Earnings stripping and foreign-owned controlled groups.

• Author: Vitola, Jr., Paul J.

Sec. 163(j), enacted by the Revenue Reconciliation Act of 1989, placed substantial restrictions on the amount of certain related-party interest expense deductions a foreign-owned U.S. corporation may take in computing its income tax (the so-called earnings stripping rules). Such restrictions generally apply to tax years beginning after July 10, 1989. These rules were enacted in response to what was perceived as an erosion of the U.S. tax base through interest expense deductions.

The earnings stripping rules generally apply to a corporation with a debt-to-equity ratio in excess of 1.5 to 1; if its net interest expense exceeds 50% of its adjusted taxable income for the year; and if the interest expense is not subject to full U.S. income or withholding tax in the hands of the recipient. Sec. 163(j)(6)(C) provides that members of an affiliated group are treated as one taxpayer for purposes of these rules. An affiliated group is defined by Sec. 1504(a) as one or more chains of includible corporations connected through stock ownership to a common parent corporation that is also an includible corporation, provided certain stock ownership requirements are met. Of course, the definition of an includible corporation expressly excludes a foreign corporation (Sec. 1504(b)(3)).

At first glance, two or more U.S. subsidiaries wholly owned by a foreign corporation would not appear to be members of an affiliated group, and thus require the earnings stripping rules to be applied on a separate company basis. However, Sec. 163(j)(7) gives the Treasury the authority to prescribe regulations necessary to carry out the purpose of the earnings stripping rules. Prop. Regs. Sec. 1.163(j)-5(a)(3)(i) expressly applies the Sec. 318 attribution rules in determining affiliated groups of corporations. As a result, two or more U.S. subsidiaries wholly, owned by a foreign corporation are considered to be members of an affiliated group; Sec. 318(a)(3)(C) will operate to treat one such subsidiary as the owner of the other and vice versa. This application significantly alters the traditional concept of an affiliated group; in essence, it has the effect of including members, which is more synonymous with the traditional concept of a controlled group.

The direct foreign ownership of several U.S. subsidiaries is not uncommon, especially when the subsidiaries are engaged in separate lines of business and the foreign parent wishes to operate the...