Many taxing authorities permit taxpayers to deduct interest paid or incurred to compute taxable income. Interest that is deducted reduces the pretax income of a corporation, which, in turn, reduces the amount of tax the corporation owes the taxing authority. Tax authorities continue to struggle with business structures that are over-leveraged to reduce taxes. Those structures can be abusive when employed by related parties by turning nondeductible dividends into deductible interest.
So how does this work? A corporation that is organized in a low-tax foreign jurisdiction that owns a corporation organized in the United States may, rather than fund the U.S. subsidiary's operating requirements with cash capital contributions, make loans or advances to the subsidiary. The foreign parent corporation then charges interest on those loans. The U.S. subsidiary, in turn, would claim an interest deduction (subject to certain limitations). If the foreign parent had funded the operations of the U.S. subsidiary through capital contributions, the amounts remitted from the U.S. domestic subsidiary to its foreign parent corporation would generally be considered dividends (taxable to the extent of the U.S. subsidiary's current and accumulated earnings and profits (E&P) or nontaxable return of capital distributions).1
So by funding the operations of its U.S. subsidiary using loans, the worldwide affiliated group has essentially converted nondeductible dividends into deductible interest (subject to certain limitations) for U.S. federal income tax purposes, effectively stripping earnings out of a high-income-tax-rate jurisdiction to a low-income-tax-rate jurisdiction, potentially with no withholding tax cost under the applicable income tax treaty between those countries. Designing an effective earnings-stripping structure, while not complicated in theory, can be very complex in a multinational corporate setting. Tax advisers can use a very basic structure, as described above, in domestic transactions involving foreign related parties and, in certain cases, nonrelated parties. This article is not all-encompassing and is intended to provide taxpayers and tax practitioners with a general overview of this complex area of U.S. tax law. Tax advisers should be aware of the limitations on the deductibility of disqualified interest discussed below. To the unpleasant surprise of many, these rules can apply even if a third-party loan is supported by a guarantee of the parent corporation.2
Note: This article does not discuss any related U.S. domestic Chapter 3 and Chapter 4 withholding and the Foreign Account Tax Compliance Act requirements or interest expense sourcing rules.U.S. Tax Rules
A deduction may not be permitted for any tax year for disqualified interest paid or accrued by a U.S. corporation for which it has excess interest expense for that tax year and whose debt-to-equity ratio exceeds 1.5 to 1 on the last day of the tax year or on any other day during the tax year.3 The amount of interest disallowed is limited to the amount of excess interest expense for the year and is carried over and treated as paid or accrued in the next succeeding tax year.4
Sec. 385 authorizes Treasury to define corporate stock and debt for all purposes of the Internal Revenue Code.5 While this statute has been in the Code for many decades, no regulations have been issued. Whether a debtor-creditor relationship exists is predicated on the facts and circumstances, and the statute contains five factors to make the determination:
- Whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest;
- Whether there is subordination to or any preference over any of the corporation's indebtedness;
- The corporation's debt-to-equity ratio;
- Whether the corporation's stock is convertible; and
- The relationship between holdings of the corporation's stock and holdings of obligations for which the determination is being made.6
Numerous court decisions have addressed the question whether a debtor-creditor relationship existed. A discussion of those cases is beyond the scope of this article.
Disqualified interest (discussed further below) is any interest paid or accrued by the taxpayer (directly or indirectly) to any related person that is not subject to gross basis U.S. income tax withholding.7 The excess interest expense of a corporation is the excess, if any,8 of its net interest expense over the sum of 50% of its adjusted taxable income for the tax year plus any excess limitation carryforward.9
Disqualified interest also refers to any interest paid or accrued by a corporation on debt owed to a person who is not a related person when two conditions exist: if there is a "disqualified guarantee" of the indebtedness and no gross basis tax is imposed under Subtitle A on the interest.12
To more clearly reflect cash flow, certain adjustments determine adjusted taxable income. The following items are added back into taxable income to determine adjusted taxable income: net interest expense; net operating loss (NOL) deductions; the domestic production activities deduction; depreciation; amortization; depletion; carryover of excess charitable deductions; increases in accounts payable included in income; decreases in accounts receivable included in income; tax-exempt interest; dividends-received deductions; increases in last-in, first-out (LIFO) recapture amounts for the tax year; and capital loss carryforwards or carryback deductions.
