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Earnings stripping and foreign-owned controlled groups.

Sec. 163(j), enacted by the Revenue Reconciliation Act of 1989, placed substantial restrictions on the amount of certain related-party interest expense deductions a foreign-owned U.S. corporation may take in computing its income tax (the so-called earnings stripping rules). Such restrictions generally apply to tax years beginning after July 10, 1989. These rules were enacted in response to what was perceived as an erosion of the U.S. tax base through interest expense deductions.

The earnings stripping rules generally apply to a corporation with a debt-to-equity ratio in excess of 1.5 to 1; if its net interest expense exceeds 50% of its adjusted taxable income for the year; and if the interest expense is not subject to full U.S. income or withholding tax in the hands of the recipient. Sec. 163(j)(6)(C) provides that members of an affiliated group are treated as one taxpayer for purposes of these rules. An affiliated group is defined by Sec. 1504(a) as one or more chains of includible corporations connected through stock ownership to a common parent corporation that is also an includible corporation, provided certain stock ownership requirements are met. Of course, the definition of an includible corporation expressly excludes a foreign corporation (Sec. 1504(b)(3)).

At first glance, two or more U.S. subsidiaries wholly owned by a foreign corporation would not appear to be members of an affiliated group, and thus require the earnings stripping rules to be applied on a separate company basis. However, Sec. 163(j)(7) gives the Treasury the authority to prescribe regulations necessary to carry out the purpose of the earnings stripping rules. Prop. Regs. Sec. 1.163(j)-5(a)(3)(i) expressly applies the Sec. 318 attribution rules in determining affiliated groups of corporations. As a result, two or more U.S. subsidiaries wholly, owned by a foreign corporation are considered to be members of an affiliated group; Sec. 318(a)(3)(C) will operate to treat one such subsidiary as the owner of the other and vice versa. This application significantly alters the traditional concept of an affiliated group; in essence, it has the effect of including members, which is more synonymous with the traditional concept of a controlled group.

The direct foreign ownership of several U.S. subsidiaries is not uncommon, especially when the subsidiaries are engaged in separate lines of business and the foreign parent wishes to operate the subsidiaries autonomously. It should also be noted that two or more U.S. subsidiaries wholly owned by two or more foreign corporations with a common parent corporation will also be considered members of an affiliated group and thus one taxpayer for purposes of the earnings stripping provisions.

As illustrated in the example at right, use of the attribution rules in determining affiliated groups for earnings stripping purposes can result in a profitable corporation with normal debt-to-equity ratios having its interest expense deductions limited because its foreign parent has one or more less profitable or more leveraged operations in the United States. in addition to the complexity of the required computations is the customary problem of obtaining information from other members of the affiliated group when a consolidated return is not filed; in fact, it is not unusual for some corporations to have little or no knowledge about other corporations, considered affiliated under the proposed earnings stripping regulations, with which they have no transactions.

Indications from the Service are that the final regulations will contain some minor changes in the affiliated group rules; however, these changes would not likely affect the result in the example. These changes may adjust the attribution rules to prevent corporations from being considered affiliated in situations in which they would not meet the Sec. 1504(a) definition of affiliation, even if foreign corporations were considered includible corporations. Taxpayers need to consider the existence of other commonly controlled corporations when applying the earnings stripping rules. This becomes even more important in light of the likely increase to corporations in exempt related person interest expense as a result of the changes made by the Revenue Reconciliation Act of 1993. This change removed the exception for interest on indebtedness grandfathered under the original legislation and treats the interest paid on a loan to an unrelated party, guaranteed by a related party who is exempt from U.S. Federal income tax, as exempt related person interest expense.

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Author:Vitola, Paul J., Jr.
Publication:The Tax Adviser
Date:Jul 1, 1994
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