Should the tax deductibility of commercial interest be terminated?

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Yes – It increases the risk of bankruptcy in times of stress

Excessive leverage is the juice that allows companies to privatize gains and socialize losses, writes Victor Fleischer. Financing business operations through debt improves returns to investors when the business is profitable and increases the risk of bankruptcy in difficult times. Business leaders must therefore balance their desire to increase shareholder returns against the risk of failure, which increases with increasing debt-to-equity ratio.

The business interest tax deduction puts a thumbs down, encouraging executives to borrow more than they otherwise would.

It rarely makes sense to use tax policy to influence business decision-making, and in this case, the deduction pushes executives in the wrong direction. Raising money through equity is less risky because a business can withhold dividend payments when the going gets tough. He cannot default on interest payments without courting insolvency. And when companies go bankrupt, shareholders and creditors aren’t the only ones hurt. Employees are made redundant. Suppliers and customers are struggling. Taxpayers pay for bailouts.

Some debts on a balance sheet can be good. Private equity, which relies more on debt than most public enterprises, highlights the promises and dangers of debt. PE owners use debt not only to increase financial returns, but also to discipline management: mandatory interest payments force companies to rationalize production, lay off unnecessary workers, and reduce waste. When the approach works, struggling businesses become more efficient. But companies owned by private capital have also facing a higher risk of bankruptcy.

Yet tax codes persist in treating debt more favorably than equity, making interest tax deductible but not dividends. Shareholders also do not receive credit for corporate taxes paid. This means that companies tend to use more debt than they would if debt and equity were treated the same.

When companies are over-leveraged, there is less equity to cushion the blow when business is bad. After the 2008 financial crisis, job losses were concentrated in high leverage companies. And today, business bankruptcies are piling up despite the trillions of dollars governments are dispersing in response to the coronavirus pandemic. Personal finance advisers recommend that individuals keep enough emergency funds to cover three to six months of expenses. Imagine how much better off workers would be right now if companies followed this rule. Eliminating the corporate interest deduction would reduce the incentive to borrow excessively.

The business interest deduction also exacerbates other tax distortions. For example, the US tax code allows corporate taxpayers to reduce their effective tax rate on capital expenditures by taking depreciation allowances on an accelerated basis. In some cases, they can immediately charge the entire purchase. This creates a timing advantage: deductions today, investment income later. For debt-financed investments, the effective tax rate is negative, which may encourage investment in unnecessary projects.

Finally, debt is a basic element of many tax avoidance strategies, such as the Transferring the profits of the Savoy Hotel out of the UK. Removing the interest deduction would help protect the corporate tax base.

Abolishing the deduction for interest payments would be a political challenge and would raise thorny technical questions about how to deal with leases, license agreements and certain other contracts. But the US tax code already limits interest deductions in certain circumstances – the 2017 tax law extended the rules against “income stripping” to limit interest deductions to 30% of adjusted taxable income. This provision is expected to expire in 2022. The US Congress should instead strengthen these limitations.

The writer is professor of law at the University of California, Irvine

No – Tax must be paid on profits, not income

It is a fundamental principle in the UK, US and most other jurisdictions that businesses pay taxes on their profits, not their income, writes Jonathan blake. It follows that companies should be able to subtract legitimate expenses when calculating their taxable profits. The deductibility of personnel, rental or inventory costs is not controversial – why should interest costs be any different?

A common argument against interest deductibility is that it encourages companies to go into debt. While over-indebtedness can make businesses less solid, there are good reasons why a business would be well advised to resort to prudent debt levels.

Not only is the debt repayment not subject to the rules that apply to the repayment of capital to shareholders, but the debt is often available at a lower cost of capital than equity, even without tax deductions. The loan avoids diluting stocks, allowing companies to use more equity to incent founders and management. Debt also allows companies to spread the cost of acquiring long-term assets and companies over their productive lifespan.

Line graph of actual quarterly dividend payouts by the S&P 500 (billion dollars) showing that U.S. dividends have increased in recent decades

In addition, some analysts Argue that debt is better than equity to ensure that management deploys funds prudently.

Private Equity Industry Data indicate that well-run businesses operate successfully with relatively high debt levels. Firms that have been taken over, which typically incur more than average debt, continued to grow in terms of investment, productivity and employment. Some studies suggest that they are more resistant. In 2018, write-offs, where the company went bankrupt, was only 1 percent UK private equity buyouts.

If we want Level the playing field between debt financing and equity financing, perhaps the best way to achieve this would be to change the tax system so that it applies to equity, making dividends also tax deductible.

Critics also argue that some companies use interest deductibility to avoid tax. However, there are already a series of measures to mitigate this risk – in the UK interest deductibility is limit at 30 percent of earnings before interest, taxes, depreciation and amortization. And to be deductible, the loan must be at arm’s length and at market rates.

It can also be argued that removing interest deductibility would increase the overall tax levy. But corporate interest is generally taxable income for the lender. Even though abolishing deductibility would have a net positive effect on tax revenue, there are three strong political arguments against this proposal:

Removing the deduction would increase costs for businesses just as they need additional resources to weather the coronavirus storm. This seems particularly unfair given that, in recent years, global government policy has sought to stimulate economic growth by maintaining low interest rate, encouraging investment through borrowing.

Making this change will make the UK, or any other country that takes this path, an outlier in terms of global tax policy, introducing uncertainty and instability, which could significantly diminish its appeal as a investment destination.

Even if we were to try to increase tax revenues or to discourage debt, this is not the right way to do it. We would depart from a long-standing and widely accepted principle and present it as a way to make businesses more resilient. This sets a bad precedent, by making the tax system less transparent – the effective tax rate increases while the overall rate remains unchanged. Further, if the deduction were removed, it would be manifestly unfair and retrospective to apply it to existing debt; if it applied only to future debt, any increase in tax revenue would be slow to materialize.

If over-indebtedness is a problem, removing interest deductibility is not the solution. Debt is an important tool for business and measures are in place in the UK and now in the US to combat its misuse. Interest charges on such debt should be deductible.

The writer heads the international private funds strategy at Herbert Smith Freehills. HSF’s Stephen Newby and Shantanu Naravane also contributed to this article

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Letter in response to this article:

When lender and equity provider are the same / By Lord Leigh of Hurley, London W1, UK

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