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Clinton aims at earnings stripping.

Practitioners dealing with multinational clients take note: President Clinton recently made it clear he intends to get tough on earnings stripping - a colorful term for a practice foreign corporations have engaged in since the 1980s, when leveraged buyouts were common.

Earnings stripping occurs when, for tax purposes, a foreign corporation's U.S. subsidiary deducts interest it paid on debt owed to the parent. Since the parent company is exempt from paying U.S. income tax, the IRS doesn't receive its piece of the pie.

Section 163(j), in force since July 10, 1989, says affected companies are not allowed to deduct interest expenses paid to their foreign parent companies. Affected companies have (1) "excess interest expense" (net interest expense over 50% of cash flow) and (2) a debt-to-equity ratio of greater than 1.5 to 1.

The lesser of such "excess interest expense" or "exempt related-party interest" (interest paid to a related foreign party) is disallowed. However, the tax code contains an exemption for certain existing indebtedness - debt with a fixed term that was issued on or before July 10, 1989, or, generally, debt that is merely guaranteed by the exempt foreign parent company.

All in all, this rule is considered to be reasonably fair by affected foreign corporations but hardly beneficial to them.

As has been the case in recent months, President Clinton added yet another twist to the story - one that takes away the exemptions while confusing and angering many.

President Clinton proposed that all interest on debt paid after 1993, regardless of the loan's issuance date, be disallowed as a deduction if it meets the above requirements. The proposal's bite was made more painful through the addition of another entry in the category of affected debt, one that has elicited cries of outrage from many multinationals.

Clinton would disallow interest on virtually all guaranteed debt and treat the interest payments as though they were made to the foreign parent. An exception would be made only if a gross basis tax is imposed on such interest - with "gross basis" defined as interest paid to a foreigner with no withholding tax exemption. Furthermore, "guaranteed" is broadly defined as any arrangement under which one party assures the payment of another's obligation (conditionally or unconditionally).

Observation: One question that begs an answer, and to which at present there is none, is whether "keep well" agreements (which are moral - but not legally enforceable - obligations by parent companies to make sure subsidiaries pay their debts) qualify as guaranteed debt.

Whatever the outcome of this proposal, the coming days seem certain to be fraught with tension and confusion when discussion turns to this issue.
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Publication:Journal of Accountancy
Article Type:Brief Article
Date:Aug 1, 1993
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