Country / Language

Corporate Taxpayer Debt-Equity Cases May Challenge International Practices


2/26/14

Synopsis

The IRS is bringing an increased number of cross-border debt-equity cases to court to challenge foreign- owned corporations’ earnings stripping practices.

Issue

U.S. corporations and foreign corporations doing business in the U.S. owned by foreign groups and funded by their foreign shareholders or affiliates (related parties) with loans and advances or unrelated party debt guaranteed by a related party run a significant U.S. tax risk if several U.S. tax rules are not respected. The possible consequences being that the related interest expense deduction will be disallowed and the payments possibly treated as dividends potentially subject to a higher U.S. withholding tax.

The payment and deduction of such interest expense is generally referred to as “earnings stripping” because the U.S. taxable income that would otherwise exist is stripped out of the U.S. tax base in a tax deductible manner. If the related party recipient is not subject to U.S. withholding tax on the outbound interest payments and is also in a tax jurisdiction with a tax rate lower than the U.S. rate, there can be a significant overall income tax reduction to the foreign multinational group at the expense of the U.S. Treasury. 

In these instances, the IRS has three principal sets of rules to curb earnings stripping:

  • The anti- earnings stripping rules in the tax code (so-called Section 163(j)) – a somewhat mechanical set of rules deferring the interest expense deduction and leaving relatively little discretion to the taxpayer in its application,
  • The fairly short debt vs. equity principles in the Code.  No regulations exist for this law and due to the very subjective nature of whether something is debt vs. equity the application is often based on case law,
  • The transfer pricing section in the Code and the broad authority it grants the IRS to adjust taxable income when the taxpayer cannot demonstrate that the interest expense is at arm’s length.
     

The IRS can and does use any and all of the above to curb “earnings stripping” where it finds facts patterns it believes to be abusive.  In other countries, these and similar rules are often referred to as “thin capitalization” rules.

What Does CohnReznick Think?
Taxpayers often think that mere compliance with the so-called Section 163(j) earnings stripping rules means that their U.S. corporation or foreign corporation doing business here is not at risk of IRS attack.  This is often not the case particularly where the taxpayer has failed to treat the related party debt as if it were owed to an unrelated party in terms of its level, interest rate, frequency of payments of principal and interest and other terms.  Planning to optimize the global tax position while controlling the tax risks requires careful consideration of the rules above, including the case law.

Contact

For more information, please contact Brian Gibney, Director, at 301-280-3075.

To learn more about CohnReznick’s Corporate Tax Practice, please visit our webpage.


Circular 230 Notice: In compliance with U.S. Treasury Regulations, the information included herein (or in any attachment) is not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of i) avoiding penalties the IRS and others may impose on the taxpayer or ii) promoting, marketing, or recommending to another party any tax related matters.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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