New IRS Corporate Inversion Rules on Foreign Presence

June 6, 2006

The Internal Revenue Service (IRS) recently unveiled new rules designed to combat corporate inversions that are designed to reduce U.S. corporate tax payments. The rules are explanations of IRS code section 7874, which was enacted as part of the American Jobs Creation Act of 2004.

The new rules take a “bright-line” approach by saying that a U.S. corporation has to have more than 10 percent of its employees, assets and sales in a foreign country in order to avoid further scrutiny by the IRS. If this test is not met, then the IRS will proceed to use a “facts and circumstances” test to determine whether the corporation is engaged in tax avoidance. This test will consider the number of employees in the country, their payroll, and past presence in the country.

Most interestingly, the IRS will not allow a corporation to include intangible assets when determining the bright-line threshold. This is undoubtedly because many corporations will place intangible assets—and sometimes, only intangible assets—in foreign jurisdictions in order to reduce their U.S. tax.

Of course, it is difficult to draw the line between legitimate tax competition, legitimate tax avoidance, and illegitimate tax evasion. With the second-highest corporate income tax rate in the OECD and a worldwide system of taxation, the U.S. is not exactly hospitable to corporate investment.

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