Friday, April 11, 2014
Steven A. Bank (UCLA), Historical Perspective on the Corporate Interest Deduction, 18 Chapman L. Rev. ___ (2014):
One of the so-called “pillars of sand” in the American business tax structure is the differential treatment of debt and equity. Corporations may deduct interest payments on their debt, but may not deduct dividend payments on their equity. This “ancient and pernicious” feature is criticized because it distorts corporate financing choices and inevitably leads to line drawing problems as the government engages in a futile chase to catch up with the latest financial innovation. Both the Obama administration and new Senate Finance Committee Chairman Ron Wyden have proposed capping the deductibility of corporate interest to mitigate these concerns. This has led commentators to come to the defense of the full corporate interest deduction, relying in part on a historical justification based on the origins of the corporate income tax as a proxy for reaching shareholder income. According to this argument, an entity-level tax was necessary to reach income that might be distributed as a dividend, since it could otherwise be avoided by deferring the dividend, but an entity-level tax was not necessary to reach income that might be paid out as interest, since interest payments were fixed and regular and non-deferrable. Therefore, interest payments were made deductible, but dividend payments were not.
This Essay, prepared in connection with a Chapman Law Review symposium on Business Tax Reform, contends that although there may be appropriate arguments in favor of maintaining a full corporate interest deduction, the historical premise for the origins of the corporate income tax system is not one of them. Corporate interest was deductible and dividend payments were not both in 1894, when deferral was not a concern because corporations routinely distributed all of their profits each year, and in 1909, when there was no individual income tax and therefore no tax incentive to retain earnings.
In fact, the early history of the deduction has more in common with modern proposals to cap the interest deduction than it does with the current system of full deductibility. In 1909, because of the fear that shareholders could easily shift their investment to bonds in order to disguise dividends as deductible interest payments, the corporate interest deduction was capped. Interest on corporate indebtedness in excess of the aggregate value of the corporation’s paid-up capital stock was made non-deductible. Business lobbying began to chip away at this limitation in the post-Sixteenth Amendment revenue acts. In 1913 and 1916, the cap on corporate interest deductions was raised to the value of the capital stock plus one-half the amount of outstanding debt. The cap was not lifted entirely until 1918, when it was done so to offset the exclusion of debt from the definition of invested capital in the war excess profits tax. Much like today, these early capped interest deduction provisions were an attempt to strike a balance between concerns about the inefficiencies of the debt/equity distinction and concerns about overburdening businesses in industries in which debt financing was a necessity.