EC - IMF Conference
Corporate Debt Bias
Economic Insights and Policy Options
U.S. Experience With Interest
Deductibility Restrictions
Stephen E. Shay
Harvard Law School
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
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
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
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
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
U.S. Approaches To Limiting Interest Deductions:
Classification of Instrument as Debt or Equity
• From inception of U.S. Federal income tax in
early 20th 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
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
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
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
U.S. Approaches: Classification of Instrument as Debt or
Equity – Traditional Factors In Recent Case
• Scottish Power (NA General Partnership v. Commissioner, 2012) – simple picture
1
Scottish
Power
Loan Notes
and Shares
Shareholders
2
UK
Scottish Power
Shares
Scottish
Power
Shares
PacificCorp
Shares
NA GP
US
PacifiCorp
US
• Court upheld taxpayer’s position that the Loan Notes were debt for U.S. tax
purposes.
• Key factors (from 9th 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
11
capitalization of debt
U.S. Approaches: Classification of Instrument as Debt or
Equity – Scottish Power (fuller picture)
Glossary:
Entity Classification
US
Foreign
Corp
Corp
Pass thru Pass thru
“Hybrid” entity
“Reverse hybrid”
3/14/2016
Pass thru Corp
Corp
Pass thru
12
U.S. Approaches: Classification of Instrument as Debt or
Equity – Scottish Power (fuller picture)
Public
UK
UK
UK
[Newly formed]
ScottishPower plc
[Re-named]
Notes
ScottishPower UK plc
NA 1
NA 2
10%
90%
NA GP
US
US
ScottishPower
Acq. Co
PacificCorp
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
A Real Picture – From LuxLeaks
14
U.S. Approaches: Classification of Instrument as
Debt or Equity
How hard for planners to achieve desired classification
under factor test?
15
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
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
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
U.S. Approaches: Limitations Without Regard to
Debt Holder’s Tax Status
How hard for planners to avoid the interest limitations
just described?
19
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
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
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 taxexempt 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
Earnings Stripping: Case 1 - Related Party Debt
Public
Shareholders
ForCo
Contribute note
USCo distributes
note, taxable as
dividend to extent
of E&P, return of
basis then capital
gain.
USCo
Debt-equity test 
USCo assets
= $3B
USCo debt
= $2B
USCo equity
= $1B
3/14/2016
Swiss finance
finance Sub
Sub
Swiss
Note
interest
US Co ATI:
$150m
USCo net interest $100m
USCo DQI
$100m
$25m USCo interest suspended
23
Earnings Stripping: Case 2 - Guarantee
Public
Shareholders
ForCo
Loan guarantee
$2B loan
Bank
USCo
$100m interest
Debt-equity test 
USCo assets
= $3B
USCo debt
= $2B
USCo equity
= $1B
3/14/2016
US Co ATI:
$150m
USCo net interest $100m
USCo DQI
$100m
$25m USCo interest suspended
24
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
U.S. Approaches: Cross-Border Limitations to
Prevent Stripping of Corporate Tax Base
How hard for planners to avoid these limitations?
26
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
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
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
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
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
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.
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We Can Do Better
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