Accounting / Tax Updates

Earning Stripping Rules (IRC 163j) - 불공정 조약?

5/21/2014

Background:

A U.S. subsidiary of a foreign multi-national corporation is often capitalized with a combination of debt and equity. If unlimited deductions were allowed for interest paid to a foreign related party, a foreign-based parent corporation would be able to “strip out” any desired amount of earnings of its U.S. subsidiary, simply by controlling the level of debt of the U.S. subsidiary. The U.S. earnings “stripped out” in the form of interest payments on the debt would result in the erosion of the U.S. tax base because the U.S. subsidiary would receive a U.S. tax deduction that reduces its U.S. taxable income and the interest paid to the foreign-based parent corporation may not be subject to U.S. withholding tax (or subject to a reduced rate) under various income tax treaties.

Disqualified Interest Expense

The current earnings stripping rule limits the deductibility of “disqualified interest expense”. Interest expense paid with respect to a debt owed to or guaranteed by related parties is treated as “disqualified interest expense” if such interest is not subject to U.S. withholding tax (or subject to a reduced rate).

Safe Harbour: Debt-to-Equity Ratio

The current earnings stripping rule is designed to defer a U.S. corporation’s deductions for all or a portion of disqualified interest expense when such corporation is thinly capitalized. A corporation is considered thinly capitalized when its debt-to-equity ratio exceeds 1.5 to 1. Therefore, the current earnings stripping rules do not apply to corporations with a low debt-to-equity ratio.

Safe Harbour: Cash Flow Safe (50% of Adjusted Taxable Income Test)

Even if a debt-to-equity ratio exceeds 1.5 to 1, a U.S. corporation is allowed current deductions as long as its cash flow is considered sufficient to service the existing debt level. Under the current rules, a U.S. corporation is allowed to deduct all of its interest expense as long as the net interest expense (interest expense minus interest income) does not exceed 50% of its adjusted taxable income. Adjusted taxable income is determined by adjusting a corporation’s taxable income for certain non-cash items (e.g., depreciation) and it roughly equals that corporation’s pre-interest cash flow.

Deferral of Disqualified Interest

If the debt-to-equity ratio exceeds 1.5 to 1, AND the net interest expense exceeds 50% of the adjusted taxable income, all or a portion of the disqualified interest expense is disallowed. Disqualified interest expense is disallowed only to the extent the net interest expense exceeds the 50% of adjusted taxable income threshold. This excess is referred to as “excess interest expense”. Disqualified interest expense disallowed under the current earnings stripping rules is carried forward indefinitely and may be deducted in later years when sufficient cash flow exists (i.e., when 50% of the adjusted taxable income exceeds the net interest expense for the year). This excess of the 50% of the adjusted taxable income over the net interest expense is referred to as “excess limitation”, and may be carried forward for three years and added to the 50% of the adjusted taxable income to increase the threshold.

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Guaranty Fee paid to Foreign Parent by US Subsidiary for Loan from US Bank

5/21/2014

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In Container Corp., 134 TC No 5 , Tax Ct Rep (CCH) 58131, 2010 WL 571831 (2010), a case of first impression, the Tax Court, per the opinion of Justice Holmes, held that payments received by Vitro, S.A., a Mexican corporation, from its US subsidiary for the guarantee of the subsidiary’s debt obligations was not income from sources within the U.S. under Section 861 , and, therefore, was not subject to withholding under Section 1442.

Vitro was a Mexican corporation engaged in the manufacture and sale of glass containers through its subsidiaries. In the 1980s Vitro decided to expand to the U.S. and identified two acquisition targets, Anchor Glass Container Corp. and Latchford Glass Co. Vitro ultimately was successful in acquiring the targets through Container Holdings Corp., organized to be the U.S. acquisition company, and a shell corporation, THR Corp., organized by Container to acquire Anchor’s and Latchford’s stock.

Although the acquisition of Anchor was completed in November 1989, the financing of the transactions ran into problems due to a declining junk bond market as well as the collapse of Drexel Burnham Lambert in February 1990. The financing complications ultimately caused the acquisition debt to be moved to Vitro International Corp. (International), another Vitro holding company outside the Container chain of U.S. subsidiaries. Vitro guaranteed $151 million of senior notes issued by International (the International 1990 bridge note) that International then loaned to THR Corp., which used them to repay a portion of its acquisition bridge financing. Further, to make the first payment on the International 1990 bridge note, International borrowed $31 million from Banca Serfin and Vitro guaranteed International’s obligations on the Banca Serfin loan. These International loans had to be refinanced in 1991, and again Vitro was required to guarantee International’s 1991 senior notes. The guarantee agreement between Vitro (Mexico) and International (U.S.) set the guarantee fee at 1.5% of the outstanding principal balance of the notes per year and required that International make guarantee fee payments to Vitro annually ranging from approximately $2M to $2.5M.

The IRS determined a deficiency against Container on the basis that International should have withheld 30% of the guarantee fees it paid to Vitro in 1992 through 1994. This was based on the IRS’s determination that the guarantee fees were fixed or determinable annual or periodical income (FDAP) from sources within the U.S. under section 881(a) , which was subject to 30% withholding under section 1442 .

The issue before the court was whether the guarantee fees should be sourced as interest income or income from services, or otherwise analogized to interest income or income from services.

Under sections 861(a)(1) and 862(a)(1) and Treas. Reg. 1.861-2 , interest generally is sourced by reference to the residence of the payor. In contrast, income from the rendering of personal services generally is sourced based on the location where the services are performed.

The Tax Court viewed the guaranty as not being "interest" since there was no lending transaction between the Mexican parent and U.S. subsidiary. The Tax Court further determined that a financial guarantee was not a service within the meaning of section 861(a)(3) since it was not directly related to the amount of services rendered. Finding that there were only a few cases to look to by analogy, the Court gave careful review and draw a comparison with a Court of Claims decision Bank of America, 230 Ct Cl 679 (Ct. Cl., 1982), where the court addressed whether commissions earned by Bank of America in connection with transactions involving commercial letters of credit should be sourced by analogy to personal services or interest. The IRS argued that two types of LOC commission fees involved in Bank of America supported its position that Vitro’s guarantee fee should be analogized to interest income. In Bank of America, the parent corporation earned a commission for acceptance of a LOC and a separate commission for confirmation of the credit line. With respect to these commissions, the Court of Claims determined that the Bank of America essentially had received commission for agreeing to become the primary obligor to the U.S. seller. The Court of Claims therefore analogized BofA’s commissions to interest income. The Tax Court, however, distinguished the LOC transactions in Bank of America and a guarantee, with the critical difference being that in the case at Vitro’s obligation was secondary, it was not required to pay out its own money until there was a default by International, and at that time Vitro would step into the shoes of International’s lenders and acquire any rights they had against International. Therefore, Vitro’s guarantee lacked a principal characteristic of a loan because Vitro did not extend funds to International.

International, the U.S. subsidiary, did not withhold US income taxes on the guarantee fees paid to Vitro, and as International did not have cash flow to make the interest payments on the International 1991 senior notes, Vitro and Container contributed almost $80M in capital to International from 1990 through 1994. Around this time the glass container business started to decline significantly, and in 1997 Anchor filed for bankruptcy.

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