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A federal tax rule could close a loophole or create a headache

A view of the U.S. Treasury building in Washington, D.C.

A view of the U.S. Treasury building in Washington, D.C. Chip Somodevilla/Getty Images

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Wednesday is the deadline for interested parties to comment on a new proposal about corporate taxes from the Treasury Department. The rule, intended to address a practice known as “earnings stripping,” is part of the Obama administration’s ongoing effort to rein in companies it says are taking advantage of tax loopholes or trying to avoid U.S. taxes through inversions. It addresses one of the many ways companies move money out of the U.S. tax system into other countries.

Here’s how it works: A company in the U.S. gets acquired by a company someplace with lower taxes. Then, at least on paper, the foreign part of the company makes a loan to the U.S. one. Here’s where it becomes tricky: The U.S. company pays interest to the foreign partner, and interest is deductible, so those payments disappear as far as U.S. taxes are concerned, and magically become earnings someplace with a lower tax rate. In other words, a corporation can essentially issue debt to itself to make its numbers look lower for U.S. tax purposes.

But if that loan was instead considered equity, stock in the U.S. company, then the cash flowing back the other way would become taxable dividends rather than interest payments. The Treasury wants to clarify when that distinction should be made, and there are tons of fine print since corporations issue debt to their subsidiaries frequently, and for a variety of reasons. The goal of the new rule is to block the loophole in which a legitimate money-lending situation isn’t what’s going on.

Hundreds of commenters have already weighed in, both on the fine print and on the speed with which the rule is being rolled out. The Obama administration is pushing to keep the rule on a tight schedule in order to get it finalized under the current administration.

“This is going to be heavy lifting for the Treasury Department to keep its loophole closed tight, but accommodate business practices that both taxpayers and the government do not think are abusive,” said Steve Rosenthal, a senior fellow at the Tax Policy Center. “It’s a very challenging enterprise.”

Dorothy Coleman, vice president of tax and domestic economic policy at the National Association of Manufacturers, said corporations use debt to move cash around all the time — and for them, compliance will be a nightmare.

“They are going to blow up our cash management systems,” she said.

And, given the speed at which the regulations are rolling out, she said “the amount of uncertainty is incredible.”

She also argues compliance would be expensive and complicated. But the Treasury’s argument is that the U.S. is losing far more than that in tax revenue because of earnings stripping.

“For sure, the rules are complicated,” Rosenthal said. “The problem that needs to be addressed is straightforward. And solving the problem is critical, because in effect it allows U.S. multinationals to elect how much taxes they want to pay.”

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