The following items are subtracted from taxable income to determine adjusted taxable income: depreciation, amortization, and depletion allowed or allowable as deductions after July 10, 1986, for property sold during the tax year; if stock of an affiliated group member is sold or disposed of during the tax year, any amounts equal to the investment adjustments attributable to depreciation, amortization, and depletion deductions taken when the stock was stock of an affiliated group member; decreases in accounts payable during the tax year; increases in accounts receivable for the year; deductions disallowed by Sec. 265 (interest incurred to purchase tax-exempt obligations) and Sec. 279 (interest on corporate indebtedness to purchase stock in another corporation); disallowed charitable contributions; decreases in LIFO recapture amounts for the tax year; and net capital loss.13
An excess limitation carryforward reduces a corporation's excess interest expense.14 If the corporation's excess interest expense gets reduced to zero for a tax year, Sec. 163(j) does not apply.15 If the corporation's excess interest expense is not reduced to zero, and the amount of the interest expense is lowered, it may reduce the amount of interest deductions that are disallowed under Sec. 163(j).16 If a corporation has an excess limitation in a tax year, that limitation carries forward to the first, second, and then to the third succeeding tax year. The corporation uses the excess limitation carryforward to offset excess interest expense that would otherwise exist. To the extent the excess interest expense is used, the excess limitation expense carryover ceases to carry forward. If a corporation has an excess limitation carryforward from more than one prior tax year, it uses the earliest of the carryforwards first.17
A related person, for purposes of determining whether the earnings-stripping provisions apply, is any person who is related, within the meaning of Sec. 267(b) or 707(b)(1), to the corporation that is paying the interest.18 The constructive ownership rules of Sec. 267(c), and other appropriate provisions, apply when required.19 For example, a foreign individual who owns over 50% of the value of a domestic corporation's stock is considered related to that corporation. A foreign corporation is related to a domestic corporation if the two corporations are members of the same controlled group.20 If a corporation pays or accrues interest to a partnership to which that corporation is related, the interest will not be considered paid or accrued to a related person if less than 10% of the profits and capital interests in the partnership are held, in total, by partners that are exempt from tax on their distributive shares of the interest. This rule does not apply to interest expense that is allocable to a partner that is related to the corporation.21
Interest is tax-exempt and therefore considered disqualified interest if it is paid or accrued to a partnership or other passthrough entity, such as a regulated investment company or real estate investment trust, as determined by looking through the entity to the separate interests of the owners. Only that portion of the interest that is paid to a related passthrough entity that is allocable to tax-exempt beneficial owners is generally considered to be disqualified interest.22
Additionally, interest is tax-exempt if a U.S. tax treaty provides that the interest is tax-free. Accordingly, the interest is disqualified interest if it is paid or accrued to a related person. If a U.S. tax treaty reduces the rate of tax, these earnings-stripping provisions treat a proportionate share of the interest as not subject to tax. The fraction used to determine the interest treated as not subject to tax equals the reduced tax rate under the tax treaty divided by the whole tax rate that would apply without the tax treaty being in force.23
A guarantee is generally defined for purposes of earnings stripping to include any arrangement under which a person assures, on a conditional or unconditional basis, the payment of another person's obligation under any indebtedness regardless of whether the guarantee is directly or indirectly through another entity.24 This rule was effective for tax years beginning on or after May 17, 2006.25Corporate Partners
A special rule in the statute was designed to prevent a corporation from avoiding the earnings-stripping rules by issuing debt through a partnership in which it holds an interest. The earnings-stripping provisions provide that a corporation's distributive share of interest income paid or accrued to a partnership is treated as interest income paid or accrued to the corporation; the corporation's distributive share of interest paid or accrued by a partnership is treated as interest paid or accrued by the corporation; and a corporation's share of the partnership's liabilities is treated as liabilities of the corporation.26Affiliated Groups
An "affiliated group" of corporations is treated as one taxpayer for purposes of the earnings-stripping provisions regardless of whether the affiliated group files a consolidated tax return.27
For the purposes of the earnings-stripping provisions, the definition of affiliated group of corporations has been expanded to include unaffiliated but related U.S. corporations that are owned by a foreign entity where at least one member of the affiliated group satisfies the 80% indirect ownership test. Brother/sister corporations or chains of corporations that are subsidiaries of a common foreign parent would be treated as members of the same affiliated group under this expanded definition.28 Numerous additional rules for affiliated groups that are complex are beyond the scope of this article.
