EARNINGS STRIPPING UNDER SECTION 163(j): STATUS QUO VADIS?

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1 International Business: Research Teaching and Practice (1) EARNINGS STRIPPING UNDER SECTION 163(j): STATUS QUO VADIS? Patrick J. Knipe CPA 4334 Tidewater Drive, Orlando, FL Judson P. Stryker Stetson University 421 N. Woodland Blvd. DeLand, FL Betty Thorne Stetson University 421 N. Woodland Blvd. DeLand, FL Foreign corporations have long searched for the most tax-efficient means of repatriating profits from their US subsidiaries. If earnings of foreign-controlled domestic corporations (FCDCs) are returned to their foreign parents through deductible interest payments, rather than dividends, the possibility exists of eliminating taxes altogether. The technique of leveraging FCDCs with intercompany debt in order to greatly reduce or eliminate US taxes is known as earnings stripping. Section 163(j) was added to the Internal Revenue Code in an effort to prevent erosion of the US tax base by abusive earnings-stripping strategies. Telephone: (386)

2 Knipe, Stryker & Thome Earnings Stripping Under Section 163(J) BACKGROUND Foreign corporations have long searched for the most tax-efficient means of repatriating their US subsidiary profits. US subsidiaries are taxed on their profits at the usual US corporate tax rates while dividend payments to their parent corporations are subject to a 30 percent statutory withholding rate or a rate reduced by tax treaty (Schadewald and Misey, 2005). So, if dividends are used to return profits of foreign-controlled domestic corporations (FCDCs) to their parent corporations, then two levels of US taxation are incurred. The total tax bill would include the tax on taxable profits plus the applicable withholding tax on dividends paid. However, if the earnings of US subsidiaries are repatriated to their foreign parents through deductible interest expense payments, then the possibility exists of eliminating US taxes altogether. This occurs when interest payments completely offset other net taxable income and the withholding tax on such interest is reduced to zero by treaty. This leveraging technique to reduce or eliminate US taxes by FCDCs is known as earnings stripping. The advantages of earnings stripping can best be illustrated by comparing the after-tax repatriated profits of a foreign parent receiving taxable dividends from its US subsidiary (see Example 1) to those of a foreign parent receiving repatriated amounts in the form of tax-deductible interest payments (see Example 2). Example 1. US Subsidiary Pays Foreign Parent Taxable Dividends Foreign parent corporation F owns 100 percent of the stock of its US subsidiary corporation, S. If S has taxable income of $1,000,000 and the US tax rate is 35 percent, then S pays US corporate income tax of $350,000, leaving $650,000 of net earnings for distribution to its parent, F. If all of the net earnings are distributed to F by dividends, and the tax treaty withholding rate on dividends is 10 percent, then F receives $585,000 ($1,000,000 taxable income less $350,000 US tax on taxable income equals $650,000, less 10 percent withholding tax on dividends of $650,000, or $65,000, equals $585,000). Total US taxes paid are $415,000, an effective tax rate of 41.5 percent on S s taxable income of $1,000,000. In Example 1, F receives $585,000 in repatriated earnings after both sets of US taxes are paid; in Example 2, F receives S s entire earnings of $1,000,000. The difference in the two approaches is $415,000, the total US taxes paid using dividends to repatriate earnings in Example 1 and using interest payments in Example 2. If the full 30 percent statutory rate on withholding tax applies in Example 1, then total taxes paid amounts to $545,000 (54.5 percent) and F receives the net balance of just $455,

