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Proposed earnings stripping regulations.

Last summer, the IRS issued proposed regulations under Sec. 163(j) to clarify the "earnings stripping" rules enacted by the Revenue Reconciliation Act of 1989. These rules address "earnings stripping" interest payments made to tax-exempt (or partially exempt) related persons. In the international tax context, these rules may limit deductions for interest paid by U.S. corporations to related foreign persons that pay no U.S. tax, or a reduced rate of tax, on the interest income received pursuant to the provisions of a tax treaty between the United States and the recipient's country of residence. The "earnings stripping" limitation on interest deductions only applies, however, if a corporation has "excess interest expense," and if the corporation's debt-to-equity ratio exceeds 1.5 to 1 at the close of its tax year (Sec. 163(j)(2)(A)).

The threshold question that must be addressed when applying these rules is whether the permissible debt-to-equity ratio is exceeded. Prop. Regs. Sec. 1.163(j)-3 discusses the computation of the ratio and specifically defines the terms "debt" and "equity." For purposes of these rules, "debt" means liabilities computed on a tax basis, which presumably excludes reserves and contingent liabilities that are recognized for financial but not tax accounting purposes. The regulations also exclude certain liabilities normally recognized for tax purposes, specifically, "short-term liabilities" and "commercial financing liabilities." Short-term liabilities are defined as accrued operating expenses, accrued taxes and any account payable no more than 90 days old, provided that it is non-interest-bearing for that period. Commercial financing liabilities include debt incurred to purchase inventory that is secured by such inventory and is due on or before its sale and, if entered into between related parties, bears arm's-length terms (Prop. Regs. Sec. 1.163(j)-3(b)(2)(ii)). The regulations also contain an "anti-rollover" rule to prevent taxpayers from reducing outstanding debt during the last 90 days of a tax year and then replacing such debt during the first 90 days of the following tax year.

Under the proposed rules, "equity" is equal to a company's total assets, computed on a tax basis, reduced by the company's debt. Short-term liabilities and commercial financing liabilities, although excluded from debt under the rules previously described, nevertheless reduce assets for the purpose of computing a company's equity. Partnership interests are to be stated at their adjusted tax basis. Stock of non-includible affiliated corporations (as defined under Sec. 1504(b)) is included at its cost basis, but as adjusted under Sec. 864(e)(4) for the subsidiary's earnings and profits. This section also contains anti-avoidance rules to prevent taxpayers from artificially improving their debt-to-equity ratio principally to avoid these rules (Prop. Regs. Sec. 1.163(j)-3(c)).

Once a corporation has computed its debt-to-equity ratio, it must identify whether it has "excess interest expense." Under Prop. Regs. Sec. 1.163(j)-1(a)(2), the "amount of exempt related person interest expense disallowed as a deduction in any taxable year shall not exceed the payor corporation's excess interest expense." Prop. Regs. Sec. 1.163(j)-2 defines these terms.

"Exempt related person interest expense" is interest expense subject to a zero rate of tax or a reduced rate of U.S. withholding tax under a treaty. If the interest is "partially exempt," only the portion of interest expense not subject to U.S. tax is taken into account (Prop. Regs. Sec. 1.163(j)-4 (b)). For instance, if a reduced treaty withholding rate of 15% applies (the statutory withholding rate is 30%), 50% of the interest expense is treated as exempt.

A "related person" is any person related under Secs. 267(b) or 707(b)(1). The attribution and constructive ownership rules of Sec. 267(c) also apply.

"Excess interest expense" is the amount by which net interest expense (total interest expense minus interest income) exceeds 50% of the corporation's "adjusted taxable income" plus any "excess limitation" from a prior year. Simply computing adjusted taxable income can be a somewhat time-consuming process. The proposed regulations contain a litany of adjustments to taxable income that are required in order to compute "adjusted taxable income," drafted with the intent of approximating cash-basis taxable income.

If 50% of the company's adjusted taxable income exceeds net interest expense, there is an "excess limitation," which may be carried forward for three years. In the effective date section, the Service has included a provision that permits companies that would have had excess limitation carryforwards in any of the three tax years prior to the effective date of the rules to use such carryforwards as though Sec. 163(j) had been in effect for all tax years beginning after July 10, 1986.

One of the most complex sections of the new regulations is Prop. Regs. Sec. 1.163(j)-5. Under this provision, all affiliated U.S. corporations must be included in the computations and treated as a single taxpayer. Members of an affiliated group (as defined in Sec. 1504(a)) must be included regardless of whether the group files a consolidated return. Furthermore, certain unaffiliated corporations are treated as affiliated under this section. Applying the attribution rules of Sec. 318, if at least 80% of a company's stock is owned (directly or indirectly) by includible corporations, the corporation must be considered affiliated. The regulations illustrate this rule with an example in which a foreign parent corporation has two wholly owned U.S. subsidiaries. Although the subsidiaries are not eligible to file a consolidated U.S. tax return (because the common parent is a foreign corporation), they must be combined for purposes of the Sec. 163(j) calculations.

This rule may present some practical problems to U.S. corporations with common foreign ownership, especially if the U.S. companies operate autonomously. In certain situations, a company may not even be aware of the existence of its affiliates. In such situations, it will be necessary for the foreign parent to coordinate the computations, and gather and disseminate information as needed.

The regulations also address the situation that arises when members leave the group, and prescribe special rules for handling inter-company adjustments and eliminations. A four-step process is used to determine each member's allowable interest deduction for each year, and its excess expense or excess limitation carryover to subsequent years.

Prop. Regs. Sec. 1.163(j)-5(e) permits an affiliated group to elect to apply a "fixed stock write-off method," under which the group includes the cost of an acquired affiliate's stock (rather than the tax basis of the affiliate's assets) when computing the group's debt-to-equity ratio. If this election is made, the total investment in the acquired affiliate (stock cost plus the affiliate's internal "debt") must be amortized on a straight-line basis over a period of either 96 or 180 months. The election must be made with the return for the tax year in which the affiliate is acquired (which apparently precludes its application to prior year acquisitions), and only applies to stock acquired in a qualified stock purchase under Sec. 338(d) for which no Sec. 338 election has been made. The method may be discontinued in any subsequent year when it is no longer advantageous.

The proposed regulations also address situations in which changes of ownership occur during a year, or when there is a limitation on the carryforward of tax attributes because of an ownership change. In addition, the regulations coordinate these rules with other rules that affect the timing of interest expense deductions, including the capitalization of interest expense under Sec. 263A. The proposed regulations have reserved a section to address loan guarantees by foreign affiliates and "back-to-back" loans made by a foreign affiliate through an intermediary.

The regulations' effective date corresponds to the statute; interest paid or accrued in a payor corporation's tax year beginning after July 10, 1989 is generally subject to these rules, although Regs. Sec. 1.163(j)-10 exempts interest on certain fixed-term obligations outstanding on July 10, 1989, in accordance with Sec. 163(j)(3)(B), and provides transitional rules for binding written contracts and demand obligations that existed as of that date.
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Author:Smaston, Carla M.
Publication:The Tax Adviser
Date:Dec 1, 1991
Words:1351
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