Comments on proposed earnings stripping regulations under Section 163(j).

On June 12, 1991, the Internal Revenue Service issued proposed regulations under section 163(j) of the Internal Revenue Code, relating to the deductibility of interest paid by a U.S. affiliate to a related entity where no or very little tax is paid (so-called earnings stripping). The regulations were published in the Federal Register on June 18, 1991 (56 Fed. Reg. 27907), and in the July 22, 1991, issue of the Internal Revenue Bulletin (1991-29 I.R.B. 19). A public hearing on the regulations was held on September 25, 1991.

For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions are cited as "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin.

BACKGROUND

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 4,700 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable use to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations relating to the deductibility of interest paid by a U.S. affiliate to a related entity under section 163(j) of the Code.

SPECIFIC COMMENTS

1. Prop. Reg. [section] 1.163(j)-2(e):

   Interest Equivalents

   Section 163(j) was added to the Code by the Omnibus Reconciliation Act of 1989 to prevent the possible erosion of the U.S. tax base by the use of excessive deductions for interest paid by a taxable corporation to a tax-exempt related party. This so-called earnings stripping provision limits the U.S. interest deduction when (i) a corporation's debt-to-equity ratio exceeds 1.5 to 1; (ii) the interest is paid to a related party who is exempt from U.S. taxation; and (iii) the corporation has "excess interest expense," i.e., its net interest expense exceeds 50 percent of its adjusted taxable income plus the excess limitation carryforward.

   Section 163(j)(B) of the Code provides that "net interest expense" may be adjusted according to regulations issued by the Secretary of the Treasury. The legislative history of the provision states that --

   [T]he conferees understand that regulations could reduce net interest expense where all or a portion of income items not denominated as interest are appropriately characterized, in the Treasury's view, as equivalent to interest income The conferees expect that an amount would not be so characterized unless it predominantly reflects the time value of money or is a payment in substance for the use of forbearance of money. Similarly, the conferees understand that Treasury might choose to increase net interest expense, under regulations, by all or a portion of expense items not denominated [as] interest but appropriately characterized as equivalent to interest expense.

   H.R. Rep. No. 101-386, 101st Cong., 1st Sess. 566-67 (1989) (hereinafter cited as "Conference Report"). Prop. Reg. [section} 1.163(j)-2(e)(3) reserves the issue of interest equivalents. In the preamble to the proposed regulations, the IRS announced its intention to treat interest equivalents as interest for purposes of section 163(j) and requested comments on the scope and operation of this rule. 1991-291 I.R.B. at 20.

   TEI recommends that interest equivalents be limited to those delineated in the Conference Report: items that predominantly reflect the time value of money or in substance represent payments for the use or forbearance of money. These are essentially the criteria used in Temp. Reg. [section] 1.954-2T(h)(1) for determining income equivalents under the foreign personal holding company rules and in Temp. Reg. [section] 1.861-9T(b)(1)(i) for determining interest equivalents under the interest allocation rules. Adoption of a broader rule would add unnecessary complexity to the area without furthering any legitimate tax policy goal.

   Accordingly, interest equivalents should not include rents or royalties from the use of property unless part of the financing structure is properly characterized by the parties as a loan (rather than as a lease or license). Such payments are not equivalent to interest. Nor should fees for services be treated as interest equivalents unless they are part of a financing arrangement in which the taxpayer's payments reflect the time value of money or the use or forbearance of money. In this regard, Prop. Reg. [section] 1.163(j)-2(e)(6) characterizes substitute payments under section 1058 security transfers as an interest equivalent, as does Temp. Reg. [section] 1.954-2T(h)(1). This conflicts with Prop. Reg. [section] 1.1058-1(d) which properly treats a substitute payment as a fee for the temporary use of property, i.e., a payment in the nature of a rental. We suggest that substitute payments -- especially substitute payments for dividends on stock transferred in a section 1058 transaction -- should not be categorically treated as interest.

2. Prop. Reg. [section] 1.163(j)-2(f):

   Adjusted Taxable Income

   1. Accounts Payable and Receivable. In enacting the earnings striply provision, Congress was primarily concerned with the thin capitalization of corporations. Specifically, concern was expressed that the original House provision was unduly expansive in that it --

      would deny interest deductions where net interest expense exceeds the income threshold not because the corporation was thinly capitalized but because of year-to-year changes in profitability or in the amount of depreciation, amortization, or depletion.

      Conference Report at 567. To address this concern, Congress provided for adjustments to taxable income for certain non-cash items to ensure that they did not "adversely affect interest deductibility." Conference Report at 567. Section 163(j)(6)(A) of the Code therefore defines "adjusted taxable income" (ATI) as taxable income computed without regard to (i) net interest expense, (ii)...