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US Inbound: Inbound debt limitations

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Jim Fuller


David Forst

With all this recent discussion in the US about inversions, increasing attention has been given to earnings stripping through intercompany debt, that is, a loan by a foreign person to a related US corporation. The perception seems to be that this often accompanies an inversion. Today, § 163(j), the provision that limits deductions for interest on inbound debt, generally limits the deduction for related-person interest expense to 50% of adjusted taxable income. Excess (disallowed) interest expense and excess limitation can be carried forward. There also is a safe harbour if the US corporation's debt-to-equity ratio does not exceed 1.5:1.

Senate Finance Committee member Charles Schumer, D-NY, introduced legislation that would target the practice of earnings stripping to help deter corporate inversions. Specifically, Schumer's Bill proposes to (1) repeal the debt-to-equity safe harbour under § 163(j) so that limitations on the interest expense deduction will apply to all inverters, regardless of their financial leverage; (2) reduce the permitted net interest expense to no more than 25% (down from 50%) of the subsidiary's adjusted taxable income; (3) repeal the interest expense deduction carryforward and excess limitation carryforward so that inverters cannot take advantage of the deduction in future years; and (4) require the US subsidiary to obtain IRS pre-approval annually on the terms of its related-party transactions for 10 years immediately following an inversion, effectively guaranteeing audits of all inverted companies.

The big surprise is that it would apply to any foreign company that ever did an inversion (as defined in § 7874, with 50% substituted for 60% for this purpose). This could go back to the 1930s, for example. It is unclear how current corporate executives would even know today if their company ever participated in such a transaction. If it ever did, its US subsidiary's related party interest deductions could be severely limited prospectively (after the Bill's effective date). The subsidiary also would have to get advance rulings from the IRS covering all related party transactions such as sales of goods and royalties.

Another part of the surprise: the Bill, if it becomes law, could affect transactions like the Daimler-Chrysler transaction if at closing the shareholders of Chrysler owned more than 50% of Daimler as a result of the transaction. Daimler might argue that it had substantial business activities in Germany at the time, but that's a facts and circumstances test, and it might not satisfy the test.

Prospects for enactment appear quite slim. Senator Hatch (R-Utah) announced opposition to the Bill. He objects to its retroactive effect, as he previously said he would. He also wants any anti-inversion bill that is in advance of general corporate tax reform to establish more of a territorial system regarding international earnings. He also wants a revenue-neutral plan to serve as a bridge to revising the tax code.

Representative Sander Levin, D-Mich., also announced a Bill to tighten the § 163(j) anti-earnings-stripping rules. In the draft of his Bill, however, the limitation would apply to all entities, not just inverted entities. Levin would also reduce the current 50% to 25%, eliminate the debt-to-equity safe harbour and deny a carryforward for excess limitation. He would limit to five years the carryforward for excess (disallowed) interest expense.

The Obama Administration also is reported to be exploring the possibilities for anti-inversion regulatory action, without statutory change. However, as one Treasury spokesperson stated, there are limits to what the Administration can do without action by Congress, and legislation is the only way to fully address inversions. The considerations by Treasury are in response to certain Democratic Congresspersons who have asked the President to act.

Some of this Administrative attention has been on earnings stripping. One former government official suggested tightening the earnings stripping rules by regulatory action. Most US tax practitioners, however, are of the view that Administrative action by itself would be very difficult, if not impossible. The rules under §§ 385 (Treatment of Certain Corporation Interests as Stock or Indebtedness) and 163(j) don't authorise regulations that would apply only to inverted entities. Thus, if any new regulations were issued, they could affect more than simply inverted entities.

Jim Fuller (jpfuller@fenwick.com) and David Forst (dforst@fenwick.com)

Fenwick & West

Tel: +1 650 335 7205; +1 650 335 7274

Website: www.fenwick.com

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