Profits Offshore Act''), with certain 
modifications. On June 18, 2002, the Committee resumed the 
mark-up and approved the bill, as modified, by voice vote.

                      II. EXPLANATION OF THE BILL


               A. Tax Treatment of Inversion Transactions


                              PRESENT LAW

Determination of corporate residence

    The U.S. tax treatment of a multinational corporate group 
depends significantly on whether the top-tier ``parent'' 
corporation of the group is domestic or foreign. For purposes 
of U.S. tax law, a corporation is treated as domestic if it is 
incorporated under the law of the United States or of any 
State. All other corporations (i.e., those incorporated under 
the laws of foreign countries) are treated as foreign. Thus, 
place of incorporation determines whether a corporation is 
treated as domestic or foreign for purposes of U.S. tax law, 
irrespective of other factors that might be thought to bear on 
a corporation's ``nationality,'' such as the location of the 
corporation's management activities, employees, business 
assets, operations, or revenue sources, the exchanges on which 
the corporation's stock is traded, or the residence of the 
corporation's managers and shareholders.

U.S. taxation of domestic corporations

    The United States employs a ``worldwide'' tax system, under 
which domestic corporations generally are taxed on all income, 
whether derived in the United States or abroad. In order to 
mitigate the double taxation that may arise from taxing the 
foreign-source income of a domestic corporation, a foreign tax 
credit for income taxes paid to foreign countries is provided 
to reduce or eliminate the U.S. tax owed on such income, 
subject to certain limitations.
    Income earned by a domestic parent corporation from foreign 
operations conducted by foreign corporate subsidiaries 
generally is subject to U.S. tax when the income is distributed 
as a dividend to the domestic corporation. Until such 
repatriation, the U.S. tax on such income is generally 
deferred. However, certain anti-deferral regimes may cause the 
domestic parent corporation to be taxed on a current basis in 
the United States with respect to certain categories of passive 
or highly mobile income earned by its foreign subsidiaries, 
regardless of whether the income has been distributed as a 
dividend to the domestic parent corporation. The main anti-
deferral regimes in this context are the controlled foreign 
corporation rules of subpart F (sections 951-964) and the 
passive foreign investment company rules (sections 1291-1298). 
A foreign tax credit is generally available to offset, in whole 
or in part, the U.S. tax owed on this foreign-source income, 
whether repatriated as an actual dividend or included under one 
of the anti-deferral regimes.

U.S. taxation of foreign corporations

    The United States taxes foreign corporations only on income 
that has a sufficient nexus to the United States. Thus, a 
foreign corporation is generally subject to U.S. tax only on 
income that is ``effectively connected'' with the conduct of a 
trade or business in the United States. Such ``effectively 
connected income'' generally is taxed in the same manner and at 
the same rates as the income of a U.S. corporation. An 
applicable tax treaty may limit the imposition of U.S. tax on 
business operations of a foreign corporation to cases in which 
the business is conducted through a ``permanent establishment'' 
in the United States.
    In addition, foreign corporations generally are subject to 
a gross-basis U.S. tax at a flat 30-percent rate on the receipt 
of interest, dividends, rents, royalties, and certain similar 
types of income derived from U.S. sources, subject to certain 
exceptions. The tax generally is collected by means of 
withholding by the person making the payment. This tax may be 
reduced or eliminated under an applicable tax treaty.

