The Base Erosion and Profit Shifting Project Should Take Note of US Tax Laws
The following article, written by US Tax & Financial Services’ Darlene Hart and Jonathan Tiegerman was published in the Swiss Association of Independent Advisors’s WEALTHGRAM magazine this month.
Presently, multinational corporations and their tax advisors endure great anxieties stemming from the uncertainty surrounding the Base Erosion and Profit Shifting (“BEPS”) project. The BEPS project, which has been at the forefront of the international tax community, aims to facilitate the synchronization of domestic tax laws among participant countries although the final reports issued by the Organisation for Economic Co-operation and Development (“OECD”) will serve simply as recommendations. As its name suggests, BEPS evidences an aggressive push by the OECD to prevent multinational taxpayers from using interest expense deductions to reduce or “erode” income in high-tax jurisdictions (i.e., “base erosion”) and in so doing, move profits from high-tax jurisdictions to low-tax jurisdictions (i.e., “profit shifting”). With roughly sixty countries privy to the development of BEPS, the final package to be disbursed later this year to G-20 finance ministers would potentially impact many existing agreements involving market participants resident in different jurisdictions and organizations operating multinational supply chains.
One main point of action concerns the availability of a company`s interest deduction on cross-border lending arrangements. The OECD`s final report on Action 4 interest expense of BEPS is expected to recommend a fixed ratio approach: a company`s interest deduction is limited to an amount determined by applying a benchmark ratio to the company`s earnings, assets, or equity. A U.S. Treasury official was recently cited as describing the benchmark ratio to exist along a “corridor” of between 10 percent and 30 percent. During a meeting before the Swiss-American Chamber of Commerce on September 23, 2015, U.S. Treasury Deputy Assistant Secretary (International Tax Affairs), Robert Stack, described the final version of the BEPS Action 4 interest expense provision to recommend a limitation on interest expense exceeding 30 percent of earnings before interest, taxes, depreciation and amortization.
Although limiting excessive interest deductions and preservation of a country`s tax base have long been policy concerns of many countries, BEPS is the first instance in which widespread international cooperation has occurred to coordinate the development of domestic tax laws to impose limitations on base erosion through the use of interest deductions and other financial payments. As BEPS has matured within a short time frame, several organizations have been outspoken concerning the inordinate detrimental impact that BEPS will have on U.S. businesses. The Chair of the Business Roundtable Tax and Fiscal Policy Committee, Louis Chenevert, observed that “the Treasury must bear in mind that the U.S. tax system with its singularly high rate and worldwide system is badly out of line with international norms. Until [U.S.] reform occurs, however, measures aimed at restricting base erosion – e.g., limits on deductions or income inclusions – will have a disproportionate adverse impact on U.S.-based companies and U.S. operations.” In a recent letter to U.S. Treasury Secretary Jack Lew, Senate Finance Committee Chairman Orrin Hatch and House Ways and Means Committee Chairman Paul Ryan expressed particular concern related to BEPS Action 4: “interest-deductibility limitation proposals on the basis of questionable empirics and metrics.” While potential hardship may result for U.S. companies as a direct consequence of BEPS Action 4, the U.S. domestic tax law still bears its own inadequacies incident to the shortcomings of Section 163(j) (i.e., “earnings stripping” rules) to impose a sensible limitation on thinly capitalized U.S. corporations deductibility of outbound interest payments.
U.S. Limitation on Deduction for Interest on Certain Indebtedness
Since 1989, the United States has had in place its own limitation on interest deductibility in order to preserve the U.S. tax base from erosion. The earnings-stripping rules of Section 163(j) often apply to limit the deduction of interest by thinly capitalized U.S. corporations when U.S. corporate debt is financed by foreign related parties. Although the perceived abuse arises in part from an anticipated loss of U.S. tax revenue from thinly capitalized U.S. corporate borrowers, the former policy is supposedly served by activating Section 163(j) in the presence of a U.S. corporation having a debt-to-equity ratio merely exceeding 1.5-to-1 at the close of the year. See Green Bay Structural Steel, Inc. v. Commissioner, 53 T.C. 451 (1969) (debt to equity ratio of 5 to 1 was not inordinately high; not thinly capitalized); see also withdrawn Treas. Reg. §1.385-6(f)(3)(debt to equity ratio of 10 to 1 or less is not excessive). Upon exceeding the debt-to-equity threshold of Section 163(j), a U.S. corporation`s related party interest expense may be currently disallowed (i.e., suspended) to the extent the corporation`s net interest expense exceeds a limitation. This limitation is determined by taking the sum of (i) any unused excess Section 163(j) limitation available from the three previous tax years and (ii) 50 percent of the current year taxable income before taking into account net interest expense, net operating losses, the domestic production activities deduction, and any allowable depreciation, amortization or depletion deductions. Amounts of disallowed interest expense may be carried forward for use in subsequent tax years.