3 International Business: Research, Teaching and Practice 2009 (3) 1 Example 2. US Subsidiary Pays Foreign Parent Tax-Deductible Interest Same facts as Example 1, except that S has an intercompany loan from F in the amount of $12,500,000 at 8 percent and the tax treaty withholding rate is 0 percent for interest paid. Without anti-earnings stripping provisions, S s entire taxable income of $1,000,000 would be eliminated by $1,000,000 in interest payments to F ($12,500,000 x 8 percent equals $1,000,000 interest expense). This mechanism would permit S to reduce its total US income taxes paid from $415,000 (41.5 percent) to zero. It is not hard to understand why foreign corporations, prior to anti-earnings stripping provisions, favored debt over equity investments in their US subsidiaries. And it also is not hard to understand why Congress and the IRS became ever more concerned that FCDCs were not paying their fair share of US income taxes. In the past, about the only method the IRS had to attack these earningsstripping activities was to try to reclassify intercompany debt as equity using the oft-times difficult argument of substance over form (Schadewald and Misey, 2005). And, as US tax collections from foreign corporations continued to diminish relative to revenues, Congress concluded that a significant part of the apparent discrepancy resulted from excessive debt used by foreign parent corporations to finance their US subsidiaries. To give the IRS a more effective means of combating these earnings-stripping schemes, Congress added antiearnings-stripping provisions to the Internal Revenue Code when it enacted the Revenue Reconciliation Act of 1989 (RRA 89). The Act added Section 163(j) to the Code in an effort to prevent erosion of the US tax base by earnings-stripping strategies, such as those described above. It should be remembered that a key ingredient in any tax planning is to keep the overall tax bill as low as possible. In the international arena, that means a foreign corporate parent looks to the most tax-efficient method of repatriating earnings from its US subsidiary. In that regard, taxes payable in the foreign parent s own country also must be considered because US tax savings may, in some cases, be offset by increased foreign taxes (Schadewald and Misey, 2005). Items of income, such as interest and dividends received from a US subsidiary, are frequently taxed at different rates by various foreign countries, and in certain foreign countries these sources of income are not taxed at all. In the case of earnings stripping, there is a net tax benefit whenever the US tax reduction for interest paid exceeds the foreign parent s tax on interest received. The tax savings is computed by multiplying the differential in tax rates by the amount of stripped income. It might be said, then, that the tax laws of certain foreign 92

4 Knipe, Stryker & Thome Earnings Stripping Under Section 163(J) countries actually encourage earnings stripping out of the United States to the extent that little or no foreign tax is imposed on interest income received by a foreign parent from its US subsidiary. Further, income shifting generally lowers a corporation s marginal cost of capital in both home and host countries and thereby results in a competitive advantage to the foreign corporation (US Department of the Treasury, 2007). REVENUE RECONCILIATION ACT OF 1989 The approach taken by Congress in RRA 89 to curtail earnings stripping was as follows. A domestic subsidiary would be denied a deduction for interest paid or accrued when all of the following occur: 1. The corporation has a debt-to-equity ratio that exceeds 1.5 to 1 on the last day of the taxable year. 2. The corporation pays or accrues disqualified interest, defined as interest paid or accrued to a related person that is wholly or partially exempt from US income tax on the interest income. 3. The corporation has excess interest expense for the year, meaning the corporation s net interest expense exceeds 50 percent of its adjusted taxable income plus any excess limitation carried forward to the year (Goodman, 1996). With regard to these conditions: Related person (determined at the time interest expense accrues) is any person as defined in Section 267(b) or Section 707(b)(1) of the Internal Revenue Code (Dionne and Throndson, 1992). Basically, any lender that owns more than 50 percent of the corporate debtor is a related person. Changes in the relationship subsequent to the time interest accrues are ignored. Wholly or partially exempt from US income tax means that no tax is paid on the interest income or, if the interest is subject to a tax treaty, a reduced rate of tax is paid making the interest income partially taxexempt to the recipient. For example, if the statutory withholding rate applicable to US-source interest income is 30 percent, and that withholding rate is reduced by tax treaty to 10 percent, then one-third of the interest income is considered taxable and two-thirds is held to be tax-exempt. Net interest expense is total interest expense for the year (not just disqualified interest paid to a related person) minus interest income. Adjusted taxable income is intended to approximate cash flow from operations (Dionne and Throndson, 1992). Beginning with taxable income, add-backs are made for net interest expense, net operating losses, depreciation, amortization and depletion, along with several other adjustments prescribed in the regulations. 93

