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 count🌞ries 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 💫𒆙corporate group.

Understanding Earnings Stripping

Earnings stripping is a form of 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:tax liabilityꦜ 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 澳洲幸运5官方开奖结果体彩网:tax-deductible interest payments on internal debt.

As part of earnings stripping, a foreign-controlled domestic corpor♌ation (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 澳洲幸运5官方开奖结果体彩网: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 澳洲幸运5官方开奖结果体彩网:debt-to-equity ratio over 1.5 to 1; a net 澳洲幸运5官方开奖结果体彩网: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.

The Bottom Line

Taxation has long been a touchy ♔and important topic in the United States, with corporations ab🌞le to take advantage of many legal loopholes in tax law to lower the taxes they pay.

Earnings stripping, whereby a company shifts profits to foreign countries with lower tax rates, has been one of them. Governments have sought ways to ꦉclose these loopholeཧs so that corporations pay their fair share of taxes, yet serious changes to tax law to prevent this have not yet happened.