This past April, the Treasury Department announced its intention to expand regulations on activities of corporations in order to make earnings stripping more difficult for inverted firms. Although the regulations under section 385 of the IRS code are not expected to be finalized until the fall, the business community has already expressed its opposition to the rule, due to its complexity, cost, and that it may have an impact on wide number of companies. The current version of the rule, despite addressing the issue of earnings stripping clearly, is costly and does not get to the root of the problems with the U.S. corporate tax.
It is important to understand why the rule was proposed and what it is attempting to target.
The general concern is that U.S. companies that invert or are taken over by foreign multinationals will be able to strip profits from the U.S. tax base. They do this by loading up the now foreign subsidiary in the U.S. with debt. When a subsidiary pays the parent company interest, it deducts this interest from taxable income in the United States. All of the deducted expenses are then included in the taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. of the parent, which is located in a foreign country.
If a multinational can deduct interest from a U.S. subsidiary that is taxed at 35 percent and transfer the interest income to the parent that is taxed at 25 percent or 20 percent in a different country, the total income of the multinational corporation would be taxed at a lower rate than previously. This reduces U.S. federal taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. revenues.
To prevent this, the proposed Treasury rule, as it stands, would treat some interest payments (debt), which are deductible, as dividends (equity), which are not deductible. It would allow the IRS to scrutinize all debt instruments among affiliates and check whether they have the following conditions: “a legally binding obligation to pay, creditors' rights to enforce the obligation, a reasonable expectation of repayment at the time the interest is created, and an ongoing relationship during the life of the interest consistent with arms-length relationships between unrelated debtors and creditors.” In other words, the IRS will obligate corporations to provide documentation for all of their debt instruments, ensuring that companies would only be allowed to deduct interest payments to a subsidiary if the relationship between the parent and the subsidiary is that of a debtor and a creditor.
These regulations, of course, come with a cost. The IRS estimates that the new regulations will cost approximately $15 million annually, mostly due to the increased paperwork burden. Furthermore, the U.S. Council for International Business claimed in its public comment that the IRS has significantly underestimated the costs and the burden of the proposed regulation. Business operations are going to be significantly affected by the rule, making the compliance quite costly, possibly outweighing the potential benefit from the reduction of corporate inversion. In addition, many claim that the rules are so broad and vague that U.S.-based multinationals could be effected.
Unfortunately, the new Treasury regulations will not target a central cause of corporate avoidance: the complex and uncompetitive corporate tax code in the United States. For instance, if Congress removed the U.S. tax code’s bias towards debt over equity, the regulations would be extraneous. If we had a more competitive corporate tax rate, earnings stripping and inversions would also be much less of an issue. However, these changes would require legislation.
The rules are, of course, not yet finalized. The IRS is set to have a public hearing on the proposed rules on July 14th, with more clarification expected on the details of the final version of the rule or the potential changes that may arise.
7/15/2016 Update: Post edited for clarity.
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