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Tax Avoidance

  1. Double Irish Dutch Sandwich
  2. Earnings Stripping
  3. Franked Investment Income
  4. Tax Avoidance
  5. Tax Efficiency
  6. Tax Shield
  7. Lien
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Earnings Stripping: Definition & Overview

Updated: November 25, 2022

Large corporations will always seek out ways to reduce their tax liabilities.

While most forms of tax avoidance are illegal and can result in heavy fines and even jail time, there are some ways to reduce tax liability legally.

One such way is through a process that is known as earnings stripping.

But what exactly is earnings stripping? Read on as we take a closer look at this legal form of tax avoidance.

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    KEY TAKEAWAYS

    • Earnings stripping is a tactic used by corporate entities to avoid high domestic taxation. 
    • It works by using interest deductions in a tax haven country in order to decrease their overall tax bill.
    • A corporation can lower its U.S. tax bill by moving its profits abroad using a process known as corporate inversion.

    What Is Earnings Stripping?

    Earnings stripping is a method that international firms frequently employ. This strategy aims to avoid paying hefty domestic taxes. This is accomplished by utilizing interest deductions in a tax environment that is favorable in order to reduce corporate taxes.

    In essence, corporate organizations employ profit stripping to try and reduce their U.S. tax obligations. This is accomplished by exporting their profits to nations with lower tax rates.

    In the course of a business inversion, the strategy of earnings stripping is frequently employed. Through this transaction, a global corporation’s corporate structure will be changed. so that the current foreign firm is replaced with a new one. Usually, this is accomplished by moving the parent corporation to a nation with a low-tax or tax-free tax structure.

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    Earnings Stripping Rules and Regulations

    Earnings stripping is a form of legal tax avoidance. It takes advantage of what’s known as a loophole in the tax code. This helps to reduce the amount of taxes that a company would owe to the United States government. 

    The earnings stripping rules apply to a corporate entity with a debt-to-equity ratio in excess of 1.5 – 1 as well as a net interest expense that is more than 50% of its adjusted taxable income for the year. Finally, it also has to have an interest expense that isn’t subject to a full U.S. income or withholding tax. This is when in the hands of the recipient. 

    Amendments to Earning Strippings Rules

    In 2016, the Obama administration created more regulations that surrounded earnings stripping. These regulations aimed to curb the number of acquisitions abroad that U.S. companies were making. Therefore, earnings stripping is not much beneficial.

    In 2018, the Trump administration lowered corporate taxes. So foreign acquisitions stayed low. 

    Impact of Earnings Stripping on Assets

    According to a study by the U.S. Treasury in 2007, earnings stripping may “either increase or decrease investment in a country with high-tax income”. This means that the overall investment by multinational companies is unlikely to affect assets or total unemployment in the U.S. 

    Although this is unless there is unemployment in markets for labor whose skill sets have a high foreign investor demand. 

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    How Can MNCs Pursue Earnings Stripping?

    By paying a lot of interest, multinational corporations (MNCs) can seek earnings stripping. To another corporation, that is Consequently, its tax liability was decreased. Taxable income must be transferred from a U.S.-based subsidiary to a foreign parent affiliate during this process. This would be done under the pretense of internal debt interest payments that are tax deductible.

    The parent firm that is not based in the United States but is under foreign ownership would issue a loan to its U.S. subsidiary as the process’ following step. Typically, this would be used for operations costs or a comparable item. This means that the U.S. subsidiary would charge the foreign-controlled inverted corporation an excessively high-interest rate on the loan, allowing the latter to write off the interest payments from its overall profits.

    The decrease in earnings has a cascading effect on the entity’s total tax obligation. This is due to the fact that interest deductions are tax-free. Given that the average corporate tax rate in the United States is currently 21%, this reduction may result in significant savings for the firm.

    Typically, the questioned subsidiary doesn’t actually borrow any money. The deal is simply signed on paper and is completely ceremonial. Consequently, the parent business does not actually enforce the debt’s collection. Instead, it merely transfers the company’s corporate earnings from the United States to a nation with a lower corporate tax rate.

    How to Prevent Earnings Stripping?

    The Revenue Reconciliation Act of 1989 placed a 50% restriction to try and curb the use of earnings strippings. This restriction was on related-party interest deductions a U.S. corporation that was foreign-owned could take while calculating its income tax. 

    Summary

    Earnings stripping is a way for corporate entities to avoid high domestic taxation and reduce their tax liabilities. Earnings stripping is technically legal through the tax code. Although the U.S. government has sought out ways to prevent it and stop the American taxpayers from suffering. 

    This is mainly through putting in place a variety of regulations. These regulations aim to try and curb the amount of tax income the government regularly loses out on.

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    FAQS on Earnings Stripping

    Is Earnings Stripping Legal?

    Even though earnings stripping is reducing the government’s tax revenues, earnings stripping is still a legal process. It is seen as a loophole in the current laws, rather than a practice that is actively encouraged by law. 

    Is Earnings Stripping Taxable?

    The process of earnings stripping means that the income is taxed in a separate, foreign country due to money being moved to a foreign entity. So while technically earnings stripping is taxable, it won’t be domestically based. 

    How Can Earnings Stripping Limit Tax Inversions?

    Earnings stripping can limit the number of companies undergoing a tax inversion because it’s a simpler method. This means that a company can lower its tax liability without having to undergo the process of a corporate tax inversion. 

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