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‘Earnings Stripping’ Fix Could Blunt Foreign Investment

by | Aug 28, 2014 | Firm News, Posted in In the News. |

By Ama Sarfo

Law360, New York (August 22, 2014, 5:19 PM ET) — New York Sen. Charles Schumer recently escalated the corporate inversion debate by pitching a proposal to blunt “earnings stripping” — where U.S. subsidiaries deduct interest payments on debt owed to their foreign parent — and experts worry the scheme could hurt non-inverting companies if it isn’t narrowly crafted.

Schumer, a Democrat, says his legislation will complement anti-inversion activity championed by Senate Finance Chair Ron Wyden, D-Ore., and Sen. Carl Levin, D-Mich., and as such will exclusively apply to inverted companies. But the law surrounding earnings stripping is already restrictive, experts say, and they fear further belt-tightening may unintentionally ensnare non-inverting companies and reduce America’s appeal as a country for investment.

“There needs to be an analysis on whether tightening the earnings stripping rules will have other detrimental effects aside from making inversions unattractive,” said Will McBride, chief economist at the Tax Foundation. “It could cause businesses considering inversions to consider other tactics like selling off their subsidiaries or moving to the individual tax code.”

Generally, earnings stripping occurs when a company pays sizable interest payments on its debts to a related company in order to reduce its taxable income. In the inversion context, this means foreign-owned U.S. companies often give their U.S. subsidiary a substantial amount of debt so the subsidiary can deduct its interest payments on the debt and shrink its U.S. tax obligations.

The Internal Revenue Code already polices earnings stripping and limits interest deductions if a subsidiary’s debt-to-equity ratio exceeds 1.5-1 and its net interest expense is more than 50 percent of its adjusted taxable income.

Schumer wants to repeal the debt-to-equity safe harbor so that the limitation will apply to all inverters. He also wants to reduce the net interest expense threshold from 50 percent to 25 percent and eliminate a carryforward that allows companies to use the deduction in subsequent years.

The plan is intended to enhance legislation introduced by Levin, who wants enact a two-year moratorium on inversion deals, and Schumer says he will work with Levin and Wyden to create a comprehensive package of anti-inversion legislation.

“Assuming that is the case, I think the proposal makes sense because it reduces the incentive to invert,” said Philip Cohen, who teaches in the legal studies and taxation department of Pace University’s Lubin School of Business. “These proposed changes to [the Internal Revenue Code] should however, I believe, be targeted to inverted companies.”

But Nancy McLernon, president of the Organization for International Investment, warns that any tweaks to the Internal Revenue Code’s earnings stripping provisions will likely inflict collateral damage upon foreign-based companies that are operating in the U.S. because that part of the code already discriminates against foreign-based entities, she says.

Although Schumer has stated that his legislation will only apply to inverted companies, McLernon’s organization — which is a business association that represents the U.S. operations of foreign-based multinationals — fears it will be difficult to achieve that task.

“The difficulty is in carving those clean lines in terms of the companies you want to hit and the companies you will hit,” McLernon said. “We think it’s really difficult to write rules that don’t have collateral damage, so any tightening in this area is of concern.”

Although the U.S. is still a top destination for cross-border investment, it has to work harder to attract that activity since its economy is already established, which means lawmakers need to seriously consider their tax policy determinations, McLernon said.

“We’re a developed economy. We won’t have double-digit growth, and we have to pull the levers we can pull,” she added. “Making a part of the tax code that’s already discriminatory even more so could force companies to review their operations in the U.S. and could have a negative impact.”

McBride also believes that Schumer’s well-intentioned fix could have serious consequences.

“We can’t lose sight that inversions are one of many ways for companies to get out from under U.S. tax. Another tactic is to move to the individuals U.S. tax, through adopting a master limited partnership form or other form of organization — that’s entirely legal and has been happening since 1986 when the incentives changed,” he said.

“It’s dangerous territory here, and I’d hope the senator and his staff could do some due diligence,” McBride added.

–Additional reporting by Igor Kossov. Editing by Jeremy Barker and Mark Lebetkin.

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