Meanwhile, the limitation on interest deductibility imposed by Section 163(j) may cease to apply if the lender should no longer remain to be a related person, for instance, upon the lender`s disposition of its shareholdings in the borrower. Thus U.S. earnings stripping rules would cause a non-U.S. shareholder of a U.S. corporation that has also loaned monies to the U.S. corporation to suffer a time-value-of-money cost (though not a permanent cash-cost) reflected in the value of the shares of the U.S. borrower. Disqualified interest deductions accruing on the loan from the non-U.S. shareholder, and subject to deferral under Section 163(j), would be liberated upon the non-U.S. shareholder`s disposition of its shareholdings in the U.S. borrower.
U.S. Corporate Debt and U.S. Corporate Tax Rates Leading up to Enactment of Section 163(j)
To fully appreciate the shortcomings of U.S. earnings stripping rules, one should consider the evolution of the capital structure which has occurred during the 20th century substantially influenced by changes in borrowing environments and market circumstances (e.g., about the time that Section 163(j) was enacted, the applicable federal rate for short term securities issued in August 1989 was 8.86%; presently, the applicable federal rate for short term securities issued during August 2015 is 0.48%). The enactment of Section 163(j) comes on the heels of a decade-long eruption of leveraged buyouts. These transactions in many instances involved domestic acquirers and were not driven with the same malus for U.S. tax avoidance as marked by modern day inversions. The Joint Committee in 1989 published statistics putatively demonstrating a rising trend of erosion of the U.S. tax base by virtue of several statistical metrics. The Joint Committee pointed to a six percentage point increase in the cash flow of non-financial corporations devoted to net interest payments during the period 1971 through 1985. See Tax Policy Aspects of Mergers and Acquisitions: Hearings Before the House Committee on Ways and Means, 101st Cong., 1st Sess., pt. 1, at 2 (1989). Also as support for its worries that excessive corporate debt posed a growing systemic risk in the market place, the Joint Committee observed that corporate debt as a percentage of gross national product rose in 1982 from 30.5 percent to 36.8 percent in 1987. See Misey, Jr., Robert J., “Unsatisfactory Response to the International Problem of Thin Capitalization: Can Regulations Save the Earnings Stripping Provision, An,” 8 Int`l Tax & Bus. Law. 171, 175 (1991). Although the debt-to-equity ratio of non-financial corporations according to GAAP value rose nearly 11 percentage points during the period 1976 to 1988, there was a countervailing 7 percentage point decrease in the debt-to-equity ratio of non-financial corporations when measured according to fair market value during the same period. See Staff of Joint Comm. on Judiciary, 101st Cong., 1st Sess., Federal Income Tax Aspects of Corporate Financial Structures 60-61 (Joint Comm. Print 1989).
Most significantly, the phenomenon unmentioned by the Joint Committee was the changing sectoral composition of the U.S. economy during relevant years. According to a study reviewing the history of corporate indebtedness in the U.S. as a component of U.S. companies` capital structures, during the latter half of the century aggregate assets held by unregulated U.S. industries boasting greater leverage ratios grew relative to the shrinking share of assets held by regulated industries, which tended to un-leverage over time. See Graham, John R. et al., “A Century of Capital Structure: The Leveraging of Corporate America,” (draft issued Dec. 7, 2012). Due to changes in the overall asset composition of the U.S. economy, aggregate leverage ratios increased over time. Thus, although Congressional xenophobia influenced the adoption of Section 163(j), the increased use of indebtedness by nonfinancial U.S. corporations may have simply been the outcome of the evolution of U.S. industries.
One may also be tempted to attribute the growing trend for non-financial U.S. corporations employing debt capital to the contemporaneously high U.S. corporate tax rates. Maximum U.S. corporate tax rates from 1920 until the late 1930s remained below 15 percent. However, war-time efforts seem to have significantly impacted U.S. corporate tax rates with the tax rate more than doubling between 1939 and 1942 to reach 40 percent. Beginning in 1952, the maximum U.S. corporate tax rate was 50 percent and remained thereabouts until 1987 when the maximum U.S. corporate tax rate regressed to 40 percent. In 1988, the maximum U.S. corporate tax rate fell to 34 percent and since 1993 has remained at 35 percent. According to a recent study sponsored by the National Bureau of Economic Research, the authors found that it is dubious whether tax rates are a significant driver of aggregate debt and whether tax rates influence issuance decisions in the aggregate. Id. at 26 (final version published June 27, 2014).
