Earnings stripping: the proposed regulations.by Pollack, Lawrence A.
A comprehensive description of the situations to which these proposed regulations apply--definitions of debt, equity, related persons, and other pertinent factors. Also there are examples of how disallowances are calculated in a variety of circumstances.
The earnings stripping limitation in Sec. 163 (j) was added by the 1989 tax act to prevent erosion of the U.S. tax base by excessive deductions for interest paid by a taxable corporation to a tax exempt, or partially tax exempt related person. Proposed regulations were issued on June 12, 1991 providing guidance in applying the earnings stripping rules.
The Way It Was
Before the enactment of Sec. 163(j), it was often possible for a foreign parent corporation to substantially reduce taxable income of its U.S. subsidiary by capitalizing it with large amounts of debt, while avoiding U.S. withholding tax on the interest received because of favorable treaty benefits. For example, assume that a U.K. parent corporation formed a U.S. subsidiary and capitalized it with $4,000,000 debt and $1,000,000 equity. The debt required annual interest payment to the parent at 10%, or $400,000. Further assume that the subsidiary earned annual net profit before interest expense of $500,000. Absent the earnings stripping limitations on the deductibility of interest expense, the U.S. subsidiary's earnings would have been "stripped" by deductible interest payments, resulting in an effective U.S. tax rate of only 6.8%, as illustrated below:
It should be noted that even before the enactment of Sec. 163(j), the IRS might have attempted to disallow part of the U.S. subsidiary's interest deductions by recharacterizing part of its purported debt as equity on the basis that the subsidiary was thinly capitalized.
The Way It Is Proposed
The earnings stripping limitation applies to domestic corporations other than S corporations, and foreign corporations with effectively connected income, whose debt/equity ration exceeds 1.5 to 1, and who pay exempt related person interest expense (ERPIE). Foreign corporations with effectively connected income include those that are engaged in a U.S. trade or business or have made an election under Sec. 882(d) to treat their income and gains from U.S. real properly as effectively connected income.
ERPIE is interest paid or accrued to a related person that is exempt, or partially exempt, from U.S. tax on the interest received. Related parties include persons related to the payor of the interest within the meaning of Secs. 267(b) or 707(b)(1), which generally require greater than 50% ownership, counting direct and indirect stock ownership.
Where interest is subject to a reduced U.S. treaty withholding rate, it will be treated as partially exempt interest and partially subject to the full 30% statutory rate, based on the ration that the reduced treaty withholding rate bears to the full 30% statutory rate, determined as follows:
30% - actual rate/30% statutory rate x interest expense = ERPIE
For example, if a U.S. corporation pays $100 of interest to its Hong Kong parent corporation, the payment would be subject to U.S. withholding tax at the full 30% statutory rate since the U.S. does not have a tax treaty with Hong Kong. Accordingly, no portion of this payment would constitute ERPIE. If the $100 payment were made to a U.K. parent corporation, the entire amount would constitute ERPIE since the U.S./U.K. treaty eliminates U.S. withholding tax on interest. However, if the $100 payment were made to a Japanese parent corporation, 2/3 of the payment, or $67, would constitute ERPIE since the U.S./Japan treaty provides for a 10% U.S. withholding rate.
Interest paid to Partnerships
In general, interest paid or accrued to a partnership is treated for earnings stripping purposes as if paid to the partners of the partnership on a proportionate look-through basis. Thus, if a U.S. corporation pays interest to a partnership in which the U.S. corporation's U.K. parent corporation holds a 50% interest, 50% of the interest would constitute ERPIE assuming the remaining partnership interests were not held by related tax exempt parties.
The proposed regulations contain a de minimis rule that applies where less than 10% of the partnership interests are held by tax exempt persons. Under this rule, interest paid to a partnership by a corporation that is related to the partnership will not be treated as paid to a related person, and not subject to disallowance under the earnings stripping rules, if less than 10% of the capital and profits interests in the partnership are held by partners that are tax exempt with respect to such interest. However, this rule would not apply to the extent the interest is includible in the gross income of a partner that is related to the payor of the interest. Related party status is determined under Secs. 267(b) or 707(b).
