Thin Capitalization Rules
This article is the second installment of a periodic series that addresses common fact patterns involving international business operations that can result in unforeseen, adverse U.S. tax consequences. The topic of this installment is the “thin capitalization” provisions related to interest expense deductions for foreign subsidiaries on loans from their U.S. parent companies.
Below are two possible scenarios and the resulting tax consequences associated with each:
- “FSub” is a foreign entity that operates a start-up enterprise in foreign country F. FSub is 100%-owned by a U.S. Corporation (“USP”).
- USP has provided financial support to FSub in the form of equity and market rate interest-bearing loans.
- FSub has been only marginally profitable and its debt/equity ratio now exceeds 1 to 1.
- FSub has not made regular interest payments to USP, but is able to make an interest payment during the current year.
- FSub does not file a U.S. income tax return and has no income “effectively connected” with a U.S. business.
- Fsub is not included in USP's U.S. return.
- USP pays U.S. tax at a 35% effective tax rate.
BASIC TAX CONSEQUENCES
- Under the general U.S. income tax rules, the interest paid by FSub to USP will be taxable to USP in the US at 35%.
- FSub must apply to foreign country F to receive permission to make payments to USP. Foreign country F’s certification process takes at least 6 months.
- However, the fact that FSub’s debt/equity ratio is greater than 1 to 1 requires further analysis.
UNFORTUNATE TAX CONSEQUENCES
- Foreign Country F has strict rules on capitalization that limit deductions for intercompany payments. To the extent FSub’s debt/equity ratio is greater than 1 to 1, FSub is considered “thinly capitalized”.
- The thin capitalization rules do not allow FSub an interest expense deduction on the foreign country F income tax return for interest paid to USP. This is because USP is not subject to tax in foreign country F.
- FSub’s payments to USP will be re-characterized as payments on equity. To the extent payments are considered a dividend, FSub must withhold foreign country F taxes at up to a rate of 35%.
- USP is entitled to claim a foreign tax credit on its U.S. income tax return for the amount of the withholding taxes. However, USP’s foreign tax credit limitations may prevent USP from getting the full benefit of the withholding taxes. Where the foreign tax credit is not available, the current worldwide tax burden may be over 50%.
TAX PLANNING OPPORTUNITIES
FSub may be able to mitigate the loss of its interest expense deduction by considering several options. For example:
- FSub may be able to obtain third party financing in foreign country F and repay USP’s loan. The interest on debt to a third party in foreign country F would be deductible by FSub. However, if USP was required to provide a loan guarantee on FSub’s third party debt, it is likely this new debt would be subject to the same thin capitalization rules.
- USP may convert a portion of the intercompany debt to equity. If USP can raise FSub’s debt/equity ratio to 1 to 1, interest expense on the remaining intercompany debt may be deductible by FSub. FSub should apply well in advance of the planned payment for the required ruling in order to pay the interest to USP without withholdings.
- We welcome the opportunity to discuss these scenarios or tax-efficient repatriation strategies and international tax planning with you in more detail. Our Tax Consulting Services Group can assist you in navigating the maze of international tax laws. Through our affiliation with Baker Tilly International, we have the resources and expertise to serve you.
We welcome the opportunity to discuss these scenarios or tax-efficient repatriation strategies and international tax planning with you in more detail. Our Tax Consulting Services Group can assist you in navigating the maze of international tax laws. Through our affiliation with Baker Tilly International, we have the resources and expertise to serve you.
Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.
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