U.S. tax treatment of inversion transactions

    Under present law, U.S. corporations may reincorporate in 
foreign jurisdictions and thereby replace the U.S. parent 
corporation of a multinational corporate group with a foreign 
parent corporation. These transactions are commonly referred to 
as ``inversion'' transactions. Inversion transactions may take 
many different forms, including stock inversions, asset 
inversions, and various combinations of and variations on the 
two. Most of the known transactions to date have been stock 
inversions. In one example of a stock inversion, a U.S. 
corporation forms a foreign corporation, which in turn forms a 
domestic merger subsidiary. The domestic merger subsidiary then 
merges into the U.S. corporation, with the U.S. corporation 
surviving, now as a subsidiary of the new foreign corporation. 
The U.S. corporation's shareholders receive shares of the 
foreign corporation and are treated as having exchanged their 
U.S. corporation shares for the foreign corporation shares. An 
asset inversion reaches a similar result, but through a direct 
merger of the top-tier U.S. corporation into a new foreign 
corporation, among other possible forms. An inversion 
transaction may be accompanied or followed by further 
restructuring of the corporate group. For example, in the case 
of a stock inversion, in order to remove income from foreign 
operations from the U.S. taxing jurisdiction, the U.S. 
corporation may transfer some or all of its foreign 
subsidiaries directly to the new foreign parent corporation or 
other related foreign corporations.
    In addition to removing foreign operations from the U.S. 
taxing jurisdiction, the corporate group may derive further 
advantage from the inverted structure by reducing U.S. tax on 
U.S.-source income through various ``earnings stripping'' or 
other transactions. This may include earnings stripping through 
payment by a U.S. corporation of deductible amounts such as 
interest, royalties, rents, or management service fees to the 
new foreign parent or other foreign affiliates. In this 
respect, the post-inversion structure enables the group to 
employ the same tax-reduction strategies that are available to 
other multinational corporate groups with foreign parents and 
U.S. subsidiaries, subject to the same limitations. These 
limitations under present law include section 163(j), which 
limits the deductibility of certain interest paid to related 
parties, if the payor's debt-equity ratio exceeds 1.5 to 1 and 
the payor's net interest expense exceeds 50 percent of its 
``adjusted taxable income.'' More generally, section 482 and 
the regulations thereunder require that all transactions 
between related parties be conducted on terms consistent with 
an ``arm's length'' standard, and permit the Secretary of the 
Treasury to reallocate income and deductions among such parties 
if that standard is not met.
    Inversion transactions may give rise to immediate U.S. tax 
consequences at the shareholder and/or the corporate level, 
depending on the type of inversion. In stock inversions, the 
U.S. shareholders generally recognize gain (but not loss) under 
section 367(a), based on thedifference between the fair market 
value of the foreign corporation shares received and the adjusted basis 
of the domestic corporation stock exchanged. To the extent that a 
corporation's share value has declined, and/or it has many foreign or 
tax-exempt shareholders, the impact of this section 367(a) ``toll 
charge'' is reduced. The transfer of foreign subsidiaries or other 
assets to the foreign parent corporation also may give rise to U.S. tax 
consequences at the corporate level (e.g., gain recognition and 
earnings and profits inclusions under sections 1001, 311(b), 304, 367, 
1248 or other provisions). The tax on any income recognized as a result 
of these restructurings may be reduced or eliminated through the use of 
net operating losses, foreign tax credits, and other tax attributes.
    In asset inversions, the U.S. corporation generally 
recognizes gain (but not loss) under section 367(a) as though 
it had sold all of its assets, but the shareholders generally 
do not recognize gain or loss, assuming the transaction meets 
the requirements of a reorganization under section 368.

                           REASONS FOR CHANGE

    The Committee believes that inversion transactions 
resulting in a minimal presence in a foreign country of 
incorporation are a means of avoiding U.S. tax and should be 
curtailed. In particular, these transactions permit 
corporations and other entities to continue to conduct business 
in the same manner as they did prior to the inversion, but with 
the result that the inverted entity avoids U.S. tax on foreign 
operations and may engage in earnings-stripping techniques to 
avoid U.S. tax on domestic operations. The Committee believes 
that certain inversion transactions (involving 80 percent or 
more identity of stock ownership) have little or no non-tax 
effect or purpose and should be disregarded for U.S. tax 
purposes. The Committee believes that other inversion 
transactions (involving more than 50 but less than 80 percent 
identity of stock ownership) may have sufficient non-tax effect 
and purpose to be respected, but warrant heightened scrutiny 
and other restrictions to ensure that the U.S. tax base is not 
eroded through related-party transactions.