For example, assume that partnership Y owns 100% of the stock of domestic corporation X and thus are related parties. Foreign corporation U, which is resident in a foreign country whose tax treaty with the U.S. provides for a 15% U.S. withholding rate on interest, holds a 19% interest in the partnership. Since foreign partner U is entitled to a 15% U.S. treaty withholding rate on interest from sources within the U.S., as compared with the 30% statutory rate, the Proposed Regulations treat one-half of U's partnership interest as held by a taxable person and the other half held by a tax exempt person. Thus, U is treated as holding a 9.5% (1/2 @ 19%) tax exempt partnership interest with regard to the interest income. Since this is less than the 10% threshold, the de minimis rule applied and no portion of X's interest paid to Y would be subject to potential disallowance under the earnings stripping limitations. This result assumes that U is not related to X and the other partners of Y are not tax exempt with regard to the interest paid by X.
Interest Paid to Certain Foreign Entities
Under various anti-deferral provisions of the Code, interest income earned by certain foreign entities may be taxable on a current basis to the foreign entities' U.S. shareholders regardless of whether any distributions are made by the foreign entities. This would generally include interest income earned by controlled foreign corporations |Sec. 951(a)(1)(A)(i), foreign personal holding companies |Sec. 551(a), and passive foreign investment companies for which a qualified electing fund election has been made |Sec. 1293(a). The proposed regulations provide that interest paid to these types of foreign entities will not constitute ERPIE to the extent such interest results in a current inclusion for U.S. tax purposes.
Debt/Equity Safe Harbor Ratio
As indicated, the earnings stripping rules will not restrict the current deduction of ERPIE paid or accrued in a taxable year in which the payor corporation's debt/equity ratio does not exceed 1.5 to 1, determined on the last day of its taxable year.
Debt. For purposes of this ratio, a corporation's debt includes its liabilities determined according to "generally applicable tax principles." Thus, a contingent liability required to be recorded for GAAP purposes, but which has not yet matured for tax purposes would not be treated as debt for purposes of the ratio. Where a corporation is a partner in a partnership, its share of the partnership's liabilities under Sec. 752 are treated as if incurred directly by the partner.
In determining debt, "short-term liabilities" and "commercial financing liabilities" are excluded. Short-term liabilities include accrued operating expenses, accrued taxes payable (i.e., the current portion thereof), and any account payable for the first 90 days of its existence provided no interest is accrued during such period. Commercial financing liabilities include debt incurred to buy inventory where the debt is secured by the inventory and payable on or before its sale.
Equity. A corporation's equity is defined as the sum of its money and the adjusted tax basis of all its other assets reduced, but not below zero, by its debt as defined previously. Where short-term or commercial financing liabilities are excluded from debt, the same amount must also be treated as a reduction to equity. Where a corporation is a partner in a partnership, it includes as an asset its adjusted basis in the partnership interest, which includes the partner's share of partnership liabilities.
To prevent temporary manipulation of a corporation's year-end debt/equity ratio with a view towards meeting the 1.5 to 1 debt/equity safe harbor, the proposed regulations contain anti-rollover and anti- stuffing rules. The anti-rollover rule disregards decreases in a corporation's aggregate debt during the last 90 days of its taxable year to the extent that the corporation's aggregate debt is increased during the first 90 days of its succeeding taxable year. The anti-stuffing rule similarly disregards increases in a corporation's assets made by a related person during the last 90 days of its taxable year to the extent there is a transfer of the same or similar assets by the corporation to a related person during the first 90 days of its succeeding taxable year. These anti-avoidance rules apply mechanically regardless of whether a tax avoidance motive existed.
