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U.S. Experience With Interest Deductibility Restrictions Stephen E. Shay Harvard Law School EC - IMF Conference Corporate Debt Bias Economic Insights and.

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Presentation on theme: "U.S. Experience With Interest Deductibility Restrictions Stephen E. Shay Harvard Law School EC - IMF Conference Corporate Debt Bias Economic Insights and."— Presentation transcript:

1 U.S. Experience With Interest Deductibility Restrictions Stephen E. Shay Harvard Law School EC - IMF Conference Corporate Debt Bias Economic Insights and Policy Options

2 Topics U.S. tax advantages of classifying instrument as debt U.S. approaches to restricting excessive interest – Classification as debt or equity – Interest deductibility limitations without regard to holder status – Cross-border interest limitations FY 2015 budget proposals affecting interest Lessons from the U.S. experience 2

3 U.S. Tax Advantages of Classifying Instrument as Debt U.S. follows classical system of corporate taxation – separate tax at the corporate and shareholder level – Interest on indebtedness is deductible at the corporate level, subject to (generally avoidable) deduction limitations discussed below – Repayment of debt principal treated as recovery of basis – Pro rata corporate distributions are first attributed to earnings (before recovery of basis) and taxable as dividends – Lower withholding taxes on interest Advantage of debt over equity is deduction for, interest, earlier basis recovery and lower withholding taxes 3

4 U.S. Tax Advantages of Classifying Instrument as Debt Current US tax rates: – Corporate tax rate – 35% – Top individual tax rate – 39.6% – Top preferential rate on long-term capital gain and dividends – 20% Interest income not taxed at corporate level, but generally is taxable as “ordinary” income at full tax rate; but many holders are not taxed on the interest. Since 2003, qualifying dividends to individuals eligible for preferential rate that is the same as for capital gain. 4

5 Instrument Classification as Debt or Equity: U.S. Stakes At top rates for individuals, combined corporate and shareholder effective tax rates are: – Dividends (qualifying): 48% (35% + 13%) – Interest: 39.6% Tax-exempt pension funds and endowments and foreign portfolio investors generally are not taxed on interest. Conclusion: Tax incentive to use corporate debt in U.S. system 5

6 Topics U.S. tax advantages of classifying instrument as debt  U.S. approaches to restricting excessive interest – Classification as debt or equity – Interest deductibility limitations without regard to holder status – Cross-border interest limitations FY 2015 budget proposals affecting interest Lessons from the U.S. experience 6

7 U.S. Approaches To Limiting Interest Deductions: Classification of Instrument as Debt or Equity From inception of U.S. Federal income tax in early 20 th century, debt-equity classification governed by case law (common law). No particular factor is conclusive in making the determination of whether an instrument constitutes debt or equity. The weight given to any factor depends upon all the facts and circumstances. 7

8 U.S. Approaches: Classification of Instrument as Debt or Equity – Traditional Factors (a)unconditional issuer promise to pay (debt); (b)holders’ rights to enforce principal and interest (debt); (c)holders’ rights are subordinate to general creditors (equity); (d)holders’ rights to participate in management (equity); (e)[extremely] thinly capitalized issuer (equity); (f)identity of debt holders and shareholders (closer scrutiny); (g)parties’ label on the instruments; and (h)treatment (as debt or equity) for non-tax regulatory, rating agency, or financial accounting purposes. 8

9 U.S. Approaches: Classification of Instrument as Debt or Equity – Failed Regulations In 1969, Congress passed statute authorizing regulations, which “may” include 5 factors (derived from the case law factors): 1.Whether there is an unconditional written promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money’s worth, and to pay a fixed rate of interest; 2.Whether there is subordination to or preference over any indebtedness of the corporation; 3.The corporation’s debt to equity ratio; 4.Whether the interest is convertible into stock of the corporation; and 5.The relationship between the holdings of stock in the corporation and holdings of the interest in question. §385 9

10 U.S. Approaches: Classification of Instrument as Debt or Equity In the late 1970s and early 1980s, Treasury tried several times to issue debt-equity regulations under § 385. Regulations withdrawn (before their effective date) because taxpayers could design instruments with guaranteed payments having a present value just greater than half of the issue price, assuring classification as debt under the regulations, while also providing variable payments tied to dividends and a conversion right (Adjustable Rate Convertible Notes or ARCNs). Treasury gave up the effort. 10

