Earnings Stripping

DEFINITION of 'Earnings Stripping'

Earnings Stripping is a commonly-used tactic used by multinational corporations to escape high domestic taxation by using interest deductions to their foreign headquarters in a friendly tax regime to lower their corporate taxes. It is commonly used during corporate inversions.

BREAKING DOWN 'Earnings Stripping'

As part of earnings stripping, a foreign-controlled domestic corporation (or, a U.S. corporation which is based in a foreign country) makes a loan to its U.S. subsidiary for operational expenses. Subsequently, the U.S. subsidiary deducts interest payments related to this loan from its overall earnings. The reduction in earnings has a domino effect on its overall tax liability because interest deductions are not taxed. Considering that the average corporate U.S. tax rate is 35%, the reduction can translate into a substantial amount of savings for the corporation.

The Revenue Reconciliation Act of 1989 placed a 50% restriction on related-party interest deductions a foreign-owned U.S. corporation could take while calculating its income tax. Theoretically, a lower number for that restriction will go a long way in restricting earning stripping, but the measure requires congressional approval and bipartisan support. 

Although it is a pernicious corporate practice that reduces the government's tax revenues, earnings stripping has not had a documented effect on U.S. unemployment. According to a 2007 study of by the U.S, Treasury, earning stripping may "either increase or decrease investment in a high-tax country." "The level of investment by multinationals is unlikely to affect total unemployment in the United States, unless there is unemployment in the markets for labor whose skill foreign investors demand," authors of the study wrote.