Example: USAco Inc. has a debt-to-equity ratio for the year of 2 to 1 (which exceeds the safe harbor of 1.5 to 1 discussed above), taxable income for the 2015 tax year of $140,000, and no excess limitation carryforward. USAco receives taxable interest income of $200,000 and pays interest of $560,000, of which $160,000 is disqualified interest paid to a related corporation that will not pay U.S. tax on its interest income. The amount of disqualified interest for USAco for its 2015 tax year and the excess limitation carried forward to the next tax year is calculated in the exhibit below.
The excess interest expense cannot go below zero. USAco's U.S. federal interest deduction for its 2015 tax year is decreased to $450,000 ($560,000 ‒ $110,000). The disallowed interest expense may be carried over by USAco to future tax years if allowed. A corporation uses Form 8926, Disqualified Corporate Interest Expense Disallowed Under Section 163(j) and Related Information, to calculate the amount of its otherwise deductible interest expense that is disallowed under the Sec. 163(j) earnings-stripping provisions.
Many foreign corporations continue to search for tax-efficient ways of repatriating their profits from their U.S. subsidiary corporations. If earnings of foreign-controlled domestic corporations are repatriated to their foreign parent corporations by deductible interest payments, rather than nondeductible dividends, U.S. taxes may be significantly reduced or completely eliminated by leveraging foreign-owned domestic corporations with intercompany debt. While this is a viable tax planning strategy, it can be scrutinized closely in the event of a tax examination, so careful planning, calculations, and monitoring of any proposed legislation should be undertaken before implementing the strategy, to ensure that it satisfies U.S. tax laws.
In addition, the foreign income tax consequences as well as the current and future effect on both U.S. domestic, foreign, as well as the worldwide income tax provision of a multinational corporation should be carefully analyzed.29
1Secs. 301, 316, and 317.
3Secs. 163(j)(2)(A)(i) and (ii).
9Secs. 163(j)(2)(B)(i)(I) and (II).
10Prop. Regs. Sec. 1.163(j)-2(d).
11Prop. Regs. Sec. 1.163(j)-2(e).
13Sec. 163(j)(6), Prop. Regs. Sec. 1.163(j)-2(f).
19H.R. Rep't No. 101-247 (P.L. 101-239), 101st Cong., 1st Sess., p. 1243 (1989).
25Secs. 501(a) and (b) of the Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222.
27Sec. 163(j)(6)(C). An affiliated group is defined as one or more chains of includible corporations connected through stock ownership with a common parent corporation that is an includible corporation, if the common parent directly owns stock meeting the requirements of the 80% vote and value test in at least one of the other includible corporations, and stock meeting the requirements of the 80% vote and value test in each of the includible corporations (other than the parent) is owned directly by one or more of the other includible corporations (Sec. 1504(a)).
28Prop. Regs. Sec. 1.163(j)-5(a)(2).
29See Secs. 7701(a)(3), (4), (5), and (30) for related definitions.
Philip Pasmanik is a senior tax manager with Hertz Herson LLP in New York City with over 25 years of domestic and international tax compliance and planning experience for both public and closely held businesses. He is vice chair of the AICPA International Tax Resource Panel, a member of the International Tax Committee of the New York State Society of CPAs, and a member of the New Jersey Society of CPAs. For more information about this column, contact firstname.lastname@example.org.