JCT examines debt and equity, including some of the tax incentives each provides
JCT examines debt and equity, including some of the tax incentives each provides
May 24, 2016
The Joint Committee on Taxation (JCT) has provided an overview of Federal income tax rules relating to debt and equity and some of the tax incentives each provides (JCX-45-16). The report was prepared for a hearing by the Senate Committee on Finance scheduled for May 24, 2016, titled “Debt and Equity: Corporate Integration Considerations.”
Background on debt and equity: issuer. The issuance of a debt or equity instrument for cash isn’t a taxable event to the issuer. Under Code Sec. 163(a), interest paid or accrued by a business is generally deductible, subject to a number of limitations; on the other hand, dividends or other returns to equity generally aren’t deductible. Interest is deducted as it is paid or accrued, depending on the taxpayer’s accounting method. Payments of principal on business debt generally aren’t deductible. The return of capital to investors in an equity investment likewise is not deductible.
Under Code Sec. 163(e), if an obligation is issued with original issue discount (OID), a deduction for interest is allowable over the life of the obligation based on a yield to maturity basis. OID arises where the amount to be paid at maturity exceeds the issue price by more than a de minimis amount.
If debt is cancelled, modified, or repurchased, the borrower generally realizes income from the discharge of indebtedness. There are exceptions to this rule for bankruptcy and insolvency, for other situations including seller financing of purchased property, qualified farm indebtedness, qualified real property business indebtedness, and contributions of debt by an equity holder. Under the exceptions, the taxpayer is usually required to reduce tax attributes (e.g., net operating losses) or to reduce the basis of property. 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 aren’t worth that amount).
Except for certain unreasonably accumulated income (the Code Sec. 531 accumulated earnings tax) and certain undistributed income of a closely-held corporation whose income is largely passive (the Code Sec. 541 personal holding company tax), there is generally no taxable income, gain, or other consequence to the issuer if dividends aren’t paid on equity, or the capital contributed by an equity holder isn’t returned.
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.
Background on debt and equity: holder. Interest on debt is taxed to a taxable individual or corporate holder at the ordinary income tax rate of the holder (currently, up to 39.6% for an individual, and up to 35% for a corporation). Dividends paid by a taxable C corporation are generally taxed to a taxable individual shareholder at a maximum rate of 20%. Such 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 (generally taxed at a maximum rate of 20%). Gain on the sale of C corporation stock is taxed to a corporate shareholder at regular corporate rates (generally 35%). Under Code Sec. 751, gain on the sale of an equity interest in a partnership is generally also capital gain of the partner, except for unrealized receivables and inventory items, which are taxable as ordinary income.
Under Code Sec. 1411, an additional tax is imposed on net investment income in the case of an individual, estate, or trust. For an individual, the tax is 3.8% of the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount.
Interest is generally taxable when received or accrued. If the OID rules apply, interest is generally includable in income, and thus taxable, before any cash payment is received. Dividends generally aren’t taxable until actually or constructively received.
Subject to the unrelated business income tax (UBIT) rules for debt-financed income, a tax-exempt investor generally isn’t taxed on investment interest.
A foreign equity investor’s receipt of U.S.-source dividend income from a U.S. domestic corporation is generally subject to a 30% gross basis withholding tax. Dividend income is generally sourced by reference to the payor’s place of incorporation such that dividends paid by a domestic corporation are generally treated as entirely U.S.-source income.
A taxable holder of either debt or equity held as an investment generally recognizes a capital loss if the instrument is sold to an unrelated party at a loss.
Nonrecognition provisions apply to certain corporate acquisitions and dispositions, generally so long as only equity interests are received or any securities received don’t exceed the amount surrendered. Similarly, certain contributions and distributions of property to and from partnerships can be made without tax if made with respect to an equity interest.
JCT’s Report. The JCT Report notes that, besides the business reasons enterprises and their investors have to structure capital investment as either debt or equity (e.g., varying levels of risk, priority in bankruptcy, control and degrees of participation in profitability or growth), the differences in the Federal income tax treatment of debt and equity create incentives to use one or the other depending on the tax characteristics of the issuer and of the particular investor.
In general, a corporate issuer is not subject to corporate tax on amounts that it deducts as interest on debt. By contrast, dividends, which are generally not deductible by the payor, come out of after-tax income of the corporation. This tax distinction is particularly important to C corporations because such entities are taxed at the entity level. For a C corporation, the after-tax effect of debt financing is more favorable than equity financing because of the deductibility of interest.
The effect of using debt rather than equity to capitalize a corporation means that a corporation may increase its after-tax earnings per share simply by substituting debt for equity capitalization. The accounting effect of allocating all after-tax earnings to a smaller pool of equity shares than before the transaction is magnified for a corporate issuer because the interest deduction from the substitution of debt for equity itself increases after-tax earnings. A common transaction in which this occurs is a leveraged buyout, which is an acquisition of corporate stock using debt imposed at the corporate level to provide the cash to buy out the former shareholders. Another common transaction is a corporation’s redemption of its own stock with cash from the proceeds of a corporate borrowing (without any acquisition of corporate stock by an unrelated firm or its shareholders), or other corporate distributions to shareholders financed through corporate borrowing.
A taxpayer may have an incentive to incur debt so that deductible interest expense, in combination with other deductions such as depreciation or amortization, may shelter or offset the taxpayer’s income. For example, if the purchase of depreciable assets is debt financed, the taxpayer may be able to acquire more assets than without incurring debt. The tax impact of leveraging the acquisition of depreciable or amortizable assets may result in a greater amount of deductible depreciation or amortization, as well as deductible interest expense, for the taxpayer.