                        EXPLANATION OF PROVISION

In general

    The provision defines two different types of corporate 
inversion transactions and establishes a different set of 
consequences for each type. Certain partnership transactions 
also are covered.

Transactions involving at least 80 percent identity of stock ownership

    The first type of inversion is a transaction in which, 
pursuant to a plan or a series of related transactions: (1) a 
U.S. corporation becomes a subsidiary of a foreign-incorporated 
entity or otherwise transfers substantially all of its 
properties to such an entity; (2) the former shareholders of 
the U.S. corporation hold (by reason of holding stock in the 
U.S. corporation) 80 percent or more (by vote or value) of the 
stock of the foreign-incorporated entity after the transaction; 
and (3) the foreign-incorporated entity, considered together 
with all companies connected to it by a chain of greater than 
50 percent ownership (i.e., the ``expanded affiliated group''), 
does not have substantial business activities in the entity's 
country of incorporation, compared to the total worldwide 
business activities of the expanded affiliated group. The 
provision denies the intended tax benefits of this type of 
inversion by deeming the top-tier foreign corporation to be a 
domestic corporation for all purposes of the Code.\1\
---------------------------------------------------------------------------
    \1\ Since the top-tier foreign corporation would be treated for all 
purposes of the Code as domestic, the shareholder-level ``toll charge'' 
of sec. 367(a) would not apply to these inversion transactions.
---------------------------------------------------------------------------
    In determining whether a transaction would meet the 
definition of an inversion under the provision, stock held by 
members of the expanded affiliated group that includes the 
foreign incorporated entity is disregarded. For example, if the 
former top-tier U.S. corporation receives stock of the foreign 
incorporated entity (e.g., so-called ``hook'' stock), the stock 
would not be considered in determining whether the transaction 
meets the definition. Similarly, if a U.S. parent corporation 
converts an existing wholly owned U.S. subsidiary into a new 
wholly owned controlled foreign corporation, the stock of the 
new foreign corporation would be disregarded. Stock sold in a 
public offering related to the transaction also is disregarded 
for these purposes.
    Transfers of properties or liabilities as part of a plan a 
principal purpose of which is to avoid the purposes of the 
provision are disregarded. In addition, the Treasury Secretary 
is granted authority to prevent the avoidance of the purposes 
of the provision, including avoidance through the use of 
related persons, pass-through or other noncorporate entities, 
or other intermediaries, and through transactions designed to 
qualify or disqualify a person as a related person or a member 
of an expanded affiliated group. Similarly, the Treasury 
Secretary is granted authority to treat certain non-stock 
instruments as stock, and certain stock as not stock, where 
necessary to carry out the purposes of the provision.

Transactions involving greater than 50 percent but less than 80 percent 
        identity of stock ownership