Shortcomings of Section 163(j) and Observations for BEPS Action 4
With Congress prescribing a debt-to-equity trigger which is far from exorbitant, it seems that preservation of the U.S. tax base was not the only contemporaneous motivation for limiting interest deductibility. Meanwhile, if a principal policy underlying Section 163(j) is to curb interest deductions claimed by thinly capitalized companies, given the low cost of debt capital in recent years, the fixed debt-to-equity ratio of 1.5-to-1 presently seems over-inclusive in that it limits the interest deductions of many U.S. corporations which according to industry lending standards would have sufficient equity capitalization and adequate cash flow to service their indebtedness. See also H.R. Conf. Rep. No. 386, 101st Cong., 1st Sess. 564-566 (1989) (In 1989, the earnings stripping bill proceeded through the legislative process, the Senate Finance Committee rejected the bill on the basis that the extant proposed legislation would disallow interest simply based on interest expense exceeding a percentage of adjusted taxable income. The Senate conferees thereafter accepted an amended provision inclusive of the 1.5-to-1 debt-to-equity trigger.).
For the month of July in 1989, the minimum interest rate prescribed by the IRS for a short-term arm`s length lending arrangement providing for annual compounding of interest was 8.86%. In contrast, in August 2015 the rate of interest applicable to the same short-term borrowing would require an arm`s length interest rate of merely 0.48%. Given the drastically lower costs associated with credit issued in the current economic environment, a borrower in present terms would certainly be able to service substantially more indebtedness as a component of its capital structure than would have been sustainable in 1989, given that the relevant applicable federal rate today is one-eighteenth of what it was in 1989. Holding all other variables constant, if a third-party lender was committed to lend capital at an interest rate of 0.48%, the borrower`s capital structure would undoubtedly be able to support substantially more debt capital than if the same borrower was required to pay an annual interest rate of 8.86% on the amount borrowed. Put another way, if the debt-to-equity ratio of 1.5-to-1 in 1989 appropriately measured the threshold for a sufficiently capitalized borrower when the minimum arm`s length borrowing rate was 8.86%, if Section 163(j) adjusted for current costs of borrowing in selecting only thinly capitalized corporations to impose a limitation on interest deductions, would a debt-to-equity ratio of 27.6-to-1 (i.e. (8.86%/0.48%)*(1.5/1)) more accurately reflect the threshold for a sufficiently capitalized U.S. borrower today? Thus, framing thin capitalization in terms of an archaic fixed-ratio adopted during vastly different credit market conditions makes little sense. If instead thin capitalization is no longer integral to the policy ends achieved by Section 163(j), then perhaps the employment of a debt-to-equity trigger is simply statutory dead wood
It is also worth noting that merely a few years earlier in 1980, the IRS issued proposed debt-equity regulations in which the IRS did not categorize a corporation`s debt-to-equity ratio of 10-to-1 as “excessive.” Although these proposed regulations were withdrawn in 1983, through this lens the 1.5-to-1 debt-to-equity threshold prescribed by Section 163(j) appears drastically modest. In support of this view, when measured according to book value, by 1990 the average debt-to-equity ratio of the members of the S&P 500 was well in excess of 1.5-to-1: Sam Ro, “The decline in S&P 500 leverage is unprecedented,” Business Insider UK (May 12, 2015). But see Jacob, “The 500 in the 80s,” Fortune, 340 (Apr. 23, 1990) (reporting that the 500 largest U.S. industrial corporations during 1989 had an average debt-to-equity ratio of 3.18 to 1.). Based on the earnings stripping provisions` debt-to-equity trigger, should we understand that the members of the Senate and Finance Committee who authored Section 163(j) viewed all the members of the S&P 500 as thinly capitalized?
Still, other countries have similarly enacted unimaginative thin capitalization provisions under their respective domestic tax laws. Canada imposes a thin capitalization limitation on the deductibility of interest accruing on indebtedness owed by a Canadian resident corporation to a foreign person owning 25 percent or more of the fair market value of the Canadian corporation`s outstanding shares if the Canadian corporation has a debt-to-equity ratio exceeding 1.5-to-1. Australia previously employed thin capitalization rules limiting an Australian resident`s deduction of interest if the Australian resident`s debt-to-equity ratio exceeded 3-to-1. However, effective 1 July 2014, the threshold debt-to-equity trigger was reduced to a ratio of 1.5-to-1. Indeed, numerous jurisdictions have employed limitations on interest deductibility using primitive fixed ratio mechanisms to activate the limitation.
Any progressive limitation on interest deductibility ultimately recommended by BEPS should take into consideration contemporaneous borrowing rates. A simple fixed-ratio based on debt-to-equity lacks sophistication and fails to reflect a borrower`s capacity to service the debt. Furthermore, this would not be an entirely novel concept within U.S. tax law, which already incorporates contemporaneous borrowing rates in statutory provisions including, for example, the limitation imposed on losses of corporations experiencing a change in control. One would expect that any competent provision rooted in limiting interest deductions of a borrower due to the premise that a borrower is thinly capitalized should reflect the viability of a borrower to make timely payments on its indebtedness. An evolved thin capitalization provision should incorporate an indexed-component which adjusts for contemporaneous borrowing rates. Otherwise, such provision would be ill-equipped to adapt to changing credit market conditions over time.
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