5 International Business: Research, Teaching and Practice 2009 (3) 1 Excess limitation is defined as the excess of 50 percent of adjusted taxable income over net interest expense. An excess limitation arising in one year may be carried forward for three years and used in the carryforward period to reduce excess interest expense. If an excess limitation occurs in more than one year, the available carryforwards are used on a first-in, first-out basis. Any disallowed interest expense deduction is limited by Section 163(j) to the lesser of the disqualified interest and the computed excess interest expense. Disallowed interest expense may be carried forward indefinitely and is deductible in a year the taxpayer generates an excess limitation (see Example 3). In no event is excess interest expense, excess limitation or the excess limitation carryforward for any taxable year reduced below zero. Should the adjusted taxable income calculation result in a negative number, then the taxpayer has an adjusted taxable loss and treated as if it had an adjusted taxable income of zero (see Example 4). It should be noted that the debt-to-equity safe harbor does not apply to interest carried over. Section 163(j) permits deductibility only of interest actually incurred in the current tax year if the debt-to-equity ratio does not exceed 1.5 to 1 (see Example 5). To be deductible, carried over interest requires excess limitation in the carryforward year. For purposes of Section 163(j), all members of the same consolidated or affiliated group of corporations are treated as a single taxpayer (Dionne and Throndson, 1992). The computation of disallowed interest expense can be a bit tedious, but it is necessary in the case of an FCDC with intercompany debt. Example 3 illustrates how the disallowed interest expense deduction is determined in a leveraged FCDC. The disallowed interest expense deduction of $2,000,000 may be carried forward indefinitely and deducted by S in a year that S has an excess limitation. In this example, the excess limitation carryforward of $3,000,000 from the preceding year is completely used up in reducing excess interest expense of the current year. Excess limitation arises when 50 percent of adjusted taxable income exceeds the current year s net interest expense. Example 4 shows the use and carryforward effects of an excess limitation arising in the previous year. As illustrated in Example 5, being at or below the 1.5 to 1 debt-to-equity ratio on the last day of the taxable year is extremely important to optimal tax planning. 94

6 Knipe, Stryker & Thome Earnings Stripping Under Section 163(J) Example 3. Computation of Disallowed Interest Expense Deduction Foreign parent corporation F owns 100 percent of the stock of its US subsidiary corporation, S. Through intercompany loans, S owes F $750,000,000 at 8 percent, giving S a debt-to-equity ratio of 3 to 1 on the last day of its taxable year. An excess limitation carryforward of $3,000,000 is available from the preceding year. S has the following items of income and expense for the year: Sales $500,000,000 Cost of Sales 390,000,000 Gross Margin 110,000,000 Operating Expenses $50,000,000 Depreciation 10,000,000 Amortization 5,000,000 65,000,000 Operating Income 45,000,000 Interest Expense (paid to F) 60,000,000 Interest Income (25,000,000) Net Interest Expense 35,000,000 Taxable Income (before adjustment) $ 10,000,000 Assume the US corporation tax rate is 35 percent and that interest income is totally exempt from withholding tax by applicable treaty reduction. Since S s debt-to-equity ratio exceeds 1.5 to 1 and S has disqualified interest expense of $60,000,000 paid to related party F (its foreign corporation parent), S must determine its adjusted taxable income and excess interest expense. S computes these items as follows: Net Interest Expense $35,000,000 Taxable Income $10,000,000 Add back: Net Interest Expense 35,000,000 Depreciation 10,000,000 Amortization 5,000,000 Adjusted Taxable Income 60,000,000 x 50% 50% of Adjusted Taxable Income 30,000,000 Plus, Excess Limitation carryforward from preceding year 3,000,000 33,000,000 Excess Interest Expense $ 2,000,000 S computes its taxable income and tax as follows: Taxable Income (before adjustment) $10,000,000 Disallowed Interest Expense Deduction: Disqualified Interest Paid to F $60,000,000 Excess Interest Expense 2,000,000 Limited to the lesser of above 2,000,000 Taxable Income (after adjustment) $12,000,000 Tax Rate 35% Tax $ 4,200,000 95

