JCX-41-11, Present Law And Background Relating To Tax Treatment Of Business Debt
Due to growing concern about the level of corporate debt (along with household and Federal debt), the Joint Committee on Taxation (JCT) has released a report on the Federal tax rules on the use of debt leverage by businesses in the U.S. From '87 to 2010, corporate debt, as a percentage of gross national product (GNP), has risen from 42.8% to 48.3%, a significant increase (although less dramatic than the 57.9% to 90.2% increase in household debt and the 41% to 63.2% increase in Federal debt).
Background on issuer treatment of debt and equity. In general, interest paid or accrued by a business is deductible under Code Sec. 163(a), subject to a number of limitations. Interest generally is deducted as it is paid or accrues. But, original issue discount (OID) interest (where the amount to be paid at the maturity of a debt instrument exceeds the issue price by more than a de minimis amount) is deducted in advance of actual payment or other accrual under the terms of the instrument. (Code Sec. 163(e))
Dividends or other returns on equity aren't deductible. The issuance of a debt or equity instrument for cash is not a taxable event to the issuer. Purchased assets generally have a cost basis for purposes of determining deprecation or gain or loss on sale, regardless of whether the purchase was financed with debt (including nonrecourse debt) or equity. If dividends are not paid on equity, or the capital contributed by an equity holder isn't returned, there is generally no taxable income, gain, or other consequence to the issuer.
If debt is cancelled, modified, or repurchased, the borrower generally realizes income from the discharge of indebtedness. Exceptions to this income inclusion are provided for bankruptcy and insolvency, other situations including seller financing of purchased property, qualified farm indebtedness, qualified real property business indebtedness, and contributions of debt by an equity holder. The exceptions usually require the taxpayer to reduce the basis of property, or to reduce tax attributes such as net operating losses. A significant modification of a debt instrument is treated as the disposition of the old instrument in exchange for the new instrument.
If nonrecourse debt is satisfied by foreclosure on the assets securing the debt, the borrower generally realizes gain from the disposition of the assets for the amount of the debt (even if the assets are not worth that amount).
Background on holder treatment of debt and equity. Interest on debt is taxed to a taxable individual or corporate holder at the ordinary income tax rate of the holder (currently, up to 35%). Dividends paid by a taxable C corporation are generally taxed to an individual shareholder at a maximum rate of 15%. Dividends are generally taxed to a C corporation shareholder at a maximum rate of 10.5% (or less, depending on the percentage ownership the corporate shareholder has in the issuing corporation). Gain on the sale of an equity interest in a C corporation or in an S corporation is generally capital gain. If the stock has been held for at least one year, such gain is generally taxable to an individual shareholder at a maximum rate of 15%. Gain on the sale of C corporation stock is taxed to a corporate shareholder at regular corporate rates (generally 35%). Gain on the sale of an equity interest in a partnership is also generally capital gain of the partner, except for amounts attributable to unrealized receivables and inventory items of the partnership, which are taxable as ordinary income. Interest is generally taxable when paid or accrued.
Interest is generally includable in income and taxable before any cash payment if the OID rules apply. Dividends are generally not taxable until paid. However, in limited circumstances, certain preferred stock dividends may be accrued under rules similar to the rules for debt. A shareholder may also be treated as having received a dividend if his percentage of stock ownership increases as a result of the payment of dividends to other shareholders.
A tax-exempt investor is generally not taxed on investment interest, subject to certain unrelated business income tax rules for debt-financed income. Although U.S.-source interest paid to a foreign investor is generally subject to a 30% withholding tax, various exceptions exist in the Code and in Treaties.
JCT's analysis. The JCT Report concludes that the Federal income tax treatment of debt and equity creates incentives to utilize one or the other depending on the tax characteristics of the issuer and of the particular investor. Taxpayers have considerable flexibility to design instruments treated as either debt or equity but which blend features traditionally associated with both. In general, a corporate issuer isn't subject to corporate tax on amounts that it deducts as interest on debt. On the other hand, dividends, which aren't deductible by the payor, come out of the corporation's after-tax income.
Debt instruments can allow the accrual of the interest deduction along with the inclusion in income by the holder at a time before the payment of cash. Interest income may be taxed at a higher rate to a taxable holder than the holder's dividends or capital gains attributable to corporate retained earnings (to which lower tax rates currently apply). While some forms of debt investments aren't subject to U.S. tax or are taxed at reduced rates in the hands of a tax-exempt or foreign investor—resulting in tax arbitrage that can shelter otherwise taxable income—special rules in the Code apply in these situations to limit interest deductions.
In some situations, businesses may have an incentive to borrow. Debt allows owners of business or investment assets to extract cash or obtain a higher basis in the leveraged asset without an additional equity investment. For example, a higher basis in a leveraged asset that is depreciable can increase depreciation deductions.
The discharge or restructuring of debt in the event of financial difficulty can cause the issuer to recognize discharge of indebtedness income or gain with respect to the satisfaction of nonrecourse indebtedness for less than the outstanding amount. The income tax treatment of debt discharge depends on whether the debt is recourse or nonrecourse, the nature of the borrower's assets and of the borrowing, and the circumstances of the restructuring or discharge. In a number of instances, no current income is recognized, though tax attributes such as net operating losses, credits, or the basis of assets may be reduced. On the other hand, the failure to pay dividends or return an equity investment in full doesn't cause income or gain to be recognized by the issuer.
The tax law generally contains no fixed definition of debt or equity. In classifying an instrument as debt or equity, the courts have applied many factors. In general, a debt instrument requires a fixed obligation to pay a certain amount at a specified date. Debt instruments provide for remedies including priorities in bankruptcy in the event of default. Conversely, an instrument designated and respected as equity for tax purposes may have features that are more economically burdensome to the issuer.
Equity can be beneficial for tax purposes in certain cases. Although corporate distributions and sales of corporate stock subject the holder to tax in addition to any tax paid by the corporation, reduced tax rates apply to holders with respect to such distributions or gain. Dividends on corporate equity are largely excludable by corporate holders (currently resulting in a maximum 10.5% tax rate under the 70% dividends received deduction). For individual shareholders, both dividends and capital gains on the sale of corporate stock are generally subject to a maximum 15% rate (compared to the top individual rate of 35%).
Different treatment of an instrument for purposes of financial reporting, for regulatory capital purposes in a regulated industry (such as an insurance or banking), for ratings agency purposes, and under foreign tax and nontax laws, may result in more favorable overall business treatment when combined with the benefits of debt or equity for Federal income tax purposes.
References: For interest deduction, see FTC 2d/FIN ¶K-5060 et seq.; United States Tax Reporter ¶1634; TaxDesk ¶311,502; TG ¶18251.