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Proposals to modify earnings stripping rules.

In February, the Clinton administration released economic proposals that contain a provision to modify the tax code's earnings stripping provisions. On April 8, the Treasury Department issued a supplement to the proposals with further modifications.

Under tax code section 163(j)'s earnings stripping provisions, adopted in 1989, in certain circumstances a corporation may be denied current deductions for interest paid to related parties not subject to U.S. taxes on the interest received. The provisions fall most heavily on foreign-owned U.S. subsidiaries paying interest to foreign related parties receiving treaty exemptions from or reductions in U.S. withholding tax.

The tax code provisions generally affect interest accrued in tax years after July 10, 1989. However, they contain a grandfather clause for debt outstanding before that date.

In light of the possibility third-party lenders might be used to avoid disallowance, the Treasury secretary was directed to issue necessary anti-avoidance regulations. The congressional conference report to the 1989 act specifically discussed guarantees and back-to-back loans as possible avoidance devices. However, the report said an exception should be provided for guarantees given in the ordinary course of business. The conference report also stated that anti-avoidance regulations for the treatment of guaranteed loans should not apply to debt that was in existence before such regulations were released.

In June 1991, the Treasury Department issued proposed section 163(j) regulations but postponed discussion of guarantee and back-to-back loans.

The February Clinton proposal would recharacterize all loans from unrelated lenders guaranteed by a related party as related-party debt. Any exceptions would be provided by the Treasury Department in regulations.

The February proposals, which would affect interest paid or accrued in taxable years after December 31, 1993, apparently have no grandfather clause for debt outstanding before their introduction or enactment. They therefore would effectively override the 1989 act's conference report statement that such rules should not apply to pre-existing debt.

The April supplement would go even further by eliminating the 1989 act's grandfather clause for related-party debt existing before July 10, 1989. The elimination of grandfather status would affect interest paid or accrued on related-party loans in taxable years after December 31, 1993.

Moreover, the supplement's provisions would expand the Treasury secretary's authority to issue regulations for back-to-back loans and similar financing arrangements, affecting not only earnings stripping provisions but other unspecified parts of the code as well.

One likely application would affect third-party loans to a U.S. parent that are part of a back-to-back loan arrangement with a controlled foreign corporation (CFC). As investments in U.S. property by a CFC, the loans would be subject to the provisions of tax code section 956.

Observation: If the Clinton proposal is enacted in its current form, the interest paid on many existing loans not currently affected by the earnings stripping provisions may suddenly be disallowed.
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Publication:Journal of Accountancy
Date:Jun 1, 1993
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