7 International Business: Research, Teaching and Practice 2009 (3) 1 Example 4. Computation and Carryforward of Excess Limitation Same facts as in Example 3 except that S has excess limitation carried forward from the preceding year in the amount of $6,000,000. In this case, there is no excess interest expense for the current year and taxable income is unadjusted at $10,000,000. Excess limitation of $1,000,000 remains from the preceding year ($6,000,000 less $5,000,000 used to reduce current year excess interest expense to zero) and may be carried forward for two additional years. Example 5. Effect of the Debt-to-Equity Safe Harbor Rule Same facts as in Example 3 except that S has a debt-to-equity ratio of 1.5 to 1 on the last day of its taxable year. Because the debt-to-equity ratio does not exceed 1.5 to 1, none of the disqualified interest paid to F is disallowed. S has taxable income of $10,000,000 and tax payable of $3,500,000. The $3,000,000 excess limitation carryforward from the preceding year may be carried forward for two additional years. Current-year tax is $700,000 less than the tax paid in Example 3 (35 percent x $2,000,000 disallowed interest expense equals $700,000). The debt-to-equity safe harbor rule is objective and mechanical. For purposes of the rules, debt is defined as liabilities determined according to general tax law principles. Excluded from the definition of such debt are short term and commercial financing liabilities. The former include accrued operating expenses and taxes payable as well as any account payable for its first 90 days, provided no interest is charged. A commercial financing liability is defined as a financing agreement for the purchase of inventory that is collateralized by such inventory, presumably including a floor plan arrangement (Dionne & Throndson, 1992). Equity is defined by Section 163(j) as the sum of money and the adjusted basis of all other assets of the corporation, less debt. To prevent abuse of the debt-to-equity provisions, decreases in corporate debt during the last 90 days of the taxable year are disregarded to the extent that overall debt is increased during the first 90 days of the following tax year. In addition to this anti-abuse provision for debt, there are two anti-avoidance rules for equity. One provides that an asset will be disregarded if the principal purpose of acquiring it was to reduce the debt-to-equity ratio; the second rule disregards any assets that are transferred to the taxpayer by a related party within 90 days of the year end to the extent that there is a transfer of the same or similar assets to a related party during the first 90 days of the following tax year (Dionne and Throndson, 1992). 96

8 Knipe, Stryker & Thome Earnings Stripping Under Section 163(J) Excess limitation may arise in the current year as well as in prior years. Example 6 describes the order that multiple carryforward excess limitations are to be used. The debt-to-equity ratio must be tracked carefully by FCDCs wishing to avoid earnings-stripping provisions. As long as the ratio does not exceed 1.5 to 1 on the last day of the taxable year, the earnings-stripping rules do not apply. But, because the ratio is stringent, inflexible and mechanically applied, it is said to be a bright line test; as shown in Example 7, just one dollar too many of debt on the last day of the year could be disastrous (Goodman, 1996). Example 6. Use of Current Year and Prior Year Excess Limitations Same facts as in Example 3, except that S pays interest of $45,000,000 to F, resulting in net interest expense of $20,000,000. In this case, taxable income is increased by $15,000,000 to $25,000,000, 50 percent of adjusted taxable income remains unchanged at $30,000,000 and S has current year excess limitation of $10,000,000 (50 percent of adjusted taxable income, $30,000,000, less net interest expense of $20,000,000). The current-year excess limitation of $10,000,000 may be carried forward for three years and used after the available preceding year s $3,000,000 excess limitation is exhausted (first-in, first-out basis). Example 7. How Failing the "Bright-Line" Debt-to-Equity Test Could Be Disastrous Refer to Example 3. US corporation S is a wholly-owned subsidiary of foreign parent corporation F. The balance sheet for S on the last day of its tax year shows the following: Debt (all due to F) $750,000,001 Equity 500,000,000 Assume S has excess interest expense for the year of $60,000,000 (all paid to F) and has no excess limitation carryover from prior years. Since S has a debt-toequity ratio that exceeds 1.5 to 1 (by just one dollar), S may not deduct $60,000,000 in interest expense for the year. If S has taxable income of $60,000,000 (after adjustment) and the corporate tax rate is 35 percent, S has additional tax to pay of $21,000,000. For want of a nail It should be noted that substituting equity investment for debt is always an option to foreign corporation parents of US subsidiaries. However, the overall 97

