Should we end the tax deductibility of business interest payments?

Should we end the tax deductibility of business interest payments?

Excessive leverage is the juice that enables businesses to privatise gains and socialise losses, writes Victor Fleischer. Financing corporate activities with debt enhances investor returns when the company is profitable and increases the risk of bankruptcy in bad times. Corporate managers must therefore balance their desire to increase shareholders’ return against the risk of failure, which rises as the ratio of debt to equity increases.

The tax deduction for business interest puts a thumb on the scale, encouraging managers to borrow more than they otherwise would.

It is rarely smart to use tax policy to influence corporate decision-making, and in this case the deduction pushes executives in the wrong direction. Raising money through equity is less risky because a company can suspend dividend payments when things are tight. It cannot default on interest payments without courting insolvency. And when businesses go bust, shareholders and creditors are not the only ones who get hurt. Employees get axed. Suppliers and customers struggle. Taxpayers pay for bailouts.

Some debt on a balance sheet can be good. Private equity, which relies more heavily on debt than most public companies, illuminates the promise and peril of debt. PE owners use debt not only to magnify financial returns, but also to discipline management: mandatory interest payments force companies to streamline production, fire unneeded workers and reduce waste. When the approach works, struggling firms become more efficient. But private equity-owned businesses also face a higher risk of bankruptcy.

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For debt-financed investments, the effective tax rate is negative, which can encourage investment in wasteful projects

Yet tax codes persist in treating debt more favourably than equity, making interest tax deductible but not dividends. Nor do shareholders receive credit for corporate taxes paid. That means companies tend to use more debt than they would if debt and equity were treated the same way.

When companies are overleveraged, there is less equity to cushion the blow when business is bad. After the 2008 financial crisis, job losses were concentrated at highly leveraged firms. And today, corporate bankruptcies are stacking up despite the trillions of dollars that governments are dispersing in response to the coronavirus pandemic. Personal finance advisers recommend that individuals keep enough emergency funds on hand to cover three to six months of expenses. Imagine how much better off workers would be right now if companies followed that 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 deductions for depreciation on an accelerated basis. In some cases, they can immediately expense the entire purchase in full. This creates a timing advantage: deductions today, income from the investment later. For debt-financed investments, the effective tax rate is negative, which can encourage investment in wasteful projects.

Finally, debt is a basic building block of many tax avoidance strategies, such as the Savoy Hotel’s profit shifting out of the UK. Taking away the interest deduction would help protect the corporate tax base.

Abolishing the deduction for interest payments would be politically challenging and raise thorny technical questions about how to treat leases, licensing arrangements and some other contracts. But the US tax code already limits interest deductions under certain circumstances — the 2017 tax law expanded rules against “earnings stripping” to limit interest deductions to 30 per cent of adjusted taxable income. This provision is scheduled to sunset in 2022. The US Congress ought to strengthen these limitations instead.

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

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

One common argument against the deductibility of interest is that it provides incentives for businesses to incur debt. While excessive debt may make companies less robust, there are sound reasons why a business would be well-advised to employ prudent levels of debt.

Not only are debt repayments not subject to the rules which apply to returning capital to shareholders, but debt is often available at a lower cost of capital than equity — even without the tax deduction. Borrowing avoids diluting shares, allowing companies to use more equity to incentivise founders and management. Debt also allows businesses to spread the acquisition cost of long-term assets and businesses over their productive life.

Further, some analysts argue that debt is better than equity at ensuring that management deploy funds prudently.

Private equity industry data indicate that well-managed companies operate successfully with relatively high levels of debt. Companies which have been the subject of buyouts, which typically employ higher than average debt, have continued to grow in terms of investment, productivity and employment. Some studies suggest they are more resilient. In 2018, write-offs, where the company failed, made up only 1 per cent of buyout divestments by British PE firms.

If we want to level the playing field between debt and equity financing, perhaps the preferable way of doing this would be by changing the tax regime to be applicable to equity, making dividends tax deductible too.

It sets bad precedent, by making the tax system less transparent

Critics also argue that some companies use the deductibility of interest to avoid tax. However, there is already a suite of measures in place to mitigate this risk — in the UK, the deductibility of interest is restricted to 30 per cent of earnings before interest, tax, depreciation and amortisation. And in order to be deductible, the loan needs to be on arm’s length terms and at market rates.

It may also be argued that abolishing the deductibility of interest would increase the overall tax take. But corporate interest is usually taxable income for the lender. Even if abolishing deductibility would have a net positive effect on tax revenue, there are three strong policy arguments against this proposal:

Abolishing the deduction would increase companies’ costs just as they need additional resources to weather the coronavirus storm. This seems particularly unfair given that, in recent years, government policy worldwide has sought to stimulate economic growth by keeping interest rates low, encouraging investment through borrowing.

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

Even if we were trying to increase tax revenues or discourage debt, this is not the right way to do it. We would be departing from a longstanding and broadly accepted principle and dressing it up as a means of making businesses more resilient. It sets bad precedent, by making the tax system less transparent — the effective rate of tax goes up while the headline rate remains unaffected. Further, if the deduction were abolished, it would be grossly unfair and retrospective to apply this to existing debt; if it only applies to future debt, any increase in tax revenue would be slow to materialise.  

If excessive debt is a problem, abolishing the deductibility of interest is not the solution. Debt is an important tool for businesses and there are measures in place in the UK and now the US to address its misuse. The interest cost of such debt should be deductible.

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

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