Posted tagged ‘deductions’

More on Wyden-Gregg’s Interest Disallowance Rule

April 28, 2010

By Jonathan Prokup and David Shakow

You might recall our prior post on the Wyden-Gregg tax reform proposal in which we discussed the proposed limitation on corporate interest deductions.  To summarize, the legislation would limit the deductibility of payments on corporate debt to the amount of the interest in excess of the annual rate of inflation, thereby discouraging the use debt to finance corporate operations.

We previously asked: “Why use inflation as the index for disallowing interest deductions, rather than simply disallowing, say, a fixed portion of the interest deduction?”  Thanks to the efforts of Greg Hillson, an enterprising 3L at UVA, we are now able to answer that question.  Mr. Hillson contacted an economist from the Senate Budget Committee who directed him to the 1984 Treasury proposal on which the interest-disallowance provision was based.  (You can find that proposal, and Treasury’s explanation, here.)  Fortunately, Treasury’s explanation of its original proposal gives a sensible explanation of why the portion of interest payments that is attributable to inflation should not be deductible.

As our readers know, neither the making of a loan nor the repayment of principal is generally considered to be a taxable event.  Generally, only the payment or receipt of interest on the loan is deductible or taxable, as the case may be (putting aside the satisfaction of a debt for less than the principal amount).

Yet, from an economic perspective, the payment of interest can actually represent, in part, the repayment of principal.  Consider that the nominal interest rate on a loan reflects a variety of components–e.g., a credit-risk component that compensates the lender for the risk that the loan might not be repaid, so that a less credit-worthy borrower pays a credit-risk premium relative to a more credit-worthy borrower.  Of primary importance here is the inflation component, which (to quote the 1984 Treasury explanation) “compensates the lender for the anticipated reduction in the real value of an obligation of a fixed dollar amount [due to inflation].”  Thus, “the inflation component of nominal interest payments is, in effect, a repayment of principal.”

Stated differently, there are two ways to account for the impact of inflation on the principal amount of a loan—(i) include an inflation component in the interest rate, or (ii) index the principal balance to inflation.  In theory, either mechanism should produce similar economic results of protecting the real value of the lender’s interest in the principal loaned to the borrower.  (Of course, in practice, the outcomes are much messier; but that is beyond the scope of this post.)  Thus, as noted above, the payment of the inflation component of interest is economically equivalent to the repayment of an inflated principal amount.

In sum, there is a principled basis for suggesting that the portion of interest payments that is attributable to inflation should be disallowed as a deduction.  Nevertheless, two further questions are raised:

(1)    By the same theory, recipients of interest (i.e., lenders) should be permitted to exclude from their gross income the same inflation component for which no deduction would be allowed to the payers of such interest (i.e., borrowers).  that was part of the 1984 Treasury proposal.  Query why it has been omitted from the Wyden-Gregg bill.

(2)    How should periods of deflation be handled?  If, during periods of inflation, interest deductions should be limited because the payment of interest reflects, in part, the repayment of principal; during periods of deflation, interest deductions should be extended above the amount of interest paid under the same reasoning.

The Wyden-Gregg Tax Reform Bill – Part I (cont’d)

March 8, 2010

By Jonathan Prokup and David Shakow

We previously discussed how the Wyden-Gregg bill proposes reducing interest deductions to the extent the interest simply compensates for inflation.  Inflation affects tax calculations in two ways.  First, it affects the dollar figures in the Code so that, for example, when your wages keep up with inflation, but you are pushed into a higher tax bracket, the resulting “bracket creep” is caused by inflation.  Second, when the value of your investment simply keeps pace with inflation and does no better, you still recognize a “gain” when you sell it.  Here, the measurement of real income has been distorted by inflation.

Many “bracket creep” issues are taken care of through section 1(f) of the Code, which adjusts dollar amounts in the Code to account for inflation.  But the Code has not generally corrected for the effects of inflation on the measurement of income.  A proposal made by the Treasury after the 1984 election would have broadly attacked the effects of inflation on income measurement.

To see an example illustrating the two ways inflation affects tax calculations as well as further discussion of the 1984 Treasury proposals, keep reading.

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Lee Sheppard Takes on Container Corp.

March 8, 2010

By Jonathan Prokup

In her column last Monday, Lee Sheppard criticized Judge Holmes of the Tax Court for, as she put it, “strain[ing] to find a reason to hold for the taxpayer” in the recent case of Container Corp. v. Comm’r, 134. T.C. No. 5.  (For our prior discussion of this case, see here.  For the text of the opinion, see here.)  According to Ms. Sheppard, Judge Holmes “appears to have assumed equitable powers in deciding” the case, and “the tax law is the worse for it.”

The basic issue in Container Corp. was whether guarantee fees paid by a U.S. corporation to its Mexican parent in respect of a debt guarantee provided by the parent should be treated as U.S.-source income (and therefore subject to withholding tax on payment to the Mexican parent).  Because the rules for sourcing income don’t address how guarantees are to be treated, the court framed its analysis as whether the guarantee fees were more like interest (which is sourced to the location of the borrower) or more like services (which are sourced to the location of the provider).

Ms. Sheppard excoriated Judge Holmes for even contemplating that a debt guarantee could be treated as a service.  To her, it “[s]ounds pretty obvious” that the parent corporation was simply protecting its investment in the subsidiary, not providing a service to the subsidiary.

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