9 International Business: Research, Teaching and Practice 2009 (3) 1 cost of such an approach must be carefully considered as interest deductions are merely deferred under earnings-stripping provisions, not lost, while equity financing creates permanent non-deductibility for dividends paid (Croker and Birnkrant, 1994). Present value computations of relative benefits likely would be required and such computations would be made complicated by the need to estimate future cash flows and taxable income of the US subsidiary. Proposed regulations implementing Section 163(j) were issued by the Treasury Department and the IRS in To date, final regulations for these earnings-stripping provisions have not been issued (US Department of the Treasury, 2007). REVENUE RECONCILIATION ACT OF 1993 In response to the earnings-stripping provisions of Section 163(j), tax planning techniques of foreign multinationals turned to the use of guaranteed debt, rather than direct related-party debt, to finance their US subsidiaries. Using this approach, foreign parents enabled their US subsidiaries to avoid paying disqualified interest to the parents (related parties) because the loans were negotiated directly with unrelated parties, usually banks. The banks were secured in their lending to the FCDCs by the foreign parents loan guarantees, but the US subsidiaries were spared the operation of Section 163(j) and the resulting disallowance of interest expense deductions. Although authorizing general anti-avoidance type regulations, Section 163(j) did not directly address the issue of loan guarantees. Further, the proposed regulations issued in 1991 also failed to address loan guarantees or to provide any guidance on the subject. Since parent companies commonly guarantee debt of their subsidiaries to contain the interest costs to outside lenders, the Treasury Department and the IRS apparently did not want to attempt to separate taxavoiding guarantees from guarantees arising in the ordinary conduct of business (Croker and Birnkrant, 1994). In the Revenue Reconciliation Act of 1993 (RRA 93), Congress widened the scope of Section 163(j) and made it unnecessary for the Treasury Department and the IRS to differentiate between ordinary business guarantees and guarantees that are tax-motivated. RRA 93 provides that the earnings-stripping provisions apply to guarantees in all cases. Disqualified interest arises under Section 163(j) when there is a disqualified guarantee and the interest income is not subject to a US gross-basis tax. A disqualified guarantee is one made by a related foreign person or a related tax-exempt entity. Gross-basis tax refers to the 30 percent withholding tax imposed on US-source investment income paid to a foreign person. Therefore, if interest subject to the full 30 percent US withholding tax is paid to an unrelated party, and the debt is secured by a disqualified (related party) guarantee, then the interest expense is not disqualified 98

