Treasury and IRS Finalize Earnings Stripping Tax RegulationsJanuary 20, 2017
Attention multinational corporations: The US Treasury Department finalized regulations during 2016 aimed at efforts to shift profits away from the US.
During 2016, The IRS and Treasury Department released final regulations aimed at preventing multinational corporations from shifting their profits offshore to lower-tax countries. Earnings stripping, as it is known, often accompanies a corporate inversion, allowing companies to reduce US corporate income taxes.
What is ‘earnings stripping’?
The IRS and Treasury Department are attempting to curb a practice tax officials refer to as “earnings stripping” by which companies shift their profits away from the US toward low-tax jurisdictions. It is often found with companies that avail themselves of corporate inversions.
What is a corporate inversion?
A corporate inversion is a transaction in which a US-parented multinational group changes its tax residence to reduce or avoid paying US taxes. This tactic can be accomplished when the US-parented group acquires a smaller foreign company and then locates the tax residence of the merged group outside of the US, typically in a low-tax country.
Why do people engage in earnings stripping?
The technique is very commonly used by corporations because it can generate large interest deductions without requiring a company to finance new investment in the U.S. After a corporate inversion is accomplished, US subsidiaries continuing to do business in the US will often pay deductible interest to their new foreign parent or one of its foreign affiliates in a low-tax country, thus stripping earnings out of the US that IRS would otherwise seek to tax.
The new rules
The IRS and Treasury Departments are hoping to limit this “earnings stripping” tactic by:
- Curbing the ability of companies to use intra-company loans (that don’t result in net new investments in the U.S.) to lower their taxes.
- Treating financial instruments that taxpayers allege to be debt, as equity in certain circumstances.
The new rules are not limited to the cross-border context, they also apply to related U.S. affiliates of a corporate group.
- Limiting earnings stripping is estimated to save as much as $600 to $700 million per year in US tax revenue.
- The new measures are hoped to more significantly protect against the continued erosion of the US corporate tax base.
Will there be any effects on regular business activities with the changes?
The IRS aimed to minimize any unintended consequences on regular business activities, in these ways:
- Exempting cash pools and short-term loans. The Treasury is providing a broad exemption for cash pools and other short-term loans (“short-term” in both form and substance) because they do not pose a significant earnings stripping risk.
- Providing limited exemptions for certain entities where the risk of earnings stripping is low. Transactions between foreign subsidiaries of U.S. multinationals, S-corporations, regulated financial companies, regulated insurance companies, and mutual funds and real estate investment trusts (other than those owned by an affiliate group of companies) are all at low risk of earnings stripping, meaning they will remain unchanged under the new regs.
- Expanding exceptions for ordinary business transactions. Exceptions for distributions, or payments made to affiliated companies, have been expanded to include future earnings. Also, corporations are now allowed to net distributions against capital contributions.
- Expanding exceptions for ordinary course transactions. Acquisitions of stock associated with employee compensation plans will remain unchanged under the new regs.
- Easing documentation requirements. The treasury has moved around a few due dates, moving the required documentation deadline for intercompany loans to when the tax return is due. The effective date of the documentation rules has been extended as well—now January 1st, 2018.
These rules are complicated—be sure to consult your tax advisors for more information. Need assistance? We can help. Contact our Global Tax Services Team today.