Earnings-stripping trap.

In 1989, Congress enacted Sec. 163(j), the earnings-stripping provisions, in an attempt to apply thin-capitalization policies to cross-border transactions. This section disallows a deduction for interest paid on loans from related parties in certain instances, most commonly in the international context. The provisions were amended in 1993 to extend coverage to loans from related tax-exempt parties and to loans guaranteed by related non-U.S. persons.

Disqualified Interest Defined

"Disqualified interest," according to Sec. 163(j)(3), is interest paid directly or indirectly by a corporation to a related person if no tax (or a reduced rate) is imposed on such interest under a U.S. tax treaty. The limit applies to any corporation for any tax year if its:

1. Net interest expense exceeds 50% of its adjusted taxable income (excess interest expense); and

2. Debt-to-equity ratio exceeds 1.5.

If a taxpayer exceeds these limits, the amount of the taxpayer's disallowed interest expense is the lesser of the "disqualified interest" or the "excess interest expense." The disallowed amount may be carried forward indefinitely, subject to the limits applicable in a future year.

Example: T, a domestic corporation, is a wholly owned subsidiary of F, a foreign corporation. During its tax year ending Dec. 31, 2003, T had adjusted taxable income of $200, which included $40 of interest income and $180 of interest expense, of which $120 was paid or accrued to F. The balance of the interest expense was paid to unrelated persons. Interest paid by T to F is not subject to U.S. tax, due to a tax treaty. T's debt-to-equity ratio exceeded 1.5 to 1 in 2003; T had no excess limit carried forward to that year. T's excess interest expense for 2003 was $40 ($180 - $40 - $100). Thus, $40 of T's exempt related-person interest expense is disallowed. T can carry forward its 2003 disallowed interest expense to its succeeding tax year.

Disqualified Guarantees

In 1993, Sec. 163(j)(3)(B)(i) was added to extend disallowance to any loan subject to a disqualified guarantee. Under Sec. 163(j)(6)(D), a loan is subject to a disqualified guarantee if it is guaranteed by a (1) related person exempt from U.S. income tax or (2) foreign person (unless the taxpayer owns at least an 80% controlling interest in the guarantor) and (3) no U.S. "gross basis tax" is imposed on the interest.

See. 163(j)'s Purpose

The earnings-stripping provisions were designed to prevent tax-free "stripping" of profits by related parties exempt from U.S. income tax. For example, in a typical foreign parent-U.S. subsidiary relationship, the subsidiary's earnings are often subject to double taxation--first, when the subsidiary pays its income taxes and, second, when it withholds tax when remitting dividends.

Prior to the enactment of Sec. 163(j), a foreign parent would commonly make loans to its highly leveraged U.S. subsidiary to combat this problem. Given the right tax treaty provisions, the interest payments that the subsidiary made to its parent would be subject to little or no withholding tax. Accordingly, the parent would repatriate its subsidiary's earnings in the from of interest, without paying the withholding for the dividend. Further, the subsidiary would reduce its U.S. tax burden via its interest deduction. The result was obviously viewed as problematic by the IRS, thus prompting the earnings-stripping provisions, which disallow the U.S. interest deduction when it is considered abusive.

Conclusion

Sec. 163(j) legitimately targets the tax-advantaged siphoning of U.S. earnings via abusive leveraging and treaty-shopping. Unfortunately, however, the absence of specific treaty-shopping provisions means Sec. 163(j) often disqualifies interest when payments are entirely legitimate and, in fact, subject to a higher rate of tax in a parent's hands than in a subsidiary's hands. Consequently, Sec. 163(j) becomes yet another trap for the unwary (but innocent) multinational.

FROM DEREK A. BURGESS, CPA, AND JAMES B. PENLINGTON, J.D., GRAND RAPIDS, MI