Further Limit the Deduction of Interest Expense for Multinational Corporations

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

Billions of Dollars 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 2.6 5.2 5.7 6.3 7.1 7.7 8.0 8.1 8.5 9.0 26.9 68.2

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

Interest payments on business loans are generally tax deductible. A consequence of that deductibility is that a multinational corporation can lower its corporate tax payments by having an affiliate in a country with a lower tax rate make a loan to a U.S.-based affiliate. Because the deduction for the interest payment is taken in the United States and the income from the interest payment is taxed by a country with a lower tax rate, income is shifted from the United States to a lower-tax country and overall tax payments are reduced. For multinationals incorporated in the United States, the ability to lower tax payments through interest payments is significantly limited because interest payments received by their low-tax foreign subsidiaries are generally taxed at the full U.S. statutory corporate tax rate in the year in which the payments are made. However, for multinationals incorporated outside of the United States, such payments are not taxed by the United States. For those foreign multinationals, opportunities to lower tax payments through interest are limited only by restrictions on the deduction of interest expense.

The existing restriction on a U.S. company’s deduction of interest expense is based on the earnings of the U.S. company and its relation to the companies to which it pays interest. The limit applies mainly to interest paid to a company that is both a “related party” and either entirely or partially exempt from U.S. taxation. (Examples of related parties to whom those rules might apply are a foreign company that owns a U.S. company or other foreign companies that are in the same foreign multinational group as a U.S. company.) Specifically, if the U.S. company’s debt-to-equity ratio exceeds 1.5 to 1 and its total net interest expense (the amount of interest paid minus the amount of interest received) exceeds 50 percent of its adjusted taxable income, then any portion of the interest expense above the 50-percent limit that is paid to the types of related companies described above cannot be deducted. A company can “carry forward” (use to reduce its tax liability in a future year) disallowed interest expense indefinitely and then deduct that interest expense from taxable income in that future year. Additionally, if a company’s net interest expense is below the allowable level, the company can carry forward its “excess limitation”—the gap between the company’s level of net interest expense and the allowable level in a given year—and use it to increase the allowable level of interest expense in any of the next three years.

Information about a company’s loans and obligations can be obtained from two main sources: tax returns, which are submitted to tax authorities and are based on tax-accounting methods; and financial statements, which provide information on the company’s financial position and are based on accepted financial-accounting methods. Differences in financial- and tax-accounting methods mean that the values reported in financial reports may differ from the values reported on tax returns. Tax returns do not necessarily include information on the other companies that are part of the multinational group, but consolidated financial statements—which combine the financial statements of a parent company and separate legal companies that are owned by that parent company—do. Consolidated financial statements are usually available for any U.S. company that controls (owns the majority of outstanding common stock) or is controlled by another company. Those consolidated financial statements contain the information needed to compare the U.S. company’s net interest expense with the overall level of net interest expense reported by its multinational group.

Under this option, a U.S. company’s allowable deduction of net interest expense would be determined on the basis of the net interest expense reported by the company’s multinational group. Specifically, the limit would be based on the overall level of net interest expense reported in the consolidated financial statement of the U.S. company’s multinational group. The deduction for net interest expense would be limited if the U.S. company’s net interest expense for financial reporting purposes exceeded the U.S. company’s proportionate share of the group’s net interest expense. The proportionate share—which could take a value from zero to 100 percent—would be equal to the U.S. member’s share of the group’s earnings before net interest expense, taxes, depreciation, and amortization were taken into account. If there are differences between the interest expense reported for financial purposes and expense reported in tax filings, then the proportion of the deduction for net interest expense that would be disallowed for tax purposes would be equal to the proportion by which the net interest expense for financial reporting purposes exceeded the allowable level. The U.S. company would have the choice of using that group-level approach or instead limiting its deduction of net interest expense to 10 percent of its adjusted taxable income. Carry-forward rules would match those in place under current law. U.S. companies that are not part of a financial reporting group would continue to face the limitations on the deduction of net interest expenses that are currently in place. The option would not apply to financial services companies or to financial reporting groups with a net interest expense of less than $5 million. The option would increase revenues by a total of $68 billion from 2017 through 2026, the staff of the Joint Committee on Taxation estimates.

The main argument in favor of this option is that it would reduce the tax advantages associated with foreign incorporation by limiting the ability of foreign-owned multinationals to move income out of the United States to lower-tax jurisdictions. Moving to a group-level standard would mean that the interest expense of the group’s U.S. affiliate would have to be proportionate to the group’s overall level of interest expense. That would prevent foreign multinationals from using loans between affiliates in lower-tax countries and their U.S. affiliates to place a disproportionate amount of debt in those U.S. affiliates, thus reducing income shifting. By lowering the benefit of foreign incorporation, the incentive for U.S. multinationals to change their country of incorporation through mergers (including corporate inversions) would be reduced.

The main argument against this option is that it could result in the denial of tax deductions for normal interest expenses. That would result in U.S. companies’ being unable to deduct standard business expenses. Although the option would probably be more effective at targeting excessive interest than a fixed standard, there could still be operational reasons that a U.S. group member would be more leveraged than the rest of its financial reporting group. To the extent that the disallowance increased the cost of attaining funds for the U.S. group member, the limit on the interest expense deduction would decrease investment in the United States.