Earnings Stripping

What Is Earnings Stripping?

Earnings stripping is a common tactic used by multinational corporations to escape high domestic taxation by using interest deductions in a friendly tax regime area to lower their corporate taxes. In other words, earnings stripping is a technique used by corporations that try to minimize their U.S. tax bills by shifting profits abroad to countries with lower tax rates.

It is commonly used during corporate inversions: a transaction through which the corporate structure of a U.S.-based multinational corporation is altered so that a new foreign corporation, typically located in a low-tax or tax-free country, replaces the existing U.S. parent corporation as the parent of the corporate group.

Key Takeaways

  • Earnings stripping is a tactic used by corporations to avoid high domestic taxation by using interest deductions in a tax country with lower rates to decrease their overall tax bill.
  • A corporation lowers its U.S. tax bill by shifting profits abroad to lower tax-rate countries using a process known as corporate inversion.
  • The process works whereby a parent company makes a loan to its U.S. subsidiary abroad for operational expenses. The subsidiary pays an excessive amount of interest on the loan and deducts these interest payments from its overall earnings. The "reduction" in earnings, therefore, reduces the amount of taxes that are owed.
  • Earnings stripping is legal through the tax code. Still, the U.S. government has sought to prevent it by instituting a variety of regulations, such as incorporating debt-to-equity and net interest expense into adjustable income ratio thresholds.

Understanding Earnings Stripping

Earnings stripping is a form of tax avoidance, a legal act that involves taking advantage of a loophole in the tax code to reduce the amount of taxes owed to the government. Earnings stripping is simply a method by which a business entity reduces its tax liability by paying excessive amounts of interest to another corporation. This method involves transferring taxable income from a U.S. subsidiary to a foreign affiliate under the guise of tax-deductible interest payments on internal debt.

As part of earnings stripping, a foreign-controlled domestic corporation (or a U.S. corporation based in a foreign country) or parent company makes a loan to its U.S. subsidiary for operational expenses. Subsequently, the U.S. subsidiary pays an excessive amount of interest on the loan to the parent company and deducts these interest payments 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 U.S. corporate tax rate is 21%, the reduction can translate into a substantial amount of savings for the corporation.

In most cases, the subsidiary doesn't actually borrow any money. It is just a transaction completed on paper and the parent company does not enforce the collection of the debt. It just shifts the company's earnings from the U.S. to a foreign country.

Preventing Earnings Stripping

To curb the practice of earnings stripping, the Omnibus Budget 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 earnings stripping, but the measure requires congressional approval and bipartisan support.

In general, the earnings stripping rules apply to a corporation with a debt-to-equity ratio over 1.5 to 1; a net interest expense that exceeds 50% of its adjusted taxable income for the year, and an interest expense that is not subject to full U.S. income or withholding tax in the hands of the recipient.

The Obama administration put in more regulations surrounding earnings stripping in 2016, which curbed the number of acquisitions abroad that U.S. companies were making as earnings stripping was not as beneficial. When Trump lowered corporate taxes in 2018, foreign acquisitions continued to remain low. Given President Biden's proposed increase in corporate taxes, it remains to be seen how regulation around earnings stripping will proceed.

How Is the Cancelation of Debt Reported for a Partnership?

If a partnership has a cancellation of debt that is less than the amount owed because the debt was canceled, forgiven, or discharged, then that portion of canceled debt is taxable. It must be reported on the following year's tax return on Form 1040.

What Is Profit Stripping?

Profit stripping, also known as earnings stripping, is a method for a corporation to reduce its tax liability. A corporation does this by paying large amounts of interest payments to a foreign affiliate, which in effect is moving taxable income from the U.S. to a foreign entity under the idea of tax-deductible interest payments on internal debt when it is really just moving income from a high tax jurisdiction to a low one.

What Are the Benefits of Tax Reform?

The primary benefit of tax reform is to help reduce the tax burden of individuals while still providing enough revenue to the government. Tax reform helps make taxation fairer, easing the amount of taxes owed by those who earn less and preventing tax avoidance by those who should be paying tax or more tax.

Article Sources
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  1. Internal Revenue Service. "Topic No. 505 Interest Expense."

  2. Internal Revenue Service. "After Tax Reform, Many Corporations Will Pay Blended Tax Rate."

  3. Internal Revenue Service. "Basic Questions and Answers About the Limitation on the Deduction for Business Interest Expense."

  4. Internal Revenue Service. "Rules Regarding Inversions and Related Transactions."

  5. Internal Revenue Service. "Topic No. 431 Canceled Debt - Is It Taxable or Not?"

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