ACT Tax Fact: Interest Deductions and Tax Reform
The Administration and Congressional Leaders have emphasized that achieving a higher rate of U.S. economic growth is of paramount importance for tax reform. The potential for higher economic growth will be realized if the United States becomes a more attractive location for investment, and this will require reforming our corporate tax rules that are now far outside international norms.
Based on international norms, a competitive corporate income tax would include a top federal corporate rate not in excess of 20 percent, a modern territorial tax system that does not tax active business income earned abroad by foreign subsidiaries of U.S. companies, and tax incentives for research and experimentation. The Unified Tax Reform Framework specifically calls for a 20-percent corporate rate, exemption of dividends from foreign affiliates, and preservation of the credit for research and experimentation.
The Framework also includes: “Broadening the tax base … by closing special interest tax breaks and loopholes.” To assure that tax reform enhances U.S. competitiveness as an investment location, the tax base should be defined in a manner that is competitive with other “best in class” OECD countries and should avoid giving rise to permanent book-tax differences relative to generally accepted accounting principles (GAAP).
A number of countries have broadened their corporate tax bases by adopting thin capitalization (“thin cap”) rules that limit excessive net interest expense, rather than imposing an across-the-board disallowance (“haircut”) for interest deductions. Under an EU tax directive, all EU member states are required to adopt thin cap rules that limit net interest expense (i.e., interest expense in excess of interest income) to no more than 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA) by January 1, 2019, consistent with the OECD/G20 Base Erosion and Profit Shifting (BEPS) Action 4 report.
While an interest expense deduction limitation is inconsistent with the measurement of income under GAAP, a limitation that permits disallowed interest expense to be carried forward indefinitely would in most cases avoid creating a permanent book-tax difference. Section 163(j), the proposed rules in H.R. 1, and the existing thin cap provisions in Germany, Italy, and the UK all permit carryforward of excess interest indefinitely. In addition, section 163(j) and the thin cap provisions in German, Italy, and the UK permit excess limitation to be carried forward for a period of time (3 years in sec. 163(j), 5 years in Germany and the UK, and indefinitely in Italy).
Carryforwards of excess interest expense and excess limitation also are important to address the concern that thin cap rules can disallow interest deductions for companies that do not have high debt-to-equity ratios, but temporarily have low earnings (or losses) due to cyclical business conditions. For similar reasons, Congress provides carrybacks and carryforwards for net operating losses and credits.
To be consistent with international practice, a thin cap rule should not limit the deduction for net interest expense to less than 30 percent of EBITDA. Even at a 30-percent of EBITDA limitation, some industries may routinely lose interest deductions due to business models that support high debt-to-equity ratios, such as utilities. For this reason, the EU thin cap directive and the BEPS Action 4 report allow countries to adopt worldwide ratio tests that permit deduction of net interest expense in excess of 30 percent of EBITDA provided that domestic debt is not disproportionate to worldwide debt. The thin cap rule in H.R. 1 and the German thin cap rule have worldwide tests based on equity-to-asset ratios, while the UK has a worldwide test based on the ratio of net interest to EBITDA.