    The second type of inversion is a transaction that would 
meet the definition of an inversion transaction described 
above, except that the 80-percent ownership threshold is not 
met. In such a case, if a greater-than-50-percent ownership 
threshold is met, then a second set of rules applies to the 
inversion. Under these rules, the inversion transaction is 
respected (i.e., the foreign corporation is treated as 
foreign), but: (1) any applicable corporate-level ``toll 
charges'' for establishing the inverted structure may not be 
offset by tax attributes such as net operating losses or 
foreign tax credits; (2) the IRS is given expanded authority to 
monitor related-party transactions that may be used to reduce 
U.S. tax on U.S.-source income going forward; and (3) section 
163(j), relating to ``earnings stripping'' through related-
party debt, is strengthened. These measures generally apply for 
a 10-year period following the inversion transaction. In 
addition, inverting entities are required to provide 
information to shareholders or partners and the IRS with 
respect to the inversion transaction.
    With respect to ``toll charges,'' any applicable corporate-
level income or gain required to be recognized under sections 
304, 311(b), 367, 1001, 1248, or any other provision with 
respect to the transfer of controlled foreign corporation stock 
or other assets by a U.S. corporation as part of the inversion 
transaction or after such transaction to a related foreign 
person is taxable,without offset by any tax attributes (e.g., 
net operating losses or foreign tax credits). To the extent provided in 
regulations, this rule will not apply to certain transfers of inventory 
and similar transactions conducted in the ordinary course of the 
taxpayer's business.
    In order to enhance IRS monitoring of related-party 
transactions, the provision establishes a new pre-filing 
procedure. Under this procedure, the taxpayer will be required 
annually to submit an application to the IRS for an agreement 
that all return positions to be taken by the taxpayer with 
respect to related-party transactions comply with all relevant 
provisions of the Code, including sections 163(j), 267(a)(3), 
482, and 845. The Treasury Secretary is given the authority to 
specify the form, content, and supporting information required 
for this application, as well as the timing for its submission.
    The IRS will be required to take one of the following three 
actions within 90 days of receiving a complete application from 
a taxpayer: (1) conclude an agreement with the taxpayer that 
the return positions to be taken with respect to related-party 
transactions comply with all relevant provisions of the Code; 
(2) advise the taxpayer that the IRS is satisfied that the 
application was made in good faith and substantially complies 
with the requirements set forth by the Treasury Secretary for 
such an application, but that the IRS reserves substantive 
judgment as to the tax treatment of the relevant transactions 
pending the normal audit process; or (3) advise the taxpayer 
that the IRS has concluded that the application was not made in 
good faith or does not substantially comply with the 
requirements set forth by the Treasury Secretary.
    In the case of a compliance failure described in (3) above 
(and in cases in which the taxpayer fails to submit an 
application), the following sanctions will apply for the 
taxable year for which the application was required: (1) no 
deductions or additions to basis or cost of goods sold for 
payments to foreign related parties will be permitted; (2) any 
transfers or licenses of intangible property to related foreign 
parties will be disregarded; and (3) any cost-sharing 
arrangements will not be respected.
    If the IRS fails to act on the taxpayer's application 
within 90 days of receipt, then the taxpayer will be treated as 
having submitted in good faith an application that 
substantially complies with the above-referenced requirements. 
Thus, the deduction disallowance and other sanctions described 
above will not apply, but the IRS will be able to examine the 
transactions at issue under the normal audit process. The IRS 
is authorized to request that the taxpayer extend this 90-day 
deadline in cases in which the IRS believes that such an 
extension might help the parties to reach an agreement.
    The ``earnings stripping'' rules of section 163(j), which 
deny or defer deductions for certain interest paid to foreign 
related parties, are strengthened for inverted corporations. 
With respect to such corporations, the provision eliminates the 
debt-equity threshold generally applicable under section 163(j) 
and reduces the 50-percent thresholds for ``excess interest 
expense'' and ``excess limitation'' to 25 percent.
    In cases in which a U.S. corporate group acquires 
subsidiaries or other assets from an unrelated inverted 
corporate group, the provisions described above generally do 
not apply to the acquiring U.S. corporate group or its related 
parties (including the newly acquired subsidiaries or assets) 
by reason of acquiring the subsidiaries or assets that were 
connected with the inversion transaction. The Treasury 
Secretary is given authority to issue regulations appropriate 
to carry out the purposes of this provision and to prevent its 
abuse.

Partnership transactions

    Under the provision, both types of inversion transactions 
include certain partnership transactions. Specifically, both 
parts of the provision apply to transactions in which a 
foreign-incorporated entity acquires substantially all of the 
properties constituting a trade or business of a domestic 
partnership, if after the acquisition at least 80 percent (or 
more than 50 percent but less than 80 percent, as the case may 
be) of the stock of the entity is held by former partners of 
the partnership (by reason of holding their partnership 
interests), and the ``substantial business activities'' test is 
not met. For purposes of determining whether these tests are 
met, all partnerships that are under common control within the 
meaning of section 482 are treated as one partnership, except 
as provided otherwise in regulations. In addition, the modified 
``toll charge'' provisions apply at the partner level.

