Financing U.S. investments after the Revenue Reconciliation Act of 1993.

• Author: Rubinstein, Aaron A.

Under the guise of a "business provision," the Revenue Reconciliation Act of 1993 (RRA) included a modification to the interest deferral mechanism known as earnings stripping that is intended to generate $400 million of additional revenue in combination with two other provisions targeting foreign investors.(1) These changes will require foreign investors and their tax practitioners to review current structures employed in financing their U.S. investments carefully and modify them accordingly.

This article will explore two of these provisions: (1) the amplification of the so-called earnings stripping rules of Sec. 163(j) and (2) the authority given the IRS in new Sec. 7701(1) to issue regulations recharacterizing multiple-party financing transactions that are deemed to have been arranged for the purpose of avoiding U.S. tax. The advent of these new provisions is a clear attempt by Congress to shut down otherwise viable cross-border financing arrangements when a taxpayer's intent in structuring a transaction, or the inevitable tax outcome of a transaction, is the avoidance of U.S. tax in some manner. The article will present a number of alternative choices available in coping with these provisions.

Amplification of the Earnings

Stripping Provision

* Brief overview of Sec. 163(j)

Before Sec. 163(j) was enacted, a foreign corporation faced little disincentive to fund the operations of its U.S. trade or business with infusions of debt. To the contrary, the existence of debt on its U.S. subsidiary's books would give rise to tax deductible interest payments, generally without limitation.(2) Additionally, the interest payments by the U.S. subsidiary to its foreign parent would potentially be partially or wholly exempt from the 30% gross basis tax if an income tax treaty were in force between the United States and the foreign parent's country of residence.(3) Infusions of capital, conversely, would provide the U.S. subsidiary with no such interest deductions, and the ultimate remittance of dividends to the foreign parent could never be wholly tax exempt.(4)

Of course, to completely understand the overall tax position of the foreign investor, consideration must be given to the foreign investor's home country tax treatment. For example, in a high tax rate jurisdiction that exempts dividends from taxation but imposes a full tax on interest, a debt structure that at first blush appears attractive when considering only the U.S. tax implications may ultimately be more costly to the foreign investor when adding in the home country tax cost. Nonetheless, this obvious tax advantage of debt over equity financing from a U.S. tax perspective, combined with the ability of foreign investors to interpose treaty country corporations into their corporate organizational structure, has given rise and continues to give rise to considerable conflict between the U.S. tax authorities and taxpayers regarding the proper characterization of such instruments.

Sec. 163(j) was enacted in 1989 as part of the Revenue Reconciliation Act of 1989 in an attempt to limit the extent to which a foreign company could reduce or "strip" the U.S. earnings of its U.S. subsidiary. Generally, Sec. 163(j) denies a current interest deduction for interest paid to tax-exempt related persons when the interest expense exceeds 50% of the payor's current year's adjusted taxable income.(5) The interest disallowed under this provision is carried over and may be deductible in future years. The earnings stripping provision applies only if the payor has net interest expense for such tax year and the corporation's ratio of debt to equity as of the close of the tax year exceeds 1.5 to 1.

A related person includes a member of any one of the enumerated relationships in Sec. 267(b), as well as a person or persons having a greater-than-50% interest in a partnership(s) as provided in Sec. 707(b)(1).(6) For this purpose, a related person also includes any foreign corporation that owns directly or indirectly more than 50% of the voting power or value of the outstanding stock at a U.S. subsidiary.(7) As applied in this context, interest paid by a U.S. subsidiary to its foreign parent (or other related person) is considered "tax exempt related person interest" if it is not subject to the 30% gross basis tax under either internal U.S. tax laws or an income tax treaty in force between the United States and the recipient's country of residence.(8) When a treaty merely reduced the amount of tax imposed on the interest paid or accrued by the U.S. subsidiary, rather than eliminating it in its entirety, the borrower's U.S. interest deduction is potentially limited to the extend of the treaty rate reduction. For example, interest paid to a related party located in Italy is subject to a reduced U.S. tax rate of 15% under the U.S.-Italy income tax treaty. In this case, one-half (i.e., the statutory rate of 30% less the 15% treaty rate) of the interest paid to a related Italian party would be considered tax-exempt for this purpose and, therefore, potentially subject to the earnings stripping rules.(9)

* The issue of guarantees

The earnings stripping provisions as originally enacted were intended to attack related person financing arrangements designed to erode the taxable earnings of a U.S. subsidiary, but fell short of eviscerating all related-party financing structures, such as those attempting to circumvent the "relationship" requirement by using a black door approach. For example, parent companies often guarantee the debt of their subsidiaries to reduce the cost of bank borrowing. While such guarantees were the subject of much debate, the 1989 Congress intentionally postponed enacting specific rule to deal with such arrangements.(10)

* RRA change to Sec. 163(j)

Congress rethrough its position concerning parent-guaranteed debt and took a new, more expansive view. The new focus embraced the concept of fungibility, while the interest expense relating to a loan secured on the credit of a foreign entity is properly considered to be the expense of the foreign entity. Accordingly, by 1993, Congress now equated the two alternative funding methods it had distinguished just four years earlier.(11) Congress now reasoned that, assuming a given creditor is willing to lend to a foreign parent-U.S. subsidiary group based...