DEFINITION of '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..

BREAKING DOWN 'Earnings Stripping'

Earnings stripping is a form of tax avoidance, a legal act that involves taking advantage of a loophole in the tax code so as 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 which is 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 35%, the reduction can translate into a substantial amount of savings for the corporation.

To curb the practice of earnings stripping, 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. In general, the earnings stripping rules apply to a corporation with a debt-to-equity ratio in excess of 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.

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 by the U.S. Treasury, earnings 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.

  1. Strip

    The strip is the process of removing coupons from a bond and ...
  2. Servicing Strip

    A servicing strip is a type of security created by the stream ...
  3. Treasury STRIPS

    Treasury STRIPS are an acronym for 'separate trading of registered ...
  4. Futures Strip

    A futures strip is the sale or purchase of futures contracts ...
  5. Stripped MBS

    A stripped MBS is a type of mortgage-backed security that is ...
  6. Stripped Yield

    Stripped yield is a measure of the non-collateralized, independent ...
Related Articles
  1. Investing

    Introduction To STRIPS

    STRIPS provide an alternative form of bond for fixed-income investors who need definite cash flows at specific times. Read the article to find out how.
  2. Taxes

    The Impact Of U.S. Corporate Taxation On Investment Decisions And CFC Transfer Pricing

    To avoid taxation, businesses do careful tax planning, taking into consideration more than one country's taxation system.
  3. Taxes

    Do U.S. High Corporate Tax Rates Hurt Americans?

    The United States has the highest corporate tax rate of the 34 developed, free-market nations that make up the Organization for Economic Cooperation and Development (OECD).
  4. Taxes

    Is Multinational Tax Avoidance at an End?

    Are governments doing enough to end corporate tax avoidance?
  5. Taxes

    Understanding taxation of foreign investments

    Find information on taxation of foreign investments. Learn how the foreign tax credit enables you to deduct most of the tax you've paid abroad.
  6. Taxes

    Highest Corporate Taxes By Sector

    The amount a U.S. company pays in tax depends upon the sector it is in.
  7. Taxes

    Trump Signs Tax Reform Bill

    The president signed the GOP's overhaul of the federal tax code into law.
  8. Taxes

    How Big Corporations Avoid Big Tax Bills

    How do companies manage to pay such low taxes? Just look at Google's 2.4% tax rate.
  9. Taxes

    Corporate Tax Inversion

    U.S. companies like Burger King use corporate tax inversion to take advantage of lower taxes abroad.
  10. Taxes

    5 Key Tax Law Changes Impacting Businesses

    The Tax Cuts and Jobs Act impacts businesses in a number of ways.
  1. What is the difference between a write-off and a deduction?

    Understand the differences between a tax write-off and a tax deduction. Learn how each one works to reduce income taxes and ... Read Answer >>
  2. Are personal loans tax deductible?

    Find out whether interest on personal loans is tax deductible and what types of loan interest can be used to reduce your ... Read Answer >>
  3. What is the purpose of a repatriated tax break, and why is it so controversial?

    The repatriated tax break gives U.S. multinational corporations a one-time tax break on money earned in foreign countries. ... Read Answer >>
  4. Can a corporation deduct dividend payments before its taxes are calculated?

    Corporations may not legally deduct the dividend payments before taxes, but there is another approach: a corporate structure ... Read Answer >>
Hot Definitions
  1. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  2. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  3. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  4. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  5. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  6. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
Trading Center