                             EFFECTIVE DATE

    The regime applicable to transactions involving at least 80 
percent identity of ownership applies to inversion transactions 
completed after March 20, 2002. The rules for inversion 
transactions involving greater-than-50-percent identity of 
ownership apply to inversion transactions completed after 1996 
that meet the 50-percent test and to inversion transactions 
completed after 1996 that would have met the 80-percent test 
but for the March 20, 2002 date.

                       B. Reinsurance Agreements


                              PRESENT LAW

    In the case of a reinsurance agreement between two or more 
related persons, present law provides the Treasury Secretary 
with authority to allocate among the parties or recharacterize 
income (whether investment income, premium or otherwise), 
deductions, assets, reserves, credits and any other items 
related to the reinsurance agreement, or make any other 
adjustment, in order to reflect the proper source and character 
of the items for each party.\2\ For this purpose, related 
persons are defined as in section 482. Thus, persons are 
related if they are organizations, trades or businesses 
(whether or not incorporated, whether or not organized in the 
United States, and whether or not affiliated) that are owned or 
controlled directly or indirectly by the same interests. The 
provision may apply to a contract even if one of the related 
parties is not a domestic company.\3\ In addition, the 
provision also permits such allocation, recharacterization, or 
other adjustments in a case in which one of the parties to a 
reinsurance agreement is, with respect to any contract covered 
by the agreement, in effect an agent of another party to the 
agreement, or a conduit between related persons.
---------------------------------------------------------------------------
    \2\ Sec. 845(a).
    \3\ See S. Rep. No. 97-494, ``Tax Equity and Fiscal Responsibility 
Act of 1982,'' July 12, 1982, 337 (describing provisions relating to 
the repeal of modified coinsurance provisions).
---------------------------------------------------------------------------

                           REASONS FOR CHANGE

    The Committee is concerned that reinsurance transactions 
are being used to allocate income, deductions, or other items 
inappropriately among U.S. and foreign related persons. The 
Committee is concerned that foreign related party reinsurance 
arrangements may be a technique for erosion of the U.S. tax 
base. The Committee believes that the provision of present law 
permitting the Treasury Secretary to allocate or recharacterize 
items related to a reinsurance agreement should be applied to 
prevent misallocation, improper characterization, or to make 
any other adjustment in the case of such reinsurance 
transactions between U.S. and foreign related persons (or 
agents or conduits). The Committee also wishes to clarify that, 
in applying the authority with respect to reinsurance 
agreements, the amount, source or character of the items may be 
allocated, recharacterized or adjusted.

                        EXPLANATION OF PROVISION

    The provision clarifies the rules of section 845, relating 
to authority for the Treasury Secretary to allocate items among 
the parties to a reinsurance agreement, recharacterize items, 
or make any other adjustment, in order to reflect the proper 
source and character of the items for each party. The provision 
authorizes such allocation, recharacterization, or other 
adjustment, in order to reflect the proper source, character or 
amount of the item. It is intended that this authority \4\ be 
exercised in a manner similar to the authority under section 
482 for the Treasury Secretary to make adjustments between 
related parties. It is intended that this authority be applied 
in situations in which the related persons (or agents or 
conduits) are engaged in cross-border transactions that require 
allocation, recharacterization, or other adjustments in order 
to reflect the proper source, character or amount of the item 
or items. No inference is intended that present law does not 
provide this authority with respect to reinsurance agreements.
---------------------------------------------------------------------------
    \4\ The authority to allocate, recharacterize or make other 
adjustments was granted in connection with the repeal of provisions 
relating to modified coinsurance transactions.
---------------------------------------------------------------------------
    The Committee notes that no regulations have been issued 
under section 845(a). The Committee expects that the Treasury 
Department shall issue regulations under section 845(a) to 
address effectively the allocation of income (whether 
investment income, premium or otherwise) and other items, the 
recharacterization of such items, or any other adjustment 
necessary to reflect the proper amount, source or character of 
the item.

