Of More than Usual Interest: The Taxing Problem of Debt Principal
51 Pages Posted: 3 Jul 2015 Last revised: 12 Feb 2016
Date Written: June 15, 2015
Leverage is an essential but often troubling component of the U.S. market. In the tax area, the potentially problematic incentive effects of interest deductibility have long engaged a wide array of tax commentators and policymakers. While interest deductibility rightly receives widespread scrutiny, a more comprehensive approach to leverage is needed. This Article focuses on the surprisingly complicated tax treatment of cash (and cash equivalent) borrowings. This Article highlights that using debt principal to finance business and investment tax benefits yields favorable tax timing mismatches for taxpayers and thereby theoretically amplifies any distortions caused by the deductibility of debt interest.
The tax system’s current approach to debt-financed tax benefits reflects reactive responses to particular forms of tax avoidance. The current system’s reliance on a factor drawn from tax avoidance case law — likelihood of repayment — has led to an inherently flawed set of tax rules. For example, the at-risk rules identify nonrecourse debt as problematic and then impose timing limitations on tax benefits financed only with that debt type even though potential timing distortions are embedded in all cash-equivalent borrowings. Thus, the at-risk rules treat nonrecourse debt as simultaneously bona fide and suspect; whether an agreement constitutes bona fide debt still must be determined using facts-and-circumstances, case-by-case analysis. The resulting tax rules are confusing and inconsistent. The rules also invite extensive tax planning. The main tax problems relating to debt principal — the timing distortion and the possibility of sham debt — should be addressed as distinct issues with priority given to resolving the timing issue. Giving renewed attention to addressing the timing distortion would facilitate a comprehensive approach to debt and would also have the likely side benefit of making debt-related tax avoidance less attractive. This Article examines multiple proposals for directly limiting timing benefits. Solving timing distortions for even simple cash debt is quite difficult. Thus, this Article details a more accurate, more complex reform avenue but also suggests a simpler, rougher justice one as well. The more complex approach rations the use of borrowed basis while the simpler approach utilizes a deferral charge. In addition, this Article briefly reviews (and rejects) two other possibilities — treating all debt as lacking basis and treating cash borrowings as income on receipt. If it is not currently possible to implement broader reforms proposals, incremental reform that distinguishes more carefully between the underlying timing distortion and tax avoidance behavior could bring greater coherence to the taxing problem of debt principal.
Keywords: income tax, debt
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