Earnings Stripping: Definition & Overview
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.
Table of Contents
- 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.
The strategy of earnings stripping is often used in the course of a business inversion. 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. The U.S. firm then pays deductible interest to the new parent company or one of its affiliates in a low tax country. This technique can generate large interest deductions without requiring a company to fund new investments in the U.S.
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 IRC section 163(j) provides a limitation on the amount of business interest expense that a company may deduct in a tax year. The interest deduction cannot exceed the sum of the company’s interest income for the year, 30% of its adjusted taxable income (ATI), and its floor plan financing interest expense for the year. For the tax years 2019 and 2020, the CARES Act temporarily increased the ATI percentage to 50%. Any amount of disallowed interest may be carried forward to next year. The limitation also applies to foreign corporations.
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.
The new rules restrict the ability of corporations to engage in earnings stripping by treating financial instruments that taxpayers claim to be debt as equity in certain circumstances. They also require that corporations claiming interest deductions on related-party loans provide documentation for the loans, similar to the common practice for third-party loans.
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.
This is assuming no unemployment in markets for labor whose skill sets have a high foreign investor demand.
How Can MNCs Pursue Earnings Stripping?
Multinational corporations (MNCs) can seek earnings stripping by making deductible interest payments to the parent company or subsidiary located in a tax haven under the pretense of inter-related company loans.
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. Typically, the loan would be used for operational costs. The parent company then would charge the U.S. subsidiary 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 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 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.
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.
This is mainly accomplished through putting in place a variety of regulations. These regulations aim to try and curb the amount of tax income the government regularly loses due to earnings stripping practices.
FAQS on Earnings Stripping
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.
The process of earnings stripping means that income is taxed in a separate, foreign country due to profits being moved to a foreign entity. So while technically earnings stripping is taxable, it won’t be domestically based.
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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