Earnings Stripping Explained: How This Tax Strategy Works

Earnings stripping is a tax strategy primarily used by multinational corporations to reduce their overall tax liability. The practice involves structuring financial arrangements, specifically intercompany debt, to shift profits from a subsidiary in a high-tax country to an affiliated company in a low-tax jurisdiction.

This method takes advantage of the tax principle that allows businesses to deduct interest payments as an expense, which lowers their taxable income. While the strategy is a form of tax avoidance that operates within legal frameworks, it has drawn significant attention from governments and tax authorities for its impact on national tax revenues.

The Mechanics of Earnings Stripping

The mechanism of earnings stripping relies on creating related-party debt, which occurs when one part of a multinational group lends money to another. For instance, a parent company in a low-tax country, Country A, extends a loan to its subsidiary operating in a high-tax country, Country B. This loan is a financial arrangement between affiliated entities.

The subsidiary in high-tax Country B makes substantial interest payments on this loan to the parent company in low-tax Country A. Under the tax laws of Country B, these interest payments are treated as a deductible business expense. This deduction reduces the subsidiary’s profits and its taxable income in the high-tax jurisdiction.

Simultaneously, the parent company in Country A receives these payments as interest income. Because Country A has a low corporate tax rate, this income is taxed at a much more favorable rate than the profits would have been in Country B. The result is that the corporation has shifted earnings from a high-tax environment to a low-tax one, lowering its total global tax payment.

Tax Implications and Regulatory Concerns

From a government’s perspective, earnings stripping poses a direct threat to its tax revenue through a process known as base erosion, as profits are moved offshore before they can be taxed. This situation creates a conflict between the objectives of multinational corporations and national governments.

While a corporation may act within the law to minimize its tax burden, governments must protect their tax base to fund public services. This tension is the primary driver behind regulations designed to limit earnings stripping.

The Section 163(j) Limitation on Interest Deductions

In the United States, the primary tool to combat earnings stripping is Section 163(j) of the Internal Revenue Code, which was expanded by the Tax Cuts and Jobs Act. This rule does not prohibit intercompany loans but instead limits the amount of business interest expense that a taxpayer can deduct in a given year. It applies broadly to most businesses, regardless of whether their debt is owed to a related party or an independent third party.

The annual deduction for business interest expense is limited to the sum of three components: the taxpayer’s business interest income (BII) for the year, 30% of the taxpayer’s adjusted taxable income (ATI) for the year, and the taxpayer’s floor plan financing interest. Business interest expense is any interest paid on debt related to a trade or business, while BII is interest income from those same activities.

Adjusted taxable income is an important element in this calculation, beginning with taxable income and modified by several adjustments. For tax years after December 31, 2021, the calculation of ATI became more restrictive. Taxpayers can no longer add back deductions for depreciation and amortization when calculating ATI, which lowers the income base and can reduce the amount of interest a business can deduct.

Any business interest expense that is not deductible in a given year due to the limitation is not permanently lost. The disallowed amount is treated as excess business interest expense and can be carried forward to the following tax year. This carryforward can continue indefinitely until the taxpayer has sufficient income to deduct it.

Exemptions and Special Considerations

Not all businesses are subject to the Section 163(j) interest limitation, with the most significant exception being for small businesses. A taxpayer qualifies for this exemption if it meets the gross receipts test under Internal Revenue Code Section 448. This test is met if the business’s average annual gross receipts for the three preceding tax years are below an inflation-adjusted threshold, which is $31 million for 2025.

This exemption allows many small and medium-sized businesses to deduct their full business interest expense without limitation. However, businesses defined as tax shelters are ineligible for this exemption even if their gross receipts fall below the threshold. Aggregation rules also apply, requiring related entities to combine their gross receipts to determine qualification, preventing larger enterprises from splitting into smaller entities to meet the test.

Certain businesses, including an “electing real property trade or business” and an “electing farming business,” can also make an irrevocable election to be exempt. Making this election allows these businesses to fully deduct their interest expenses, which is beneficial for highly leveraged industries.

This benefit comes with a trade-off, as a business that makes this election must use the Alternative Depreciation System (ADS) for certain property. ADS requires assets to be depreciated over a longer period, reducing the annual depreciation deduction. For example, an electing real property business must depreciate residential rental property over 30 years instead of 27.5 years and is ineligible for bonus depreciation on certain assets.