Bifurcation - the non-sexy aspect of interest stripping.

The interest-stripping rules of Sec. 163{j) are designed to prevent foreign corporations from siphoning off income from undercapitalized domestic subsidiaries, thus paying less U.S. tax. Sec. 163(j) defers deductions for interest that undercapitalized domestic taxpayers pay to affiliated foreign persons until those domestic taxpayers subject substantial amounts of income to U.S. taxation. If a domestic taxpayer pays interest to an affiliate in a country that has a tax treaty with the United States, the calculations under Sec. 163(j)create only a partial deferral, based on how much of the foreign affiliate's interest income is subject to U.S. tax withholding.

The proposed regulations do not give much guidance as to this process. Individuals at the IRS National Office refer in general to a "bifurcation" process, which presumably means that the nonexempt portion of the interest paid to the foreign affiliate will be treated as if it were paid to an unrelated person. It is not known when and how this will be implemented.

In trying to plan, practitioners will soon discover that bifurcation is not the bonanza it seems. Effective planning results much more from detailed numerical analysis than linear reasoning. It is really a mini-maze of moving targets. See the example on pages 520-521.

It is necessary to wait for final regulations clarifying how Sec. 163(j}'s intended benefit may be achieved when making interest payments to affiliates in countries with positive-rate U.S. tax treaties. However, the need for good numerically based tax planning is essential early in the year, before any interest payments are made to foreign affiliates.

From Hal McKinney, Jr., CPA, Hood and Strong, San Frarciso, Cal.