Earnings-stripping trap

In 1989, Congress enacted Sec. 163(j), the earnings-stripping provisions, in an attempt to apply thin-capitalization policies to cross-border transactions. This section disallows a deduction for interest paid on loans from related parties in certain instances, most commonly in the international context. The provisions were amended in 1993 to extend coverage to loans from related tax-exempt parties and to loans guaranteed by related non-U.S. persons. The absence of specific treaty-shopping provisions means Sec. 163(j) often disqualifies interest when payments are entirely legitimate and, in fact, subject to a higher rate of tax in a parent's hands than in a subsidiary's hands.