Multinationals Dodged Bullet on ‘Earnings Stripping’ Rules

Pressed by corporations, Treasury exempted S-corps., banks, and insurers from anti-inversion rules.
David KatzNovember 4, 2016
Multinationals Dodged Bullet on ‘Earnings Stripping’ Rules

Many kinds of U.S. multinational companies, including  S-corporations, REITS, and financial services companies apparently dodged a bullet last month when the U.S. Treasury Dept. issued its final, substantially revised rules aimed at curtailing “earnings stripping.”

U.S. Treasury Secretary Jacob Lew

U.S. Treasury Secretary Jacob Lew

The revised regulation represents an attempt by Treasury to help “narrow the rule and avoid any unintended consequences” of previously proposed regulations, U.S. Treasury Secretary Jacob Lew said in a press release, noting that the department “heard from many U.S. companies that the proposed rules could unduly constrain ordinary business practices.”

Issued on Oct. 13, the final rules zeroed in on the practice of earnings stripping, particularly as a tax-avoidance method following a corporate inversion. In the fact sheet accompany the original Treasury proposal, the DoT defines an inversion as “a transaction in which a U.S.-parented multinational group changes its tax residence to reduce or avoid paying U.S. taxes. More specifically, a U.S.-parented group engages in an inversion when it acquires a smaller foreign company and then locates the tax residence of the merged group outside the United States, typically in a low-tax country.”

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Once they have done this, inverted, now-foreign-owned companies have sought further tax benefits via earnings stripping. In a typical earnings stripping maneuver, the U.S. company, which by means of the inversion has become a subsidiary of a foreign-based parent company, issues a note or bond to the foreign parent company. The U.S. parent company then pays interest to the foreign company.

In many such transactions, even though they make the interest payments, the U.S.-based subsidiaries receive none of the borrowed money from the parent companies. Up until the new rules, however, the U.S.-based-companies could deduct the interest payments from their taxable income. Proponents of a government crackdown on earnings stripping, like the Citizens for Tax Justice, call the practice “hopscotch loans.”

The new DoT regulations, however, curb “the ability of corporations to engage in earnings stripping by treating financial instruments that taxpayers purport to be debt as equity in certain circumstances,” according to the press release. In changing the characterization from a loan to a stock transaction, the interest payments are deemed dividend payments, and hence don’t gain the deduction for interest payments.

The final rules, like the proposed ones, don’t stop at inversions, however. “The ability to minimize income tax liabilities through the issuance of related-party financial instruments is not, however, limited to the cross-border context, so these rules also apply to related U.S. affiliates of a [U.S.-based] corporate group,” according to Treasury.

But by creating a number of significant exemptions to restrictions on U.S. based multinationals, the new rules probably eased what had been the considerable anxiety among a broad swath of them that the proposed rules had gone too far. “As proposed, it had a huge footprint and probably affected U.S. multinationals more than it did foreign MNCs, including ones created by inversions,” says Ronald Dabrowski a principal in the Washington national tax practice of KPMG. “It created a hue and cry, and treasury scaled it back a long way.”

Calling the final rule “a huge change in the scope” of the proposed one, Dabrowski adds that the October regulation “probably is going back to targeting better what it was intended to target all along, and that is for multinationals using debt to reduce the U.S. tax base. So these rules are all about how multinational groups use their free cash and their intercompany debt.”

What they aren’t about, Treasury made clear, is the issuance of debt by non-U.S. MNCs. “The foreign issuer exception—which exempts any debt issued by a foreign corporation from the regulations—is the headline improvement” of the new rules over the proposed ones, according to Dabrowski. “That change addresses the major concerns for most U.S. multinationals, including with respect to cash pooling, and also reduces the complexity for non-U.S. multinationals.”

The new rules exempt cash pools and short-term loans from the debt strictures in the proposed regulation. “Treasury is providing a broad exemption for cash pools, which are essentially common funding accounts for related businesses. Treasury is also providing an exemption for loans that are short-term in both form and substance,” according to the DoT release.

“Cash pooling is a major, entrenched cash-management tool for MNCs and generally involves, in the context of offshore subsidiaries getting together and entering into a pooling arrangement, an effective use of free cash-flow,” said Dabrowski.

Besides cash pooling, the final rules provide “limited exemptions for certain entities where the risk of earnings stripping is low,” including transactions among S corporations (also known as pass-through businesses).

“Financial institutions and insurance companies that are subject to regulatory oversight regarding their capital structure are also excluded from certain aspects of the rules,” Treasury also noted.