Calculating Disallowed ERPIE
Let's assume that a domestic corporation has paid ERPIE and its debt/equity ratio exceeds 1.5 to 1. The next step is to determine the amount of the corporation's ERPIE that will be disallowed under the earnings stripping rules. The basic rule provides that ERPIE will be disallowed to the extent that the payor's "net interest expense" exceeds 50% of "adjusted taxable income" plus any "excess limitation" carried forward to the taxable year. Excess limitation is the excess, if any, of 50% of a corporation's adjusted taxable income over its net interest expense.
If a corporation has an adjusted taxable loss for a taxable year, then its adjusted taxable income is treated as zero. However, the full amount of an adjusted taxable loss will reduce taxpayer's excess limitation carryforward.
Net interest expense is defined as the excess, if any, of all interest expense (whether or not paid to a related party) over all interest income.
Adjusted taxable income is a corporation's taxable income, as modified by the following list of adjustments intended to convert taxable income to an approximation of cash flow excluding net interest expense:
Additions to Taxable Income:
1. Net interest expense, as defined previously;
2. Net operating loss deduction;
3. Tax depreciation and amortization expense;
4. Depletion expense under Sec. 611;
5. Charitable contribution carryovers from prior years to the extent deductible in the current taxable year;
6. For accrual basis taxpayers, the increase, if any, between the end of the preceding year and the end of the current year in accounts payable, other than interest payable;
7. For accrual basis taxpayers, the decrease, if any, between the end of the preceding taxable year in accounts receivable, other than interest receivable;
8. Municipal bond interest excluded from gross income.
9. Dividends received deduction, except for the 100% deduction under Sec. 243(a)(3) for dividends received from an affiliated group member;
10. The increase, if any, in the LIFO recapture amount nine between the end of the preceding taxable year and the end of the current taxable year; and
11. Any deduction in the current taxable year for capital loss carrybacks or carryovers from other years.
The LIFO recapture amount in item 10 is defined in Sec. 312(n)(4)(B) as the excess, if any, that the inventory amount computed under FIFO exceeds the amount as computed under LIFO.
Subtractions from taxable income:
1. With respect to the sale or disposition of property, any depreciation, amortization, or depletion deductions which were allowed or allowable for the taxpayer's taxable years beginning after July 10, 1986, with respect to such property;
2. With respect to the sale or disposition of stock of a member of a consolidated group that includes the selling corporation, the consolidated return investment adjustments (See Reg. Secs. 1.1502-32 and 1.1502-32T) with respect to such stock that are attributable to depreciation, amortization, or depletion expense for the taxpayer's taxable years after July 10, 1986;
3. With respect to the sale or disposition of an interest in a partnership, the taxpayer's distributive share of depreciation, amortization, or depletion expense for the taxpayer's taxable years after July 10, 1986 with respect to property held by the partnership at the time of such sale or disposition;
4. For accrual basis taxpayers, the decrease, if any, between the end of the preceding taxable year and the end of the current taxable year in accounts payable other than interest payable;
5. For accrual basis taxpayers, the increase, if any, between the end of the preceding taxable year and the end of the current taxable year in accounts receivable other than interest receivable;
6. Expenses and interest which are not deductible under Sec. 265 due to their relationship to tax exempt income;
7. Interest expense incurred to acquire stock or assets of another corporation which is not deductible under Sec. 279;
8. Charitable contributions made during the current taxable year which exceed the 10% of taxable income limitation of Sec. 170(b)(2);
9. The decrease, if any, in the LIFO, recapture amount between the end of the preceding taxable year and the end of the current taxable year; and
10. Net capital loss recognized in the current taxable year.
Example of Earnings Stripping Calculation
In Example 1, the $100 of ERPlE will be "disallowed" to the extent of the corporation's excess interest expense, or $10. The deduction for the remaining $90 of ERPIE will not be restricted under Sec. 163(j). The $10 of disallowed ERPIE carries over indefinitely, and may be deducted in later taxable years to the extent of the corporation's excess limitation.
