A pair of Democrats in the House have introduced legislation to reduce the number of corporate tax inversions by clamping down on the strategy of earnings stripping.

[IMGCAP(1)]House Ways and Means Committee ranking member Sander Levin, D-Mich., and Budget Committee ranking member Chris Van Hollen, D-Md., introduced the bill Tuesday. Earnings stripping—a common tax strategy following an inversion—involves disproportionately leveraging a U.S. company with debt and “stripping” the U.S. tax base through deductible interest payments.

The lending foreign parent (or another foreign affiliate) typically pays a reduced or zero tax rate on the interest income under an existing U.S. tax treaty. A 2007 Treasury report indicated that foreign-controlled inverted corporations aggressively engage in earnings stripping practices. The Stop Corporate Earnings Stripping Act would limit the use of earnings stripping by corporations that engage in tax-motivated inversions for companies whose inversions are completed on or after May 8, 2014.

“There is no doubt that there needs to be tax reform, and for it to be successful, there must be changes in how companies engaged globally are taxed,” Levin said during a committee hearing Wednesday on international tax reform. “There is considerable talk today that as a first step we should reform our tax code as it relates to companies that are American based with operations overseas. But there are immense difficulties in doing piecemeal tax reform. And it can’t be done just to raise short-term revenue without considering long-term effects.”

The current law disallows a deduction for excess interest paid by a U.S. entity to a related party (where the interest payment is exempt from U.S. withholding tax) when the entity’s debt-to-equity ratio exceeds 1.5, and its net interest expense exceeds 50 percent of its adjusted taxable income.

Disallowed interest expense can be carried forward indefinitely for deduction in a subsequent year. In addition, the entity’s excess limitation for a tax year—that is, the amount by which 50 percent of adjusted taxable income exceeds net interest expense—may be carried forward to three subsequent tax years. However, foreign-controlled groups have been able to work around any limitations on interest deductions because the current law requires a group to exceed both the debt-to-equity ratio threshold as well as the net interest expense threshold before excess interest deductions are disallowed. As long as the borrowing entity is able to maintain a debt-to-equity ratio of less than 1.5, it is not limited by the 50 percent net interest expense threshold.

[IMGCAP(2)]For any U.S. corporation that inverts on or after May 8, 2014, the bill would further limit the foreign-controlled inverted group’s ability to strip its U.S. tax base by repealing the debt-to-equity ratio threshold, reducing the permitted net interest expense threshold to no more than 25 percent of the entity’s adjusted taxable income, repealing the excess limitation carryforward, and permitting disallowed interest expense to be carried forward only for five years, rather than indefinitely under present law. The limitations would apply if historical shareholders of the U.S. entity own more than 50 percent (but less than 80 percent) of the new foreign parent entity following an inversion.

“American taxpayers are on the hook for billions of dollars in corporate tax obligations because Congress has failed to close the egregious inversion loophole,” said Van Hollen in a statement. “We cannot continue to allow companies to shift their tax obligations onto American workers and families simply by changing their mailing address. Putting an end to earnings stripping by inverted companies is an important step toward ensuring these companies aren’t reaping taxpayer-funded benefits while failing to pay their fair share.”

The prospects for passing the bill are slight, particularly in an election year. Levin and other House Democrats have previously introduced legislation to restrict inversions in both 2015 and 2015, but both bills failed to make headway.

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