                             EFFECTIVE DATE

    The provision is effective for any risk reinsured after 
April 11, 2002.

                    III. BUDGET EFFECTS OF THE BILL


                         A. Committee Estimates

    In compliance with paragraph 11(a) of rule XXVI of the 
Standing Rules of the Senate, the following statement is made 
concerning the estimated budget effects of the committee 
amendment to the bill as reported.


                B. Budget Authority and Tax Expenditures


Budget authority

    In compliance with section 308(a)(1) of the Budget Act, the 
Committee states that the revenue provisions of the committee 
amendment to the bill as reported involve no new or increased 
budget authority.

Tax expenditures

    In compliance with section 308(a)(2) of the Budget Act, the 
Committee states that the revenue provisions of the committee 
amendment to the bill as reported involve no new tax 
expenditures.

            C. Consultation with Congressional Budget Office

    In accordance with section 403 of the Budget Act, the 
Committee advises that the Congressional Budget Office 
(``CBO'') has not submitted a statement on the bill. The letter 
from CBO was not received in a timely manner, and therefore 
will be provided separately.

                       IV. VOTES OF THE COMMITTEE

    In compliance with paragraph 7(b) of rule XXVI of the 
Standing Rules of the Senate, the following statements are made 
concerning the votes taken on the Committee's consideration of 
the bill.

Motion to report the committee amendment

    The bill was ordered favorably reported by a voice vote, a 
quorum being present, on June 18, 2002.

Votes on other amendments

    None.

                 V. REGULATORY IMPACT AND OTHER MATTERS


                          A. Regulatory Impact

    Pursuant to paragraph 11(b) of rule XXVI of the Standing 
Rules of the Senate, the Committee makes the following 
statement concerning the regulatory impact that might be 
incurred in carrying out the provisions of the bill as amended.

Impact on individuals and businesses

    The provisions do not impose increased regulatory burdens 
on individuals.
    The provisions affect certain businesses that have 
undertaken, or that plan to undertake, inversion transactions 
and partnership transactions covered by the bill. Businesses 
that have not undertaken or planned to undertake such 
transactions generally are not affected by the provisions of 
the bill. Thus, the bill generally does not impose increased 
regulatory burdens on businesses.

Impact on personal privacy and paperwork

    The provisions of the bill do not impact personal privacy.

                     B. Unfunded Mandates Statement

    The Committee on Finance has reviewed the provisions of the 
bill as approved by the Committee on June 18, 2002. In 
accordance with the requirements of Public Law 104-4, the 
Unfunded Mandates Reform Act of 1995, the Committee has 
determined that the provisions of the bill contain Federal 
private sector mandates. The Committee has concluded that the 
provisions of the bill contain no intergovernmental mandates 
within the meaning of Public Law 104-4.

                       C. Tax Complexity Analysis

    Section 4022(b) of the Internal Revenue Service Reform and 
Restructuring Act of 1998 (the ``IRS Reform Act'') requires the 
Joint Committee on Taxation (in consultation with the Internal 
Revenue Service and the Department of the Treasury) to provide 
a tax complexity analysis. The complexity analysis is required 
for all legislation reported by the Senate Committee on 
Finance, the House Committee on Ways and Means, or any 
committee of conference if the legislation includes a provision 
that directly or indirectly amends the Internal Revenue Code 
(the ``Code'') and has widespread applicability to individuals 
or small businesses.
    The staff of the Joint Committee on Taxation has determined 
that a complexity analysis is not required under section 
4022(b) of the IRS Reform Act because the bill contains no 
provisions that amend the Internal Revenue Code and that have 
``widespread applicability'' to individuals or small 
businesses.

        VI. CHANGES IN EXISTING LAW MADE BY THE BILL AS REPORTED

    In the opinion of the Committee, it is necessary in order 
to expedite the business of the Senate, to dispense with the 
requirements of paragraph 12 of rule XXVI of the Standing Rules 
of the Senate (relating to the showing of changes in existing 
law made by the bill as reported by the Committee).

                                  
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