In Example 2, since net interest expense does not exceed 50% of adjusted taxable income, no portion of the $100 of ERPIE would be disallowed under the earnings stripping limitation. Further, the $10 of excess limitation carries forward up to three years, and may increase the limitation on deductible ERPIE in the carryforward years.
Suppose that a U.K. parent corporation wishes to capitalize its U.S. subsidiary with substantial interest-bearing debt while avoiding the earnings stripping limitation. It might attempt to accomplish this objective by structuring a "back-to-back" loan arrangement with an unrelated bank. The U.K. parent corporation might deposit $100 with an unrelated U.K. bank at 10% rate of interest. The bank deposit would be made subject to the understanding that the bank would loan $100 to the U.S. subsidiary at, say, 11%. The 1% spread earned by the bank would represent an accommodation fee for its services in the loan arrangement. Based solely on the form of the transaction, the U.S. subsidiary would not have paid any ERPIE, since all the interest would have been paid to an unrelated party, the U.K. bank.
The proposed regulations reserve as to the treatment of back-to-back loans. However, based on the Service's published position regarding back-to-back loans in Rev. Rul. 87-89, such an arrangement is subject to collapse and treated as a direct loan from the original lender, i.e., the U.K. parent corporation, to the ultimate borrower, i.e., the U. S. subsidiary, thus invoking the earnings stripping rules. This recast would likely be made if the foreign corporation's bank deposit and the corresponding bank loan to the U.S. subsidiary were interdependent transactions. This situation would exist if the bank would not have made the loan to the U.S. subsidiary on substantially the same terms without the parent's compensating deposit arrangement. According to the 1987 IRS ruling, if the bank has the right to offset the foreign parent's deposit against the subsidiary's loan, that constitutes presumptive evidence of interdependence. The preamble to the proposed Sec 163(j) regulations refers to Rev. Ruls. 84-152, 84-153, and 87-89, for guidance concerning back-to-back loans.
Foreign Parent Guarantees
Suppose that a U.K. parent corporation were to borrow funds from a U.K. bank for lending to its U.S. subsidiary. This financing structure would not fare well from a Sec. 163(j) perspective since the subsidiary's interest expense would constitute ERPIE, subject to potential disallowance. To restructure the financing arrangement with a view toward avoiding the earnings stripping limitation, the U.K. parent corporation might request the U.K. bank to loan the funds directly to its U.S. subsidiary, subject to a loan repayment guarantee of the U.K. parent corporation. Again, based solely on the form of the transaction, the U.S. subsidiary would not have paid any ERPIE, since all the interest would be paid to an unrelated party, the U.K. bank.
Foreign Parent Guarantees
Suppose that U.K. parent corporation were to borrow funds from a U.K. bank for lending to its U.S. subsidiary. This financing structure would not fare well from a Sec. 163(j) perspective since the subsidiary's interest expense would constitute ERPIE, subject to potential disallowance. To restructure the financing arrangement with a view toward avoiding the earnings stripping limitation, the U.K. parent corporation might request the U.K. bank to loan the funds directly to its U.S. subsidiary, subject to a loan repayment guarantee of the U.K. parent corporation. Again, based solely on the form of the transaction, the U.S. subsidiary would not have paid any ERPIE, since all the interest would be paid to an unrelated party, the U.K. bank.
As with back-to-back loans, the proposed regulations reserve as to the effect of parent guarantees, but the preamble refers taxpayers to Plantation Patterns, Inc., v. Commissioner, (462 F.2d 712 (5th Cir., 1972) for guidance in determining whether guaranteed debt would be recast as equity. That is, if the U.S. subsidiary is not sufficiently creditworthy under normal commercial standards, the bank would not have made the loan to the subsidiary absent the parent's guarantee, and the arrangement was structured for the purpose of avoiding Sec. 163(j), the IRS might recast the bank loan as if made to the U.K. parent followed by a capital contribution to its U.S. subsidiary. In this case, purported interest payments made by the U.S. subsidiary to the U.K. bank would be treated as constructive distributions to the U.K. parent corporation, potentially subject to U.S. withholding tax. Most importantly, the Committee Reports to Sec. 163(j) indicate that parent guarantees given in the ordinary course of business, without intent of avoiding Sec. 163(j) will be respected.