10 Knipe, Stryker & Thome Earnings Stripping Under Section 163(J) interest (Croker and Birnkrant, 1994). However, if a tax treaty reduces the withholding rate below 30 percent, then interest on debt to an unrelated person with a disqualified guarantee is subject to earnings-stripping provisions in the same proportion as the amount of treaty reduction. So, as with direct relatedparty debt in Example 1, if the treaty rate is reduced from 30 percent to 10 percent, then two-thirds of the interest on disqualified guarantee debt is considered to be exempt from US tax and subject to the earnings-stripping provisions of Section 163(j) (Schadewald and Misey, 2005). Example 8 compares the effects of substituting foreign parent loan guarantees to unrelated parties for direct intercompany loans to an FCDC. Example 8. Intercompany Loans versus Guarantees of Intercompany Loans Refer to Examples 3-7, but instead of issuing intercompany loans, foreign parent corporation F guarantees (unrelated party) foreign bank loans to US subsidiary corporation S. By tax treaty, the interest is wholly exempt from the 30 percent US withholding tax. In all five scenarios, the results would be the same because F, as a related party to S, creates a disqualified guarantee and the interest income by tax treaty is not subject to US gross-basis (withholding) tax. Guarantee is given a broad definition in Section 163(j). The term includes any assurance, whether conditional or unconditional, that another person s obligation will be paid. Guarantee includes a comfort letter, whether or not the arrangement constitutes a legally enforceable obligation. A commitment to make a financial contribution to the borrower or to keep the borrower financially viable would be considered a guarantee. Basically, any form of credit support by a related party, even one contingent on a future event, constitutes a guarantee under the earnings-stripping provisions (Croker and Birnkrant, 1994). As is true with direct debt financing, if a US subsidiary borrower using a disqualified guarantee has a debt-to-equity ratio of 1.5 to 1 or less, the earningsstripping limitation of Section 163(j) does not apply TREASURY DEPARTMENT STUDY The target of a 2002 Treasury Department study of earnings stripping was centered on so called corporate inversions. A corporate inversion occurs through a transaction that changes the structure of a US-based multinational corporation. In an inversion, the US parent corporation is replaced by a new foreign corporation, usually located in a low- or no-tax country. When the transaction is completed, the US operations of the group are highly leveraged 99

11 International Business: Research, Teaching and Practice 2009 (3) 1 with intercompany loans from the new foreign parent, or from related foreign corporations, and the resulting deductible interest payments to foreign members of the group are subject to little or no US tax on the interest income. In fact, SEC filings proposing these inversion transactions and asking for shareholder approval, often list significant US tax savings as a key reason for undertaking them (US Department of the Treasury, 2007). The 2002 study found that corporate inversions lead to major reductions in US tax on the domestic operations of foreign-controlled groups through deductible interest payments. The study points out, however, that this earningsstripping technique is not unique or limited to groups that have undergone an inversion transaction, but rather are available to any foreign-controlled corporate group. The study report indicated that corporate inversions really just exposed areas of weakness in the Code and related inter-workings with certain US tax treaties (US Department of the Treasury, 2007). This Treasury Department study of inversion transactions provided evidence that earnings-stripping provisions are not accomplishing their intended purposes. In conclusion, the 2002 inversion report pointed out that more study was needed of the effects of Section 163(j) on earnings stripping and reductions of withholding taxes on interest through taxreducing treaties. Subsequent to the 2002 Treasury Department report on inversion transactions, an independent study compared pre-inversion taxes and postinversion taxes paid by four large, selected inverted corporations (ICs). All four ICs studied were within the 1.5 to 1 debt-to-equity safe harbor of Section 163(j). This report found significant shifting of income out of the United States and large concomitant reductions in effective tax rates. Total losses to the US Treasury for the years 2002 and 2003, on just these four ICs, were estimated to be more than $700,000,000 (US Department of the Treasury, 2007). The conclusions drawn indicated that ICs were shifting substantially all of their income out of the United States through interest payments on intercompany debt, that the primary motivation for US inversion transactions is to reduce US corporate taxes significantly, and that on average the worldwide effective tax rate of ICs is reduced by one third. AMERICAN JOBS CREATION ACT OF 2004 The next legislative measure to address earnings stripping was the American Jobs Creation Act of 2004 (AJCA). Section 424 of the Act directed the Secretary of the Treasury to conduct a study of earnings-stripping provisions of the Code. Although earnings stripping can be accomplished in a variety of ways, such as payment of tax-deductible royalties, the use of interest on related-party debt has proven to be the easiest way of shifting income out of US corporations. As a result, the Treasury Department has interpreted Section 424 of AJCA as a 100

