Posted tagged ‘inflation’

It’s April 29th; Do You Know Where Your Euros Are?

April 29, 2010

By David Shakow and Jonathan Prokup

By now, most observers of, and participants in, the European economy are familiar with the drama playing out in Greece.  Swamped by large debts and a seemingly uncontrollable fiscal deficit, the Greek government is facing the possibility of defaulting on its sovereign debt obligations.  Even if Greece’s monetary partners (and the IMF) come to its rescue, questions will remain about the ability of the Greek government to reorganize its fiscal affairs to avoid a repeat of this scenario one, two, or more years in the future.

Adding a new wrinkle to this fiscal crisis is Greece’s inability to use monetary policy to resolve the problem.  Historically, nations faced with unmanageable sovereign debt have often simply printed more money, thereby creating inflation, which reduces the real value of the government’s typically fixed-rate debt.  As a member of the European Monetary Union, however, Greece does not have this option.  As a result, an increasing chorus of commentators and public officials have been asking whether Greece might be forced to take a “holiday” from the Monetary Union or, even worse, whether the “Greek Tragedy” presages the eventual collapse of the entire Monetary Union.   (For recent coverage of this possibility, see here.)

As a blawg dedicated to “tax talk for tax pros,” the situation naturally causes us to ask: what federal tax consequences would result if Greece took a “holiday” from the euro or if the monetary union itself were to dissolve.  Assuming that holders of euros received legacy currencies in exchange for their euros, would that exchange be a realization event under Code section 1001?  On a more limited basis, would the exchange give rise to currency exchange gain or loss under Code section 988?  Finally, if the qualified business unit (“QBU”) of a taxpayer were forced to switch its functional currency from the euro to a legacy currency, should that switch be considered a change in the taxpayer’s method of accounting for purposes of Code section 481?

Of course, the Treasury Department previously addressed these issues in 1998 and 2001 when it issued temporary and final regulations, respectively, regarding the transition from the various legacy currencies to the euro.  The regulations generally treated the conversion as a non-taxable event, deferring any gain that would otherwise have been recognized under section 988.  In the event that the euro were abandoned, should these rules simply be applied in reverse, allowing taxpayers to switch back to a legacy currency while deferring the recognition of any currency exchange gains or losses?

While we have not yet formed any opinions about the potential impact of these prospective events, we raise the question in the hopes of spurring discussion within the tax community.  We don’t know if our colleagues at the Treasury Department have given any consideration to this issue; but it seems to us that they probably should.  After all, a withdrawal of one or more members from the European Monetary Union, or a dissolution of the Monetary Union altogether, is not going to be as easily anticipated or as well planned as the its original formation.

<!–[if !mso]> <! st1\:*{behavior:url(#ieooui) } –> By now, most observers of, and participants in, the European economy are familiar with the drama playing out in Greece.  Swamped by large debts and a seemingly uncontrollable fiscal deficit, the Greek government is facing the possibility of defaulting on its sovereign debt obligations.  Even if Greece’s monetary partners come to its rescue, questions will remain as to the ability of the Greek government to reorganize its fiscal affairs to avoid a repeat of this scenario one, two, or more years in the future.  Further clouding Greece’s economic prospects is the increasing possibility that Greece might be forced to withdraw from the European monetary union or, even worse, that the entire monetary union itself might collapse.  (See ___________.)

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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