US SUBSIDIARIES OF FOREIGN COMPANIES are starting to focus on a potential threat to their interest deductions.

A bill introduced by Rep. Bill Thomas (R.-California), the chairman of the House tax-writing committee, would tighten existing limits on the amount of the deduction that a US company can take for interest payments it makes to a related party. The bill closely tracks recommendations made by the Bush administration in June.

Under current law, a US subsidiary of a foreign company can deduct all interest paid to a foreign affiliate if the US subsidiary’s debt-to-equity ratio is less than 1.5 to 1. If the subsidiary fails this test, then the amount of its deduction is capped at the dollar amount equal to 50% of its net taxable income. Any interest above this threshold may be carried forward indefinitely. Interest paid to third parties is also caught if the debt is guaranteed by a foreign affiliate.

The Thomas bill would eliminate the debt-equity test, replacing it with a rule that would disallow all interest deductions to the extent that a corporate group’s level of indebtedness in the US exceeds its worldwide level of indebtedness. The bill would also reduce the cap on deductible interest from 50% to 35% of the US company’s net taxable income. The company’s ability to carry forward any excess would be limited to five years.

Thomas’s bill closely follows a list of recommendations on “corporate inversion” transactions that was presented to the House Ways and Means Committee by Pamela Olson, the assistant Treasury secretary for tax policy, in June. Inversions are transactions where a US company with foreign subsidiaries turns itself upside down. It becomes a subsidiary of a new parent company in Bermuda or another tax haven and the foreign subsidiaries of the US company are moved directly under the new Bermuda parent. The growing popularity of inverting to avoid US taxes has led to calls for reform of the US tax rules that encourage such transactions.

The section of the US tax code that would be affected by these changes is section 163(j).

The Thomas bill is controversial. A planned “mark up” of the bill by the House Ways and Means Committee in late July was put off until September.

Keith Martin