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Earnings Stripping is a practice of reducing the taxable income of a corporation by paying excessive amounts of interest to related third parties.
Sec. 163(j), enacted by the Revenue Reconciliation Act of 1989, placed substantial restrictions on the amount of certain related-party interest expense deductions a foreign-owned U.S. corporation may take in computing its income tax (the so-called earnings stripping rules). Such restrictions generally apply to tax years beginning after July 10, 1989. These rules were enacted in response to what was perceived as an erosion of the U.S. tax base through interest expense deductions.
The earnings stripping rules generally apply to a corporation with a debt-to-equity ratio in excess of 1.5 to 1; if its net interest expense exceeds 50% of its adjusted taxable income for the year; and if the interest expense is not subject to full U.S. income or withholding tax in the hands of the recipient. Sec. 163(j)(6)(C) provides that members of an affiliated group are treated as one taxpayer for purposes of these rules.