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Caution: watch out for the earnings stripping provisions.

For a variety of reasons, an increasing number of foreign corporations are expanding their businesses into the U.S. market. Many such corporations are attracted to U.S. interest rates on borrowing (currently at a long-time low), while others are simply looking to expand their operations globally. For whatever reason, the influx of foreign investment appears to be on the rise. While foreign investment in the United States can be structured several ways, the most commonly recommended approach includes the establishment of a wholly owned U.S. subsidiary. In this way, foreign corporations can avoid the branch profits tax as well as many of the other ramifications that typically accompany forms of investment. However, there may still be unforeseen tax implications.

Example 1: A foreign corporation, F, establishes a wholly owned U.S. subsidiary, U. F capitalizes U with a $1,000,000 loan bearing an annual interest rate of 10% and $100,000 of equity capital. U pays F $100,000 per year in interest and claims a deduction for such expense on its U.S. tax return. Further, the U.S. income tax treaty with F's country exempts the interest income from U.S. withholding tax.

Prior to 1990, the United States generally ignored international transactions of this type. Not surprisingly, foreign companies and individuals would capitalize their U.S. businesses with as much debt as possible. But the Omnibus Budget Reconciliation Act of 1989 brought with it the so-called "earnings stripping provisions" of Sec. 163(j). These provisions place significant limitations on the extent to which foreign companies can receive earnings from their U.S. operations tax free in their home countries and tax deductible in the United States. Generally effective for tax years beginning after July 10, 1989, these rules apply to corporations whose debt-to-equity ratios exceed 1.5 to 1. Obviously, these rules were meant to be far-reaching, since few corporations (foreign or domestic) regularly maintain such low ratios.

Under Sec. 163(j), a company's deduction for related-party interest expense is limited when the recipient is not subject to U.S. tax or receives the benefit of a reduced rate of tax on interest under treaty provisions. The limitation generally disallows such related-party interest to the extent that net interest expense exceeds 50% of the company's adjusted taxable income - that is, taxable income (before any interest deduction) adjusted for noncash items. The proposed regulations under Sec. 163(j) provide a list of the adjustments to be made in the determination of a company's adjusted taxable income. For example, taxable income must be increased for depreciation, amortization and any increase in accounts payable. Similarly, taxable income must be reduced for an increase in accounts receivable. From a practical standpoint, the intent is to compare related-party interest expense to current cash earnings, and disallow a deduction to the extent that any such interest is "excessive." The fundamental theory underlying the stripping provisions is that an excessive interest payment is, in substance, a dividend from accumulated earnings and profits and, therefore, a nondeductible expenditure. Example 2 illustrates the operation of these rules.

Example 2: Assume the same facts as in Example 1. Since the debt to equity ratio is clearly in excess of 1.5 to 1, the stripping provisions will apply. In year 1, U had adjusted taxable income of $140,000 and net interest expense of $100,000 (all related-party interest). The disallowed interest amount would be $30,000 ($100,000 - (0.50 x $140,000)).

To the extent that U can defer the payment of accounts payable at year-end, a significant planning opportunity exists. By not reducing year-end accounts payable, U is able to reduce the gap between net interest expense and 50% of its adjusted taxable income - thereby reducing the interest limitation. A deferral of $60,000 in year-end payments would have resulted in the complete elimination of any disallowed interest. Of course, such deferral would result in a decrease in adjusted taxable income in year 2 when paid, which might contribute to an interest limitation in that year.

This being the case, all affected taxpayers should monitor their overall cash flow and the timing of payments (and receipts to the extent possible) from year to year as part of an overall plan to minimize the effects of the stripping provisions. When an interest limitation does exist, however, such amount is not permanently lost. Any disallowed interest may be carried over to succeeding tax years, and such interest is to be treated as interest paid or accrued during those years for purposes of the stripping provisions. Therefore, in Example 1, U would have $30,000 of additional interest expense to carry over to year 2.

Although these examples deal with excess interest, in many cases net interest expense may be less than 50% of adjusted taxable income.

Example 3: U's adjusted taxable income in year 2 is $300,000 and net interest expense is $130,000 ($100,000 paid in year 2 + $30,000 carryover from year 1). The excess of 50% of adjusted taxable income over net interest expense is $20,000 ((0.50 x $300,000) - $130,000). This excess may be carried forward to the three succeeding years and used to offset disallowed interest expense in those years. Therefore, assuming disallowed interest (before any excess limit carryforward) is $100,000 in year 3, U would offset $20,000 of this amount by using its excess limit carryforward from year 2 - resulting in the disallowance of $80,000 in year 3 interest expense.

When excess limitation carryforwards exist, taxpayers should carefully monitor their availability for coordination with other areas of planning (i.e., timing of cash payments). For example, year-end deferrals might not be necessary if sufficient excess limitation carryforwards exist. It should be noted that the carryforward rules are intended to allow for the year-to-year fluctuations that many companies experience. Consistent with this, the proposed regulations make it mandatory that all taxpayers take into account any excess limitation carryforwards that would have originated from tax years beginning after July 10, 1986, had the stripping rules been in effect in such years. This rule can be of significant benefit to many taxpayers with substantial "cash basis" earnings in those earlier years.

Ultimately, practitioners need to be mindful of how these provisions operate and should seek ways to minimize any impact on their clients. Since it is difficult to get around these provisions, practitioners should advise their clients to consider alternative capital structures (i.e., less debt with greater equity) on the making of initial and subsequent investments in their foreign-owned U.S. subsidiaries. Also, it may be desirable to restructure the capital of existing U.S. subsidiaries to avoid the stripping provisions, although the benefits of such restructuring should be carefully weighed against the costs. And finally, if the stripping provisions do apply, practitioners and clients should time payments and monitor cash flows.
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Author:Pruzansky, Mitchell J.
Publication:The Tax Adviser
Date:Feb 1, 1993
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