12 Knipe, Stryker & Thome Earnings Stripping Under Section 163(J) directive to study the transferring of income out of domestic corporations to foreign entities through interest payments on intercompany debt (US Department of the Treasury, 2007). In addition to requiring a study of earnings stripping in general, AJCA made significant changes to tax rules applicable to international transactions. One such change was the enactment of Section 7874 which addressed the tax consequences of certain corporate inversions. Section 7874 applies to inversions where ownership is substantially the same before and after the transaction. With a 60 percent continuity of ownership between the former US parent corporation and the new foreign parent corporation, Section 7874 sets limitations on tax benefits that may be derived from the transaction. If there is an 80 percent continuity of ownership, Section 7874 taxes the new foreign parent corporation as though it were a domestic corporation (US Department of the Treasury, 2007). Section 7874 applies only to inversions occurring after March 4, 2003; corporations inverted before that date are grandfathered. There do not appear to have been any significant corporate inversions after the enactment of Section Therefore, Section 7874 appears to be doing its job in curtailing major corporate inversions and the intended subsequent earnings stripping associated with such transactions (US Department of the Treasury, 2007). While directly addressing the tax consequences of inversion transactions, AJCA did not specifically amend or alter other provisions of the Code related to earnings stripping. As mentioned earlier, the Act required the Treasury Department to conduct a study of earnings stripping by FCDCs. That study has been completed and a report was submitted to Congress in November, TREASURY DEPARTMENT REPORT Predictably, the main focus of this 2007 Treasury Department study of earnings stripping was excessive payment of tax-deductible interest by FCDCs to related parties, primarily foreign parent corporations, to whom the interest income is exempt, or partially exempt, from US taxation. The Treasury Department got data for its report by studying payments set forth on IRS Form 5472 (US Department of the Treasury, 2007). This form is a device for gathering information on a 25 percent or more foreign-owned US corporation or a foreign corporation engaged in a US trade or business. Form 5472 includes information on transactions between FCDCs and foreign related parties. The data from the study of Form 5472 confirms that the great majority of earnings stripping are through interest payments. However, the study does show that a portion of the stripping emanates from the payment of royalties. This finding is understandable since interest and royalties comprise the two most common intercompany payments between related corporations, and treaty-reducing withholding rates are often zero for both interest and royalties (US Department of the Treasury, 2007). 101

13 International Business: Research, Teaching and Practice 2009 (3) 1 The 2007 Treasury Department study found that, using data available, it is not possible to determine the extent of earnings stripping by FCDCs in general, but that the weight of evidence points strongly to earnings stripping on the part of the subset of FCDCs that had undergone an inversion transaction (US Department of the Treasury, 2007). In fact, the data on ICs would indicate that these corporations are shifting virtually all of their income out of the United States, primarily through deductible interest payments to related foreign corporations. Consequently, the US operations of ICs are shown to be very unprofitable. This finding confirms the conclusion drawn in the 2002 Treasury report and the subsequent independent study on ICs. The reasonable conclusion to draw from the 2007 Treasury report is that Section 163(j) and related regulations are not preventing erosion of the US tax base through the inappropriate shifting of income outside the United States by ICs. It would certainly seem from this study and report, and other available evidence, that the principal purpose of entities entering into an inversion transaction, especially groups of significant size, is to reduce US taxes through earnings-stripping activities. Section 424 of AJCA, mentioned earlier, posed mandates to the Treasury Department to study specific issues related to earnings-stripping provisions of the Code. Four of these mandates, formulated as questions, and information from the answers produced by the Treasury Department s study results (US Department of the Treasury, 2007), are: 1. How effective is Section 163(j) of the Code in preventing the shifting of income outside the United States? The Treasury report indicates that while there is strong evidence that inverted corporations are stripping, it is not possible at this time to quantify with accuracy the extent of income shifting by the broader group of FCDCs generally. Therefore, based on the information that is available, it cannot be determined with certainty whether or not Section 163(j) is by and large effective in preventing the shifting of income outside the United States. It would appear, however, that Section 163(j) is ineffective in preventing earnings stripping by ICs. This can be shown because it is possible to quantify income stripping by inverted corporate groups pre- and post-inversion. 2. How are earnings stripping activities impacting the US tax base? As discussed above, the Treasury report states that the extent of income shifting by FCDCs in general cannot be quantified with accuracy. Therefore, the overall effect on the US tax base of earnings-stripping activities is not determinable. However, one independent study of four ICs, mentioned earlier, would indicate that this small subset of FCDCs has reduced US tax revenue by more than $700,000,000 in just a two- 102