11 U.S. Approaches: Classification of Instrument as Debt or Equity – Traditional Factors In Recent Case 11 Scottish Power (NA General Partnership v. Commissioner, 2012) – simple picture Shareholders Scottish Power Shares 1 2 Scottish Power UK Loan Notes and Shares Court upheld taxpayer’s position that the Loan Notes were debt for U.S. tax purposes. Key factors (from 9 th Circuit 11-factor test): parties’ intent, reasonable expectation of payment of interest and repayment of principal based on projected cash flows, ability to obtain third-party financing Factors considered less relevant/irrelevant: late payment of initial interest payments, senior indebtedness, structural subordination, subsequent capitalization of debt PacificCorp Shares PacifiCorp US NA GP US

12 U.S. Approaches: Classification of Instrument as Debt or Equity – Scottish Power (fuller picture) 4/29/ Glossary:Entity Classification USForeign Corp Pass thru Pass thru Corp CorpPass thru “Hybrid” entity “Reverse hybrid”

13 U.S. Approaches: Classification of Instrument as Debt or Equity – Scottish Power (fuller picture) ScottishPower plc ScottishPower UK plc NA 1NA 2 10% 90% NA GP UK US ScottishPower Acq. Co PacificCorp [Newly formed] [Re-named] NA GP issued $4B fixed rate notes and $895M of floating rate notes. NA GP failed to make some interest payments, used PacificCorp dividends to pay interest and when PacificCorp dividend suspended for regulatory reasons, borrowed from ScottishPower to pay interest. After interest made current, the floating and some of the fixed debt was capitalized Public Notes

14 A Real Picture – From LuxLeaks 14

15 U.S. Approaches: Classification of Instrument as Debt or Equity 15 How hard for planners to achieve desired classification under factor test?

16 Topics U.S. tax advantages of classifying instrument as debt  U.S. approaches to restricting excessive interest – Classification as debt or equity  – Interest deductibility limitations without regard to holder status – Cross-border interest limitations FY 2015 budget proposals affecting interest Lessons from the U.S. experience 16

17 U.S. Approaches: Limitations Without Regard to Debt Holder’s Tax Status In 1969 legislation, interest in excess of $5 million a year on certain corporate acquisition indebtedness disallowed, but the conditions are easily avoided. §279 In response to a wave of leveraged buyouts, In 1989 legislation, deductions not allowed for disqualified original issue discount (OID) on “applicable high-yield discount obligations” (so-called “AHYDO” debt) until payment. The target is so-called payment-in-kind (“PIK”) interest, but the limits are generous, routinely worked around in leveraged transactions and less relevant in a low-interest rate environment. §163(e)(5). 17

18 U.S. Approaches: Limitations Without Regard to Debt Holder’s Tax Status 1989 legislation also adopted a limit on an NOL carryback attributable to a corporate equity reduction transaction (CERT) from a stock acquisition or an excess distribution using debt the interest on which is included in an NOL. §172(h) In 1997, legislation adopted disallowing an deduction for interest on corporate debt payable with equity or convertible at issuer option into equity or the interest on which is determined by reference to the value of equity (with exceptions for security dealers). The holder’s tax treatment is unaffected. §163(l) 18

19 U.S. Approaches: Limitations Without Regard to Debt Holder’s Tax Status 19 How hard for planners to avoid the interest limitations just described?

20 Topics U.S. tax advantages of classifying instrument as debt  U.S. approaches to restricting excessive interest – Classification as debt or equity  – Interest deductibility limitations without regard to holder status  – Cross-border interest limitations FY 2015 budget proposals affecting interest Lessons from the U.S. experience 20

21 U.S. Approaches: Cross-Border Limitations to Prevent Stripping of Corporate Tax Base 1989 anti-earnings stripping legislation - objective rules for disallowing (suspending) interest deduction for “disqualified interest” up to the amount of “excess interest expense.” §163(j) For the rules to apply, a corporation must have – A debt-to-equity ratio at the end of the year in excess of 1.5/1.0 based on adjusted basis of assets, and – Excess interest expense. 21

