Tax Blog/Blawg

Last Tuesday, Senators Ron Wyden (D-Ore.) and Judd Gregg (R-N.H.) released a proposed tax reform bill (the "Bipartisan Tax Fairness and Simplification Act of 2010") that has received substantial press coverage. For some initial reactions, see here, here, and here.  As much for the apparent bipartisanship of its origins, the bill has received attention for the boldness of its proposals.  Many commentators have likened the Wyden-Gregg alliance to the Reagan-Bradley pairing that ushered in the Tax Reform Act of 1986.  Like its nearly 25-year-old predecessor, the current proposal focuses generally (but not exclusively) on broadening the individual and corporate tax bases and lowering the statutory rates applicable to each group.

In this first analysis of the legislation, we focus on the legislation's targeting of debt-financing in the private sector.  Perhaps seeking to limit corporate (and especially banks') use of leverage, on which many place substantial blame for the recent financial crisis, the bill substantially reduces the attractiveness of debt as a financing vehicle by disallowing the portion of corporate interest deductions that is due to inflation.

Technically, the legislation would add to Code section 163 a new subsection (n) that would read:

‘‘(n) INDEXING CORPORATE INTEREST DEDUCTION FOR INFLATION.—

(1) IN GENERAL.—In the case of a corporation, the deduction allowed under this chapter for interest paid for any taxable year with respect to any obligation shall be adjusted by multiplying the amount otherwise so allowed by 1 minus the fractional exclusion rate for such taxable year.

(2) FRACTIONAL EXCLUSION RATE.—For any taxable year, the Secretary shall determine the fractional exclusion rate using—

(A) a fraction—

(i) the numerator of which is the cost-of-living adjustment determined under section 1(f)(3) for the calendar year in which the taxable year begins by substituting ‘the second preceding calendar year’ for ‘calendar year 1992’ in subparagraph (B) thereof, and

(ii) the denominator of which is the nominal interest rate for such obligation, and

(B) a constant real before tax rate of return of 6 percent.

In sum, then, the new section 163(n) would index corporate interest deductions for inflation by disallowing that portion of the interest being paid on corporate debt that is attributable to inflation.  So, if XYZ Corp issued $1,000,000 of 10-year bonds yielding 8 percent, and inflation for the year in question (measured by reference to the CPI) is 3 percent, then instead of being able to deduct interest of $80,000 per year, XYZ would instead be limited to a deduction of $80,000 * (1 - [3/8]) = $80,000 * 37-1/2% = $30,000.  By so limiting the deduction, debt would become a less attractive financing mechanism because the tax benefits of using debt would have decreased substantially.

Now, here at the TaxBlawg, we are generally agnostics about policy aspects of tax law.  Consequently, we will let others debate the propriety of eliminating (or at least reducing) the incentives for corporations to favor debt over equity in their financing decisions.

Yet, a few questions and initial reactions stand out:

(1)  If reducing the incentives to use debt is the goal, why exclude only a deduction for the portion attributable to inflation?  Perhaps the partial exclusion is intended to be a compromise that the private sector might find palatable.  Perhaps there is concern for companies who will need to refinance their debt in the near future and the higher interest rates they might face in replacing existing (and fully deductible) debt with new (only partially deductible) debt.

(2)  Why use inflation as the index for disallowing interest deductions, rather than simply disallowing, say, a fixed portion of the interest deduction?  The "disallowance index" (determined by reference to section 1(f)(3), as modified by the proposal) would change every year depending upon changes in the CPI.  As a result, if inflation were running at 4 percent at the time an 8 percent bond were issued, and five years later, inflation had increased to 8 percent per year, the corporation's entire deduction for interest on the bond would have been eliminated.  There may well be a policy-based reason for this outcome (e.g., in periods of high inflation, debtors get the benefit of repaying fixed debts in cheaper dollars, so perhaps they don't care as much about the tax deduction); but at first glance, it appears to simply be an arbitrary decision.

(3) Would passage of this measure simply encourage companies to use a greater amount of variable-rate instruments; and, if so, is that a healthy development to encourage?  For example, might we see companies issue more debt with yields of "the CPI plus __ basis points" (in effect, private sector TIPS)?  While we have no position about the likelihood or wisdom of that outcome, we take note of its possibility.