Treasury tackles earnings stripping

Yesterday, Treasury finally announced its promised earnings stripping rules-- and they go well beyond just trying to curb tax-motivated corporate inversions, which is a positive development for tax policy.  

Earnings stripping often occurs after U.S. corporations merge into smaller foreign corporations (an inversion), foreign corporations take over smaller U.S. corporations, or through a combination of equals.

Any of these arrangements shifts ownership of the U.S. firm to a foreign parent corporation. The U.S. firm still pays U.S. taxes, but can reduce its U.S. tax liability by appearing to borrow from its foreign parent. (The U.S. firm does not actually borrow any money—it just distributes a note to its parent and then makes interest payments.)  The interest is deductible against the firm’s U.S. earnings and taxable to the foreign corporation. That action—called “earnings stripping”—effectively shifts taxable earnings from the U.S. to the parent’s country with a lower tax rate.

If the U.S. firm were the parent corporation, it could not benefit from a similar type of transaction with a low-tax foreign affiliate.  Under subpart F of the Internal Revenue Code, interest receipt or other forms of passive income that U.S. corporations receive from controlled foreign corporations are taxable as earned.  So while the U.S.  parent could still deduct the interest it would report as income the offsetting interest it received from its affiliate.

Treasury’s new rules will treat a note distributed to the foreign parent as stock, not debt. Thus the new rules treat payments as dividends, which are not deductible, instead of interest, which is.  A U.S. firm that is acquired by a foreign parent will no longer be able to use this accounting trick to shift income to a lower taxed jurisdiction.  

The breadth of Treasury’s earnings stripping rule is helpful.  Congress and the Treasury have already adopted many rules to make inversion transactions unattractive.  As a result, cross-border mergers recently have been combinations of roughly equal size or foreign takeovers of smaller U.S. companies, which are not subject to the anti-inversion rules.   

But the new earnings stripping rule applies to all cross-border combinations, which will level the playing field.  Smaller US companies will be less tempting targets of larger foreign companies, if the combination is not subsidized by the prospect of earnings stripping.   The rules also apply to foreign companies that establish a new US subsidiary and, at the start, or later, distribute out a note.

Congress could extend the broader approach to create new exit taxes as well.  If a U.S. company voluntarily departs, or is acquired by a foreign company in a hostile takeover, the U.S.  should charge the domestic company the tax due on its deferred earnings, just as it collects the deferred tax on IRAs of people who relinquish their U.S. citizenship.   Collecting the toll on voluntary departures and hostile acquisitions would make U.S. companies less attractive takeover targets.  And the threat of an exit charge could deter U.S. companies from accumulating earnings off-shore, with a hope of avoiding tax on their earnings permanently.