How do the earnings stripping and interest limitation rules under IRC 163(j) affect foreign-owned U.S. entities?

The TCJA significantly revised IRC Section 163(j), which now limits the deduction for business interest expense to the sum of: (1) business interest income, (2) 30% of the taxpayer's adjusted taxable income (ATI), and (3) floor plan financing interest. For tax years beginning after 2021, ATI is computed without adding back depreciation, amortization, or depletion — making it closer to EBIT than EBITDA. Any disallowed business interest expense carries forward indefinitely. This limitation applies to all taxpayers (not just those with related-party debt), but it disproportionately affects highly leveraged entities, including foreign-owned U.S. companies funded by intercompany loans.

With $40 million in ATI, your Section 163(j) limit is 30% x $40M = $12 million (assuming zero business interest income and floor plan financing). Your $15 million in interest expense exceeds this by $3 million. The excess $3 million is disallowed in the current year and carries forward to future tax years. This means you can only deduct $12 million of your $15 million interest payment, even though the interest is owed to a related party at arm's-length rates.

Before the TCJA, the old Section 163(j) (sometimes called the "earnings stripping" rule) specifically targeted interest paid by thinly capitalized U.S. entities to related foreign parties exempt from U.S. tax. It disallowed excess interest expense when: (1) the debt-to-equity ratio exceeded 1.5 to 1, and (2) net interest expense exceeded 50% of adjusted taxable income. The TCJA replaced this targeted rule with the broader 30% ATI limitation that applies to all business interest, regardless of whether it is paid to a related foreign party. The new rule is both broader (applies to all taxpayers) and in some cases more restrictive (30% vs. 50% threshold, and no debt-to-equity safe harbor).

Even if your interest deductions pass the Section 163(j) limitation, the interest rate on intercompany loans must be at arm's length under Section 482. The IRS can adjust the interest rate if it determines that the rate on the intercompany loan is not comparable to what unrelated parties would charge. Additionally, thin capitalization issues can arise under transfer pricing principles — if the U.S. entity is funded with an unreasonable proportion of debt relative to equity, the IRS may recharacterize some of the "debt" as equity, converting "interest" into non-deductible dividends.

Businesses with average annual gross receipts of $30 million or less over the prior three years are exempt from Section 163(j). Certain industries (such as real property trades or businesses) can elect out of the limitation, though this comes with trade-offs (required use of the alternative depreciation system). For foreign-owned U.S. entities with gross receipts above the threshold, the 30% ATI limit is the binding constraint, and careful planning around the timing of income and deductions can help manage the limitation.