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British pharmaceutical firm GlaxoSmithKline (GSK) is gearing up for a multi-billion dollar tax fight with the US Internal Revenue Service in a keenly-watched case which could affect how multinationals structure their international affairs.

The case centres on a practice known as ‘earnings stripping,’ whereby allegedly ‘excessive’ payments of deductible interest are made by foreign-controlled US corporations to related persons in whose hands that interest is partially or fully exempt from US tax. For example, the company may create a debt obligation from the corporation’s new US subsidiary to the new foreign parent, typically incorporated in a low-tax jurisdiction. The interest payments on this related-party debt create deductions that reduce US tax without creating an offsetting increase in the foreign tax due.

Earnings stripping was one of three international tax issues examined in a US Treasury Department report sent to Congress in November 2008, the other two being transfer pricing and US tax treaties. This study concluded that it is “not possible” to quantify accurately the extent of earnings stripping generally, although it said that “strong evidence exists” of earnings stripping by foreign-controlled domestic corporations that have undergone so-called "inversion" transactions, in which the US parent company of a multinational corporate group is replaced with a foreign parent in a low-tax or no-tax country. President Obama intends to restrict the use of this financing technique in his international tax reforms, presented as part of the 2010 budget blueprint.

The tax dispute with the US authorities is acknowledged in GSK’s 2008 annual report, which stated that Statutory Notices of Deficiency were issued by the IRS following its audit of the period 2001 to 2003. These Notices “assert income and withholding tax deficiencies, and associated penalties, arising from its reclassification of an inter-company financing arrangement in those years from debt to equity, and its consequent recharacterization of the amounts paid as dividends subject to withholding tax under the US – UK treaty.”

While the report said that all amounts due under the financing arrangement “were timely paid,” the IRS is now taking issue with aspects of GSK’s tax arrangements for the period 2004 to 2006. “GSK disagrees with the IRS’s position,” the report stated, adding that the company has initiated actions in the United States Tax Court to contest the Notices.

GSK estimates that the IRS claim for tax, penalties, and interest at December 31, 2008, net of federal tax relief, for 2001 through 2003 is USD864m. If the IRS prevails in its argument before a court in respect of the years 2001-2003, GSK expects to have an additional liability for the five year period 2004-2008 of USD1.06bn in tax, penalties, and interest.

If GSK and the IRS cannot reach a settlement, a court decision is not anticipated before 2011.