Highlights of the proposed earnings stripping regulations under Sec. 163(j); an admirable first effort in implementing a harsh statutory rule.

• Author: Dionne, Marylouise

Congress and the IRS have become increasingly hostile towards foreign-owned U.S. corporations, based on their belief that these corporations are not paying their fair share of federal income taxes. In particular, Congress has been concerned with "earnings stripping," under which a U.S. corporation or branch of a foreign corporation obtains an interest deduction for its interest expense, but the payee is exempt from U.S. tax on the interest income. To prevent such interest deductions if the interest income is neither effectively connected with a U.S. trade or business nor subject to the full 30% withholding tax due to a tax treaty, Sec. 163(j) was enacted as part of the Revenue Reconciliation Act of 1989 (1989 RRA).

This article will examine Sec. 163(j) and analyze its proposed regulations, which were issued in June 1991.

Sec. 163(j)

Under Sec. 163(j), deductions for interest paid or accrued by a U.S. corporation or branch of a foreign corporation may be disallowed if the following three conditions are met. 1. The payor corporation's debt-to-equity ratio exceeds 1.5 to 1. 2. The payor corporation has "excess interest expense" for the tax year. 3. Interest is paid to a "related person" that is exempt from U.S. tax, in whole or in part, on the interest income. Sec. 163(j)(6)(C) requires that these calculations be made on an affiliated group basis.

Interest paid to a related person may be disallowed to the extent of "excess interest expense," the amount by which "net interest expense" exceeds 50% of "adjusted taxable income" plus any "excess limitation carryforward." Disallowed interest may be carried forward indefinitely and is deductible in a carryforward year to the extent of excess limitation generated in the carryforward year.

If 50% of adjusted taxable income exceeds net interest expense, excess limitation is generated. Excess limitation may be carried forward three years and used in the carryforward years to offset excess interest expense.(1) Example 1: Foreign corporation FC is exempt from tax under a tax treaty on interest payments received from its wholly owned U.S. subsidiary (DC). DC's net interest expense is $90 and its adjusted taxable income is $90. All its interest is paid to FC. DC's excess interest expense is $45 ($90 - (0.50 x $90)).

Alternatively, if DC has $200 of adjusted taxable income, it has no excess interest expense because 50% of its adjusted taxable income ($100) exceeds its net interest expense of $90. Instead, DC has $10 excess limitation carryforward.

Proposed Regulations

* In general The proposed regulations are effective for interest paid or accrued in tax years beginning after July 10, 1989.(2) In general, the regulations reflect the mechanical nature of Sec. 163(j), and address the following issues.

* What is a related person? * When is interest exempt from U.S. tax? * What is excess interest expense? * What is net interest expense? * What is adjusted taxable income? * Does the 1.5 to 1 debt-to-equity safe harbor apply? * What are the rules for affiliated groups and branches of foreign corporations?

* Definitions A related person is any person who is related to the payor corporation under Sec. 267(b) (including the constructive ownership rules of Sec. 267(c)) or 707(b)(1).(3) Relatedness is determined at the time an item of interest expense accrues. Any subsequent changes in the relationship between the related party and the taxpayer are ignored.(4) A broad anti-abuse rule is included, which provides that arrangements to shift stock ownership or voting rights away from any person for the purpose of avoiding Sec. 163(j) will be recharacterized.(5)

Interest is considered as exempt from U.S. tax if no tax is paid on the interest income, or if it is subject to a reduced treaty rate.(6) Interest subject to a reduced treaty rate is treated as partially taxable. For example, the U.S.-Japan income tax treaty reduces the withholding tax rate on interest from 30% to 10%. Interest payments to a Japanese parent company will be treated as one-third taxed and two-thirds tax-exempt. Two-thirds of any interest payments to the Japanese parent will be included in the computation of exempt related-person interest expense. The determination of whether interest is subject to tax is made on the date interest is paid or accrued by the payee.(7)

Sec. 163(j) will have little effect on outbound investors. A foreign corporation is not covered by the proposed regulations unless it has income effectively connected with a U.S. trade or business. Therefore, interest payments between controlled foreign corporations are not subject to disallowance.

Loans from a foreign corporation to its U.S. shareholder are also not subject to Sec. 163(j) in many cases. The proposed regulations provide that interest paid or accrued to a controlled foreign corporation (treated as subpart F income), or a passive foreign investment company that is a qualified electing fund, is not treated as tax-exempt to the extent included in income by a U.S. shareholder.(8) A similar rule applies to a foreign personal holding company.

This rule presents a problem because interest paid to a controlled foreign corporation will always constitute foreign personal holding company income, but will not necessarily be included in the income of a U.S. shareholder. For example, under Sec. 954(b)(4), any item of controlled foreign corporation income, including interest income, that is taxed at high rates by a foreign jurisdiction is treated as nonforeign personal holding company income and, as such, is not subject to current inclusion in a U.S. shareholder's income.

Excess interest expense is defined as the excess, if any, of "net interest expense" over 50% of "adjusted taxable income" plus any excess limitation carryforward.(9)

There is a limitation on disallowance. The proposed regulations follow the statute and limit the disallowed interest expense to the lesser of excess interest expense or exempt related-party interest expense.

Net interest expense is determined by netting gross interest income and gross interest expense.(10) Interest that is disallowed or capitalized under another Code section is never taken into account in computing net interest expense.(11) An interest deduction that is deferred, e.g., under Sec. 267(a)(3) for interest accrued by a U.S. subsidiary payable to its foreign parent, is taken into account for Sec. 163(j) purposes when no longer deferred under the applicable deferral provision.(12)

Unfortunately, the proposed regulations do not provide for a separate netting of related and unrelated interest transactions. See Example 2, on page 55.

Example 2: Determining Net Interest Expense

DC, from Example 1, has the following income and expenses.

Between Between related unrelated parties(*) parties Total Interest income $10 $10 $20 Interest expense 10 20 30 Net interest expense $ 0 $10 $10 DC's excess interest expense is $10 ($10 + ($0 x 0.50)). As currently drafted, the proposed regulations do not permit DC to deduct $10 of its interest expense in the current year if the debt-to-equity ratio is not met. Disallowed interest expense is the lesser of excess interest expense ($10) or exempt related-party interest expense ($10). If a separate netting were allowed for related and unrelated transactions, DC's $10 of exempt related-party interest income and $10 exempt related-party interest expense would offset each other, resulting in a net exempt related-party interest of $0. No amount would be...