Limiting Interest Deductions

Published by Michael Novogradac on Friday, May 18, 2012 - 12:00am

As momentum grows for tax reform, specific proposals are also gaining steam. One of these is the proposal to limit individuals’ and businesses’ ability to deduct interest expense.

For example:

  • Last year Ways and Means Chairman Dave Camp and Senate Finance Committee Chairman Max Baucus held a joint hearing on tax reform that focused specifically on the tax treatment of debt and equity.
  • Sens. Ron Wyden, D-Ore., and Dan Coats, R-Ind., introduced a tax reform bill that includes a proposal to prevent businesses from receiving a deduction for the portion of interest expense that reflects inflation. In a March 15 Business article Sen. Wyden suggested that eliminating this so-called automatic escalator for debt “strikes a good balance.”
  • The Obama Administration’s Framework for Business Tax Reform also suggests reducing the bias toward debt financing by reducing the deductibility of interest for corporations. The framework says “reducing the deductibility of interest for corporations could finance lower tax rates and do more to encourage investment in the United States than keeping rates higher or paying for the rate reductions in other ways.”

At the individual level:

What This Could Mean for Tax Credits

As a tax reform advances, revenue generated through limiting interest expense deductions could allow lawmakers to lower the corporate tax rate without eliminating other tax expenditures, such as the low-income housing tax credit, new markets tax credit, historic preservation tax credit or renewable energy tax credits.

Opponents of the proposal warn that changing the tax treatment of debt will make structuring profitable transactions more difficult for businesses that rely on the tax deductibility of interest. On the other hand, it’s possible that reducing businesses demand for debt could help keep interest rates lower on Treasury debt. 

Limiting the deduction of interest expense would likely lead many corporations to increase the percentage of their activities financed by equity as opposed to debt. A shift to more equity and less debt would reduce business leverage ratios, meaning companies would be in a better position to survive economic downturns.

Because of the deduction’s popularity with private equity firms, any limitation or elimination will likely face an uphill battle in Congress. But as pressure builds to find ways lower the corporate tax rate without expanding the federal budget deficit, that hill might become a little less steep.