Negative effective tax rates may result from the use of debt by a domestic corporation to finance a foreign acquisition. A domestic corporation may incur interest expense that is related to income eligible for deferral. While Code Sec. 864 provides detailed rules for the allocation of expenses between U.S.-source and foreign-source income, these rules don’t affect the timing of the expense deduction; rather, for a domestic corporation, they apply principally for purposes of determining the foreign tax credit limitation. Thus, a domestic corporation may claim a current deduction, even for expenses that it incurs to produce tax-deferred income through a foreign subsidiary. By reducing the amount of tax imposed on currently taxable income, these interest expense deductions enhance the benefits of the existing deferral regime by yielding low, and in some cases negative, effective tax rates on that income.
Debt instruments can permit 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 (to which lower tax rates currently apply). However, 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. There are a number of special rules in the Code that are designed to protect the corporate tax base by limiting the tax benefits that can be obtained from interest deductions. Tax-exempt or foreign holders that do not pay tax on interest income are indifferent to the consequence of including interest income for tax purposes prior to the receipt of cash. As in the case of any other interest payments to tax indifferent parties, the issuer deducts the interest expense and no tax is imposed on the holder. The value of the deduction is increased to the extent it is allowed before payment.
To the extent that debt finances assets that produce tax-exempt or otherwise tax-favored income, the interest deduction is available to offset other income taxed at higher rates. The resulting tax arbitrage can shelter otherwise taxable income. There are a number of special rules in the Code directed at limiting this effect.
Where debt is discharged or restructured because of financial difficulty, the issuer may recognize discharge of indebtedness income or, alternatively, 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 (where the borrower is personally liable for the debt) or nonrecourse (where the creditor’s right of recovery is limited to the secured asset), the nature of the borrower’s assets and of the borrowing, and the circumstances of the restructuring or discharge. In certain cases, no current income is recognized, though tax attributes such as net operating losses, credits, or the basis of assets may be reduced. By contrast, the failure to pay dividends or return an equity investment in full does not cause income or gain to be recognized by the issuer.
Many factors have been applied by courts in classifying an instrument as debt or equity. 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. However, an instrument designated and respected as debt for tax purposes may have features that make it less likely to cause bankruptcy in the event of a downturn: for example, a delayed period before payment is due, the ability to miss scheduled payments over a period of time before default occurs, the ability to satisfy required payments with instruments other than cash, limits on the thin capitalization of the issuer, or ownership of the debt by equity owners who may be willing to modify its terms. On the other hand, an instrument designated and respected as equity for tax purposes may have features that are more economically burdensome to the issuer, such as significantly increased dividend payment requirements after a specified period, puts and calls having the effect of requiring a cash redemption by a specified date, or provisions giving the holders certain corporate governance rights in the event scheduled payments are not made.
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 (under which corporate shareholders are allowed a deduction for dividends received). For individual shareholders, both dividends and capital gains on the sale of corporate stock are generally subject to a maximum 23.8% (compared to the top individual rate of 43.4%). The present value of the shareholder-level tax on corporate earnings may be reduced to the extent earnings are retained and to the extent shareholders do not sell their stock.
This second level of tax may be eliminated entirely to the extent non-dividend-paying stock is held until the death of the owner to the extent the stock does not pay dividends and the appreciation in value of the stock (due to retained earnings or otherwise) obtains a stepped up basis at death. This may create an incentive to retain earnings. The effect is also mitigated if shareholder level income from enhanced corporate value is taxed to the shareholder at a lower tax rate than is available on other forms of income. The treatment of an instrument for purposes of financial reporting may differ from its Federal income tax treatment. These differences may result in more favorable overall business treatment when the benefits of debt or of equity for a Federal income tax purpose are combined with the benefits of a different treatment for financial reporting purposes.
A corporate issuer that has significant losses or tax-exempt income and that does not expect to be able to use an interest deduction may nevertheless have earnings and profits that cause distributions to be treated as dividends. Such a corporation may have an incentive to issue equity to provide a corporate holder with a dividends received deduction (or a taxable individual shareholder with a beneficial rate on dividends), even though the earnings did not bear corporate-level tax prior to distribution.
In addition, even a corporation that expects to have entirely taxable income may be able to obtain a lower cost of capital on at least part of its capital structure by issuing stock to those investors that are eligible for the lower rates on dividend income but would not receive the lower rates on interest income (e.g., U.S. taxable individuals or corporations).
Hybrid instruments. The JCT Report notes that taxpayers have considerable flexibility to design instruments so they are treated as either debt or equity but which blend features traditionally associated with both. In general, instruments are not bifurcated into part debt and part equity, and the categorization as one type of instrument or the other applies across the board for all tax purposes. For example, issuers may seek to structure an instrument offering many of the attributes of equity while still providing an interest deduction. Some investors may seek debt-like protections while allowing for the possibility of sharing in the earnings or appreciation of a business. Instruments characterized as debt for tax purposes that have significant equity-like features may mitigate the economic risks of high leverage. To the extent debt provides interest deductions, but also some flexibility to prevent bankruptcy, and lacks covenants that inhibit operations, it may be viewed in the marketplace as a less risky capital structure than other, more restrictive debt.
References: For debt vs. equity, see FTC 2d/FIN ¶ K-5812 et seq.; United States Tax Reporter ¶ 3854; TaxDesk ¶ 313,500 et seq.; TG ¶ 18650 et seq.