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.
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.
