Section 163(j) of the US tax code prevents foreign parent companies from stripping earnings of their US subsidiaries by capitalizing the subsidiaries with debt and then trying to pull out the earnings as “interest” on the debt. Interest payments are deductible by the subsidiary, and they attract a 0% withholding tax at the US border under many tax treaties.
Section 163(j) denies an interest deduction for the US subsidiary in cases where the US subsidiary has a higher debt-equity ratio than 1.5 to 1 and its interest expense for the year exceeds 50% of its income. Ordinarily, the focus is on interest paid to a foreign parent company. However, interest the subsidiary pays to a bank or other third party is also disallowed if the interest is paid on debt that a foreign affiliate has guaranteed (on the theory that this is no different than if the interest were paid to the foreign affiliate directly, which it then pays to the bank).
Disallowed interest is carried forward until the US subsidiary has the capacity to use it within the cap imposed by section 163(j).
A US company asked the IRS earlier this year for a private ruling that disqualified interest had lost its taint. The company had paid the interest to a bank. A foreign affiliate guaranteed the bank debt. However, by the time of the ruling, the debt had been refinanced without a guarantee. The interest in question was still being carried forward.
The IRS declined and ruled, instead, that the interest remained tainted. Its status as disqualified interest is determined in the year the interest is paid. That status is not changed by later events. The ruling is PLR 200243035.