Earnings stripping: effective tax strategy to repatriate earnings in a global economy.

• Author: Pasmanik, Philip T.

Many taxing authorities permit taxpayers to deduct interest paid or incurred to compute taxable income. Interest that is deducted reduces the pretax income of a corporation, which, in turn, reduces the amount of tax the corporation owes the taxing authority. Tax authorities continue to struggle with business structures that are over-leveraged to reduce taxes. Those structures can be abusive when employed by related parties by turning nondeductible dividends into deductible interest.

So how does this work? A corporation that is organized in a low-tax foreign jurisdiction that owns a corporation organized in the United States may, rather than fund the U.S. subsidiary's operating requirements with cash capital contributions, make loans or advances to the subsidiary. The foreign parent corporation then charges interest on those loans. The U.S. subsidiary, in turn, would claim an interest deduction (subject to certain limitations). If the foreign parent had funded the operations of the U.S. subsidiary through capital contributions, the amounts remitted from the U.S. domestic subsidiary to its foreign parent corporation would generally be considered dividends (taxable to the extent of the U.S. subsidiary's current and accumulated earnings and profits (E&P) or nontaxable return of capital distributions). (1)

So by funding the operations of its U.S. subsidiary using loans, the worldwide affiliated group has essentially converted nondeductible dividends into deductible interest (subject to certain limitations) for U.S. federal income tax purposes, effectively stripping earnings out of a high-income-tax-rate jurisdiction to a low-income-tax-rate jurisdiction, potentially with no withholding tax cost under the applicable income tax treaty between those countries. Designing an effective earnings-stripping structure, while not complicated in theory, can be very complex in a multinational corporate setting. Tax advisers can use a very basic structure, as described above, in domestic transactions involving foreign related parties and, in certain cases, nonrelated parties. This article is not all-encompassing and is intended to provide taxpayers and tax practitioners with a general overview of this complex area of U.S. tax law. Tax advisers should be aware of the limitations on the deductibility of disqualified interest discussed below. To the unpleasant surprise of many, these rules can apply even if a third-party loan is supported by a guarantee of the parent corporation. (2)

Note: This article does not discuss any related U.S. domestic Chapter 3 and Chapter 4 withholding and the Foreign Account Tax Compliance Act requirements or interest expense sourcing rules.

U.S. Tax Rules

A deduction may not be permitted for any tax year for disqualified interest paid or accrued by a U.S. corporation for which it has excess interest expense for that tax year and whose debt-to-equity ratio exceeds 1.5 to 1 on the last day of the tax year or on any other day during the tax year. (3) The amount of interest disallowed is limited to the amount of excess interest expense for the year and is carried over and treated as paid or accrued in the next succeeding tax year. (4)

Sec. 385 authorizes Treasury to define corporate stock and debt for all purposes of the Internal Revenue Code. (5) While this statute has been in the Code for many decades, no regulations have been issued. Whether a debtor-creditor relationship exists is predicated on the facts and circumstances, and the statute contains five factors to make the determination:

1. Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest;

2. Whether there is subordination to or any preference over any of the corporation's indebtedness;

3. The corporation's debt-to-equity ratio;

4. Whether the corporations stock is convertible; and

5. The...