Stripping is associated in most people’s minds with one of two things, either dancing while steadily removing garments accompanied by music by David Rose, or taking layers of paint and varnish off some surface. In the financial world it means roughly the same thing, only better – for the bottom line. And since we’re not talking our our bottoms, but those of U.S. corporations with overseas affiliates, or those which want to shape themselves that way, let’s try to understand the language they are speaking.
The financial definition of Earnings Stripping is:
“A method of avoiding taxes by paying excessive amounts of interest to another party. For example, an American subsidiary of a foreign company might reduce its taxable income by paying an excessive amount of interest to its parent. The IRS has developed regulations that are intended to limit earnings stripping.”
Yes. the Internal Revenue Service is trying to do something about this highly dubious practice, in Section 163(j) of the law. Implementing Section 163(j) means the IRS would require adherence to the “arms length” standard in intercompany indebtedness. In one example, if 60% of an affiliated firm’s assets are financed by debt, then the deduction for interest is limited to 50% of the firm’s operating profits. [TaxTR]
In order to carry out the law, the IRS has to be able to do two things. First, it has to evaluate whether or not there’s an arms length interest rate. The key to arms length transactions is that neither side has any incentive to act against his or her own interest. If I’m the banker I’m going to try to charge the highest interest rate for a loan I can, and if you are the borrower you are going to smile nicely, threaten to go to another bank, and work to get me to reduce the interest rate for the loan. But, how to evaluate the arms length status of a loan made from the parent company to an affiliate?
Secondly, there has to be a way to determine if the operating profits truly reflect the “income attributable to the functions, assets, and risks incurred by the affiliate.” [TaxTR] The affiliates credit rating helps determine if the interest rate is at least close to “arms length,” and the operating profits have to be such that the IRS can see that the intercompany interest rate at least has the appearance of propriety.*
And now the fun begins. The current flap over corporate inversions plays is related to good old fashioned earnings stripping, the Wall Street Journal explains:
“When a U.S. company acquires a foreign firm, and decides to domicile overseas in a low-tax country like Ireland, it will often load the U.S. subsidiary up with debt that is “owed” to the foreign headquarters. Interest payments on this debt can often be deducted from taxable income. If the debt is considered “excessive,” the practice is known as “earnings stripping.”
The Bush Administration took a look at these dubious practices back in 2007. The report (pdf) analyzed several proposals offered at the time to restrict the ability of foreign controlled domestic corporations to practice earnings stripping. The report concluded that corporate inversions were associated with earnings stripping, and that the government needed to (1) look carefully at the arms length part of the problem, (2) update the regulations from those issued in 1968, and (3) new rules should be made to help determine the amount of income from a multi-national company is subject to U.S. taxation.
By August, 2014 not much movement had been made on restricting the global corporations from engaging in earnings stripping. In what has become a familiar refrain, the WSJ explains:
“The Obama White House has already proposed that Congress pass a law that would effectively end such earnings stripping arrangements, but Congress hasn’t acted. The Treasury Department could instead decide to act unilaterally to prohibit the practice, effectively by amending 163(j) in the tax code.” (emphasis added)
The White House proposal is summarized by the analysts at CTJ:
“President Obama included two proposals in his most recent budget plan that would address the problem. The first would treat the entity resulting from a U.S.-foreign merger as an American corporation for tax purposes if it is majority-owned by shareholders of the original American corporation. The proposal would also treat the resulting entity as an American corporation if it has substantial business in the United States and is managed and controlled in this country.
The president’s second proposal would address earnings-stripping by barring American companies from taking deductions for interest payments that are disproportionate to their revenue compared to their affiliated companies in other countries.”
The issue was beginning to get some traction by August 14, 2014 when Senator Charles Schumer (D-NY), a member of the Senate Finance Committee, proposed a four part bill to end the earnings stripping game. Republicans were unwilling to move, saying it might make U.S. companies more attractive for foreign takeovers. [WSJ]
Opponents of restricting the stripping also cite the “high” U.S. corporate tax rate of 35%, however, large corporations – as in Fortune 500 – on average paid only 19.4% of their profits in federal income taxes from 2008 to 2012, and 26 companies in the Fortune 500 paid nothing at all during the five year period. In other words, no matter how low the U.S. corporate income tax is set there will always be some entity lower, say at an inviting 0% – or Tax Havens. It doesn’t seem at all practical to allow U.S. corporations to pretend their profits are earned in Cyprus, Luxembourg, Bermuda, the Cayman Islands, Switzerland, or Singapore, [TW] when it’s perfectly clear for all to see their major business operations are in the United States.
Another argument for doing nothing, or even doing something worse, is that taxing overseas profits gives corporations an incentive to become foreign. Fact checks are necessary at this point. U.S. taxes on foreign profits are minimal and American companies get “a tax credit equal to any taxes they pay to foreign governments, and are allowed to defer U.S. taxes until they officially bring their offshore profits to the U.S.” [CTJ]
If anything is done at all by the Do Less Than Nothing 113th Congress we might count it as miraculous. One peek at the official calendar for the House of Representatives demonstrates the point. The House Majority Leader’s calendar illustrates the point that there are only five days on which votes are scheduled for the entire month of September. (pdf) No voting will take place in the House during the month of October, except for October 2nd, thereafter all days are labeled “district work week” – the district work being getting re-elected. The Senate calendar isn’t much more full.
While Congress fiddles, or the band continues to play “The Stripper,” the list of U.S. corporations which have availed themselves of tax havens and possibly earnings stripping continues to grow. And the band plays on. The longer the music continues the more average American income earners will be expected to shoulder the burden of generating revenue, and the less will be expected from corporations – those other kinds of “people,” my friend.
*For a more technical look at some of the controversy around Section 163(j) see Morrison, “Section 163(j) and Disregarded Entities,” Bloomberg BNA. April 6, 2011.