According to a Joint Committee on Taxation (JCT) report released on May 20 (JCX-45-16 ), under the current U.S. tax code, “the after-tax effect of debt financing is more favorable than equity financing because of the deductibility of interest.” This JCT conclusion mirrors the argument recently put forth by Senate Finance Committee (SFC) Chairman Orrin g. Hatch, R-Utah, on behalf of corporate integration tax reform (TAXDAY, 2016/05/18, C.1 ).
“The current system explicitly favors debt-financed investment over equity-financed investment,” Hatch said at a May 17 SFC hearing on corporate integration. “The current system creates a bias in the choice of business entity, disfavoring the corporate model versus others,” he added. Put simply, debt interest paid is generally deductible. Dividends or other returns to equity are not.
“An overreliance on debt financing can lead to risky behavior, cause deviations from efficient market forces, and reward gamesmanship in structuring business finance,” Hatch said in a statement. The next scheduled SFC hearing examining corporate integration is May 24. The upcoming hearing is set to particularly focus on a debt-versus-equity analysis.
Debt Tax Incentives
A significant difference exists between C corporations and all other business entities in regards to the effect of deductions. Returns to debt investment are deductible by a borrowing business, but returns to equity investment are not, the JCT report noted. This creates a prominent tax distinction because only C corporations are taxed at the entity level, and the deductibility of interest encourages corporate debt-financing.
Combining interest deductions with depreciation deductions, credits, preferential rates or tax exemption of the earnings financed with debt may allow for a negative tax rate for corporate income, according to the JCT report. “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” , it said.
Substituting debt for equity in corporate transactions may increase earnings per share, the report noted. Using debt, rather than equity, to capitalize a corporation means that a corporation may increase its after-tax earnings per share by substituting debt for equity capitalization, it added.
Equity Tax Incentives
“Equity may permit a corporate holder to obtain a dividends received deduction or an individual holder to obtain a favorable tax rate,” the report said. A corporation that owns stock in another corporation may be granted a dividends received deduction excluding up to 100 percent of the dividend from the recipient’s income, it added. That deduction, however, is subject to many applicable rules that aim to limit its use.
Additionally, a corporation that anticipates its income will be entirely taxable may still be able to obtain a lower cost of capital, the report noted. This is achieved ” 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,” it said.
By Jessica Watkins, Wolters Kluwer News Staff