US Tax Legislation Update - "Earnings Stripping"
Willys H. Schneider, Partner, Kaye Scholer LLP
Proposed tax legislation that would have expanded significantly the scope of the so-called “earnings stripping” rules has been dropped from a key tax bill pending in the US Congress, making passage of such a measure unlikely this year. The proposal had triggered considerable attention, and consternation, on the part of non-US investors in US assets, including US real estate.
The “earnings stripping” rules limit the ability of US corporate subsidiaries to claim tax deductions for interest on debt owed to, or guaranteed by, certain non-US affiliates (and other tax-exempt persons), i.e., limiting the ability to “strip” income from the United States. Enactment of the original proposal would have further cut back on the ability to claim such deductions and significantly increased the complexity of computations necessary to ensure compliance with the rules.
In general, under current law, the current earnings stripping rules limit interest deductions if
(i) the payor’s debt-to-equity ratio for the taxable year exceeds 1.5 to 1 and
(ii) its “net interest expense” (the excess of interest paid or accrued over interest includible in gross income) exceeds the sum of (A) 50% of “adjusted taxable income” (generally, taxable income computed without regard to deductions for net interest expense, net operating losses, and depreciation, amortization and depletion) plus (B) a prescribed “excess limitation” carry-forward.
If these two conditions are met in a given year, then the lesser of excess net interest or “disqualified interest” is disallowed as a deduction for such year. “Disqualified interest” is defined as interest paid to a related person not taxed on such interest (e.g., a non-US person) or interest paid to an unrelated person if, in general, a related non-US taxable person has guaranteed the debt, and no withholding tax is imposed on the interest. Any amounts disallowed as a deduction may be carried forward to subsequent years, with no limit on this carry-forward period.
Proposed legislation significantly expanding the earnings stripping rules had been included in a House of Representatives bill (the “House Bill”) containing measures repealing US export tax breaks that have been ruled illegal by the World Trade Organization and substituting therefor other corporate tax relief. The proposed legislation would have (i) eliminated the above-described rule permitting imposition of the earnings stripping limitations only if the payor of interest’s debt-to-equity ratio is in excess of 1.5 to 1, (ii) lowered the threshold for disallowance of deductions for “disqualified interest” on debt owed to affiliates (although not on affiliate-guaranteed debt) and (iii) reduced the unlimited carry-forward period for disallowed interest. An even more controversial, worldwide, limitation on interest, based on the overall debt-to-equity ratio of a global affiliated group of corporations, was eliminated from a prior bill earlier this year.
The elimination from the House Bill of the above-described proposed expansion of the earnings stripping rules makes it unlikely that any such measure will be passed this year. A companion Senate bill, also containing export tax provisions, would apply the earnings stripping rules to partnerships and “S” corporations, but would not otherwise expand the scope of the rules. The two bills will be considered in tandem when Congress reconvenes after its summer recess. Passage of legislation based on these bills is a priority, given the retaliatory trade sanctions that have been imposed on the United States in response to the export tax breaks that the legislation would repeal.
Willys Schneider is a partner in the tax department at Kaye Scholer LLP. She is a member of the Board of the International Tax Institute and has chaired two subcommittees of the American Bar Association Tax Section dealing with foreign investment in US real property. Ms. Schneider graduated cum laude from Princeton University and received her JD from Columbia Law School, where she was an editor on the Columbia Law Review.
