DISCLAIMER: These materials do not, and are not intended to, constitute legal or tax advice. You should consult an attorney or tax advisor for individual advice regarding your own situation.Although we have made considerable efforts to be thorough in the construction of these pages, we offer no assurance that the information posted here is timely, accurate, complete or applicable to any particular set of facts. To the contrary, be aware that some of the material on these pages is out of date, incomplete and/or altered in relation to the official version. These documents are not posted here for commercial use and should not be relied upon for any purpose whatsoever.

(Excerpt from The Joint Committee on Taxation, JCX-67-03)

A U.S. corporation with a foreign parent may reduce the U.S. tax on its U.S.-source income through the payment of deductible amounts such as interest, rents, royalties and management service fees to the foreign parent or other foreign affiliates that are not subject to U.S. tax on the receipt of such payments. These transactions are commonly referred to as “earnings stripping” transactions. Although foreign corporations generally are subject to a gross basis U.S. tax at a flat 30-percent rate on the receipt of payments like interest, rents, royalties, and certain similar types of income derived from U.S. sources, this tax may be reduced or eliminated under an applicable income tax treaty. Consequently, U.S. corporations may use certain treaties to facilitate earnings stripping transactions without having the benefit of their deductions offset by U.S. withholding taxes.

Section 163(j) addresses earnings stripping involving interest payments, by limiting the deductibility of interest paid to certain related parties if no income tax is imposed on the interest (“disqualified interest”), if: (1) the payor’s debt-to-equity ratio exceeds 1.5 to 1 (the so-called “safe harbor”); and (2) the payor’s net interest expense exceeds 50 percent of its “adjusted taxable income” (generally taxable income computed without regard to deductions for net interest expense, net operating losses, and depreciation, amortization, and depletion). Interest amounts disallowed under these rules can be carried forward indefinitely. In addition, excess limitation (i.e., any excess of the 50-percent limit over a company’s net interest expense for a given year) can be carried forward three years.

More generally, section 482 and the regulations thereunder require that all transactions (regardless of whether the transactions involve the payment of interest, royalties, rents, management service fees or other payments) between related parties be conducted on terms consistent with an “arm's length” standard, and permit the Secretary of the Treasury to reallocate income and deductions among such parties if that standard is not met.