14 Knipe, Stryker & Thome Earnings Stripping Under Section 163(J) year period. Since these four corporations are but a small fraction of the total number of ICs in operation, it reasonably can be supposed that the revenue loss for all ICs would be a significantly larger amount. 3. Do the laws of foreign countries facilitate the stripping of earnings out of the United States? According to the Treasury study, foreign country tax laws may facilitate such stripping. Some foreign corporations, located in no-tax or low-tax countries, gain directly from stripping earnings out of their US subsidiaries. Other foreign corporations, based in high-tax countries, may be subject to tax laws that permit deferral of tax on income earned offshore. In these instances, the foreign corporations can strip income from the United States to a third, no-tax or low-tax country and avoid both US tax and tax in their country of origin. 4. What should be done to improve earnings-stripping provisions of the Code? Listed in the Treasury report are a number of legislative and other proposals, none of which has gained any traction, that have been made in recent years in an attempt to tighten the earnings-stripping provisions of the Code. A few of these include: Eliminate the 1.5 to 1 debt-to-equity ratio safe harbor. Reduce the threshold for excess interest expense from 50 percent to 35 percent of adjusted taxable income. Limit the carryforward period for disallowed interest to five years and eliminate altogether the existing three-year carryforward period for excess limitation. Replace the existing 1.5 to 1 debt-to-equity safe harbor with a safe harbor based on a series of debt-to-asset ratios. For certain ICs only, eliminate the debt-to-equity ratio safe harbor and reduce the threshold for excess interest expense from 50 percent to 25 percent of adjusted taxable income. Eliminate all the rules related to guaranteed debt. CONCLUSIONS Return now to the title page two-in-one question concerning earnings stripping under Section 163(j): Status quo vadis? How do things now stand ( status quo ) and where do we go from here ( quo vadis )? The 2007 Treasury Department report mandated by AJCA concludes that additional information is needed to determine whether or not modifications should be made to current interest-stripping provisions of the Code. In order to obtain the needed data and further the administration of Section 163(j), a new tax form has been proposed, Form 8926, Disqualified Corporate Interest Expense 103

15 International Business: Research, Teaching and Practice 2009 (3) 1 Disallowed Under Section 163(j) and Related Information (US Department of the Treasury, 2007). Form 8926, to be completed by corporations beginning in tax year 2008, solicits information relating to the determination and computation of a corporate taxpayer s: Debt-to-equity ratio; Net interest expense; Adjusted taxable income; Excess interest expense; Total disqualified interest for the tax year; Amount of interest deduction disallowed under Section 163(j); and Excess limitation carryforward. The name and country of incorporation of related persons receiving disqualified interest are also being requested on the form. The answers to our two questions, then, are simple. There are no changes being made or proposed to Section 163(j) at this time and the Treasury Department needs (and seeks) more information in order to determine what, if anything, should be done to strengthen the earnings-stripping provisions of the Code. REFERENCES Croker, Jr., J.E. & Birnkrant, H.J. (1994) Inclusion of guaranteed loans further complicates earnings-stripping provisions, Journal of Taxation, 80(1): Dionne, M. & Throndson, T.J. (1992) Highlights of the Proposed Earnings Stripping Regulations Under Sec. 163(j), The Tax Adviser, 23(1): Goodman, G.R. (1996) Teasing the Limits of Interest Stripping, Tax Notes, 27: Schadewald, M.S. & Misey, Jr., R.J. (2005) Practical Guide to U.S. Taxation of International Transactions, Fifth Edition, CCH: Chicago. U.S. Department of the Treasury (2007), Report to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties. 104