An Earnings Stripping Strategy

An Earnings Stripping Strategy

February 01, 2005

An earnings stripping strategy for British companies with US subsidiaries is under attack in the pages of Tax Notes magazine.

The magazine is popular with policymakers in Washington.“Earnings stripping” refers to what happens when a parent company pulls earnings out of a foreign subsidiary in a deductible form. For example, a parent company might capitalize its foreign subsidiary heavily with debt. The subsidiary has earnings, but they are paid to the parent as interest on this debt. This reduces the subsidiary’s taxable income, since the interest payments are deductible.

British parent companies have been using “deferred subscription agreements” to strip earnings out of their US subsidiaries. In the simplest form of such arrangements, a US subsidiary might sign a contract to subscribe for shares in a sister company in Britain. The two subsidiaries — the US subsidiary and its British sister — have the same British parent. The subscription agreement requires the purchase price for the shares to be paid over a number of years.

Another British subsidiary with the same parent takes assignment of the share subscription agreement from the US sub.

The US sub gives it a note to compensate it for taking on the obligation to pay the share subscription price. The US sub deducts its interest payments on the note. This reduces or eliminates the US tax base. The US-British tax treaty waives any withholding tax that might otherwise be collected by the United States on the cross-border interest payments. Meanwhile, the British subsidiary receiving the “interest” report it for tax purposes in Britain as a tax-free return of capital.

Recent versions of the strategy interpose an additional “hybrid” company in the transaction underneath the US subsidiary — a company that is ignored for US tax purposes because the US subsidiary has elected to treat it as a “disregarded entity” while Great Britain views it as a corporation.

Lee Sheppard, a contributing editor of Tax Notes, has been urging the US Treasury Department since early last year to crack down on the transactions. The IRS says it is still “gathering information.” Her attacks on other foreign tax planning strategies in the past have not always led to IRS action.

Keith Martin