22 U.S. Approaches: Cross-Border Limitations to Prevent Stripping of Corporate Tax Base “Excess interest expense” is net interest expense over 50% of adjusted taxable income plus any excess limitation carryforward. Adjusted taxable income approximates EBITDA. “Disqualified interest” is – Interest paid to a related person if no U.S. tax is imposed on the interest (i.e., interest paid to a tax- exempt or foreign person to the extent withholding is reduced), or – There is a disqualified guarantee on the debt and no gross tax on the interest. Excess limitation carries over. 22

23 Earnings Stripping: Case 1 - Related Party Debt 4/29/ ForCo USCo Public Shareholders USCo distributes note, taxable as dividend to extent of E&P, return of basis then capital gain. Debt-equity test  USCo assets= $3B USCo debt = $2B USCo equity = $1B US Co ATI: $150m USCo net interest $100m USCo DQI $100m $25m USCo interest suspended Contribute note Swiss finance Sub Note interest Swiss finance Sub

24 Earnings Stripping: Case 2 - Guarantee 4/29/ ForCo USCo Public Shareholders Bank $2B loan $100m interest Loan guarantee Debt-equity test  USCo assets= $3B USCo debt = $2B USCo equity = $1B US Co ATI: $150m USCo net interest $100m USCo DQI $100m $25m USCo interest suspended

25 U.S. Approaches: Cross-Border Limitations to Prevent Stripping of Corporate Tax Base Related party loan interest must be arm’s length. §482 – Safe harbor for interest on US dollar debt that is at least at the “applicable federal rate” (AFR) and does not exceed 130% of AFR. Safe harbor does not apply to loans by business lender to unrelated persons. Interest paid to a related foreign person may not be deducted until paid. §267(a)(3). A similar rule applies to OID. §163(e)(3) Dual consolidated loss rules - Net operating loss of a U.S. corporation may not be available to offset income of its affiliates if the corporation is a “dual resident corporation.” §1503(d) 25

26 U.S. Approaches: Cross-Border Limitations to Prevent Stripping of Corporate Tax Base 26 How hard for planners to avoid these limitations?

27 Topics U.S. tax advantages of classifying instrument as debt  U.S. approaches to restricting excessive interest – Classification as debt or equity  – Interest deductibility limitations without regard to holder status  – Cross-border interest limitations  FY 2015 budget proposals affecting interest Lessons from the U.S. experience 27

28 FY 2015 Budget Proposals Affecting Interest A financial reporting group member’s interest deduction limited if the member’s net interest expense for financial reporting purposes exceeds the member’s proportionate share of the group’s net interest expense. Excess limitation carries over. Proposal does not apply to financial businesses. Deny deductions for interest and royalty payments involving a hybrid arrangement made to related parties if there is no corresponding inclusion to the recipient in the foreign jurisdiction or the hybrid arrangement permits an additional deduction for the same payment in another jurisdiction. 28

29 FY 2015 Budget Proposals Affecting Interest US FY 2016 budget proposals: – A new 19% minimum tax on foreign income (after an allowance for corporate entity). Interest expense incurred by a U.S. corporation that is allocated and apportioned to foreign earnings on which the minimum tax is paid would be deductible at the residual minimum tax rate applicable to those earnings. No deduction would be permitted for interest expense allocated and apportioned to foreign earnings for which no U.S. income tax is paid. 29

30 Topics U.S. tax advantages of classifying instrument as debt  U.S. approaches to restricting excessive interest – Classification as debt or equity  – Interest deductibility limitations without regard to holder status  – Cross-border interest limitations  FY 2015 budget proposals affecting interest  Lessons from the U.S. experience 30

31 Lessons From U.S. Experience Structure of U.S. corporate tax encourages debt financing. – Some form of corporate integration, as in Australia, would mitigate this incentive but this is unlikely to occur. Rule-based responses to abuses are difficult to make effective – the “fur-kin arc-kins” (FRCNs and ARCNs) 31

32 Lessons From U.S. Experience Structural reforms are needed to reduce effective rate differences that are the reason for tax avoidance planning. Broaden the tax base and lower the statutory tax rate is as good a prescription as you will get. – N.B. An ACE deduction goes narrows the tax base and requires higher statutory rate. 32

33 We Can Do Better 33


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