Affiliated Group Rules
The debt/equity ratio and the calculation of the earnings stripping limitation of a consolidated return group are required to be determined on a consolidated basis. Moreover, certain "affiliated," but non- consolidated, groups are likewise required to make these determinations on a group basis. The proposed regulations define an affiliated group for this purpose as requiring 80% stock ownership, counting shares held directly and indirectly by application of the Sec. 318 attribution rules. By virtue of this broad definition of affiliation, brother-sister domestic corporations that are wholly-owned by the same foreign parent corporation are treated as an affiliated group. Thus, the brother-sister corporations would be required to make their earning stripping calculations on a group basis even though they would otherwise be prohibited from filing a consolidated tax return.
Debt/equity Ratio of Affiliated Groups. In determining the debt/equity ratio of an affiliated group, the following special rules apply: (i) The basis of stock in group members is eliminated from assets (however, see the discussion later regarding the "fixed stock write-off method"); (ii) Assets include the adjusted basis of stock in non-includible corporations, e.g., foreign corporations. Further, the basis of stock in 10%-or-more owned non-includible corporations is required to be increased by earnings and profits attributable to the stock and decreased by deficits therein; (iii) Intercompany debt and corresponding receivables among group members are eliminated; (iv) The basis of an asset is decreased to the extent that any associated deferred intercompany gain has not yet been taken into account.
Election to Use Fixed Stock Write-off Method. Where a corporation has made a qualified stock purchase of a target corporation but has not made a Sec. 338 election to step-up the inside basis of the target's assets, the proposed regulations permit the acquiring corporation to elect the fixed stock write-off method in determining the group's debt/equity ratio. Under this elective method, rather than including the target's assets at their adjusted tax basis, which may be significantly lower than their fair market value, the acquiring corporation may instead include as an asset, the cost of target's stock as increased by target's liabilities. Where elected, this special basis is required to be amortized over 8 years. However, if more than 50% of the target's assets are certain long-lived assets, the amortization period is extended to 15 years. Long-lived assets include for this purpose inventory, non-wasting tangible or intangible assets such as land or goodwill, and depreciable, depletable or amortizable assets with recovery periods over 25 years.
Calculating the Earnings Stripping Limitation for Nonconsolidated Affiliated Groups. The proposed regulations contain a complex four-step process that applies to affiliated groups not all of which file a single consolidated tax return. Essentially, the rules require ERPIE, net interest expense, and adjusted taxable income to be determined on a group basis. Then disallowed interest expense, currently deductible disallowed interest expense carryforward from preceding years, and excess limitation carryforward, which are initially determined on a group basis, are allocated back to each member of the group for purposes of filing their separate tax returns.
Effective Dates and Transitional Rule
The provisions of Sec. 163(j) are generally effective for interest paid or accrued in taxable years beginning after July 10, 1989. However, interest expense on fixed-term debt obligations outstanding on July 10, 1989 is not subject to disallowance under Sec. 163(j) unless "modified" thereafter.
An important transitional rule permits taxpayers to carry forward excess limitation from taxable years beginning after July 10, 1986, to the extent of its three-year life-span, as if Sec. 163(j) had been in effect in such pre-effective date years. Thus, in determining the earnings stripping limitation for the first three taxable years beginning after July 10, 1989, an analysis should be performed to determine whether the taxpayer would have had excess limitation in such pre-effective date years.
Lawrence A. Pollack, JD, LLM, CPA, is a senior tax manager with Ernst & Young's New York office. He is co-editor of the International Taxation column of the CPA Journal and a member of the NYSSCPA Committee on International Taxation.
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