Of More Than Usual Interest: the Taxing Problem of Debt Principal
| Publication year | 2015 |
ABSTRACT
Leverage is an essential but often troubling component of the U.S. market. The financial crisis highlighted the risks and complexity of a leverage web that includes flesh-and-blood people from all walks of life and paper people from all corners of the business and investment world. In the tax area, the potentially problematic incentive effects of interest deductibility have long engaged a wide array of tax commentators and policymakers. While interest deductibility rightly receives widespread scrutiny, a more comprehensive approach to leverage is needed. This Article focuses on the surprisingly complicated tax treatment of cash (and cash equivalent) borrowings. This Article highlights that the current tax treatment of debt principal used to finance business and investment deductions yields favorable tax timing mismatches for taxpayers and thereby theoretically amplifies any distortions caused by the deductibility of debt interest.
The tax system's current approach to debt-financed tax benefits reflects reactive responses to particular forms of tax avoidance. The current system's reliance on a factor drawn from tax avoidance case law-likelihood of repayment-has led to an inherently flawed set of tax rules. For example, the at-risk rules identify nonrecourse debt as problematic and then impose timing limitations on tax benefits financed only with that debt type even though potential timing distortions are embedded in all cash borrowings. Thus, the at-risk rules treat nonrecourse debt as simultaneously bona fide and suspect, yet whether an agreement constitutes bona fide debt still must be determined using a facts-and-circumstances, case-by-case analysis. The resulting tax rules relating directly to debt principal are confusing and inconsistent. The rules also invite extensive tax planning, whether legitimate or avoidant.
The main tax problems relating to debt principal-the timing distortion and the possibility of sham debt-should be addressed as distinct issues with priority given to the timing issue. Giving renewed attention to resolving the timing distortion would facilitate a comprehensive approach to debt and would also have the likely side benefit of making sham debt less attractive. This Article examines multiple proposals for directly limiting timing benefits. Solving timing distortions for even simple cash debt is quite difficult. Thus, this Article details a more accurate, more complex reform avenue but also suggests a simpler, rougher justice one as well. The more complex approach rations the use of borrowed basis while the simpler approach utilizes a deferral charge. In addition, this Article briefly reviews (and rejects) two other possibilities-treating all debt as lacking basis and treating cash equivalent debt as income on receipt. If it is not currently possible to implement broader reform proposals, incremental reform that distinguishes more carefully between the underlying timing distortion and tax avoidance behavior could bring greater coherence to the taxing problem of debt principal.
CONTENTS
INTRODUCTION ....................................................................................... 35
I. THE MECHANICS OF BORROWING DEDUCTIONS ................................. 40
II. A TOUR OF THE AT-RISK RULES AND PASS-THROUGH ENTITY DEBT ................................................................................................................ 53
III. RATIONING BORROWED BASIS ......................................................... 66
1. Nonrecourse Debt Directly Owed by Individuals ....................... 70
2. Pass-Through Entities With Limited Liability ............................ 72
IV. ALTERNATIVE APPROACHES ............................................................ 77
CONCLUSION ........................................................................................... 83
INTRODUCTION
Leverage is an essential but often troubling component of the U.S. market.(fn1) The financial crisis highlighted the risks and complexity of a leverage web that includes flesh-and-blood people from all walks of life and paper people from all corners of the business and investment world.(fn2) The recent crisis will fuel economic, financial, and legal scholarship and debate for decades-perhaps centuries-to come.(fn3) In the tax area, a central concern has been whether the tax system improperly persuades taxpayers to take leveraged positions that they would not take in the absence of tax incentives.(fn4) To put it another way, the question is whether the tax system's treatment of leverage causes significant and problematic economic distortions.(fn5)
Much of the analysis of this question focuses on the tax treatment of the interest on debt.(fn6) Under current federal tax law, all or a portion of interest paid on debt used to finance investment assets, business operations, and home ownership is deductible.(fn7) The potentially problematic incentive effects of this deductibility have long engaged a wide array of tax commentators and policymakers.(fn8) For example, proposals regularly emerge suggesting the reduction or elimination of the deductibility of home mortgage interest.(fn9) Recently, the ability of U.S. corporations to deduct cross-border interest payments has drawn attention in the debate about corporate tax inversions.(fn10)
While interest deductibility rightly continues to receive widespread scrutiny, this Article highlights the need for a more comprehensive approach to leverage. The tax issues surrounding leverage are highly varied and complex with key decisional frameworks-such as which financial obligations should be treated the same as cash debt-remaining unresolved.(fn11) This Article focuses on just one aspect of the leverage web, but one that is foundational to crafting a more comprehensive tax approach: the surprisingly problematic tax treatment of simple cash borrowings.(fn12) If leverage is to be addressed in a principled way by the tax system, an obvious place to start is ensuring that cash (and cash equivalent) borrowings are treated accurately.
Under well-established tax authorities, taxpayers do not include borrowed cash in income; they generally are, however, still able immediately to use borrowed money to finance business or investment tax benefits.(fn13) In tax parlance, taxpayers receive basis when they borrow cash, and they are able immediately to use that basis to generate tax benefits.(fn14) This opens up avenues for significant time-value-of-money benefits and for tax avoidance.(fn15) Congress and the courts have acted to curtail obvious tax avoidance techniques that rely for power on pumped-up debt principal,(fn16) but taxpayers' basic ability to use borrowed money to fund deductible expenses or purchase depreciable assets remains largely intact. To borrow money from a banker, taxpayers must pay interest, but a taxpayer may, in effect, borrow deductions from the Treasury without making any interest-like remuneration to the government.(fn17)
This Article emphasizes that the current tax treatment of debt principal used to finance business and investment deductions continues to yield favorable tax timing mismatches for taxpayers and thereby theoretically amplifies any distortions caused by the deductibility of debt interest.(fn18) The ability, in effect, to borrow basis has also proven to be a temptation to taxpayers looking to accelerate deductions.(fn19) The tax system's approach to debt-financed deductions has been to deal reactively and in a piecemeal fashion to particular avoidant behavior.(fn20) Rather than deal directly with the timing benefits, tax statutes and regulations categorize debt according to likelihood of repayment and use the resulting categories to implement various restraints on taxpayer behavior.(fn21) This Article recommends a renewed focus on the underlying timing temptation to advance a more comprehensive, principled approach to borrowing deductions.(fn22) Resolving the timing temptation requires greater attention to the tax concept of basis and less to the likelihood of repayment-a nontax concept-in determining tax consequences.
The concept of likelihood of repayment in the tax system does, however, make sense when it is utilized as one factor for distinguishing bona fide cash (or cash equivalent) debt from sham debt.(fn23) Tax avoiders are likely inclined to limit economic risk and are thus more apt to use structures reducing their potential for true economic costs.(fn24) Congress seized on...
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