Thursday, January 18, 2018
Thomas J. Brennan (Harvard) presents Debt and Equity Taxation: A Combined Economic and Legal Perspective (with Robert L. McDonald (Northwestern)) at Indiana-Bloomington today as part of its Tax Policy Colloquium Series hosted by Leandra Lederman:
We describe the law distinguishing debt from equity in the corporate setting, and we discuss the historical development of the rules. We show how economically similar positions may be treated differently because of binary categorizations that are not updated over time, and we use simple economic models to illustrate how dynamic bifurcation of instruments into debt and equity components could eliminate such inconsistencies and associated distortions.
We discuss how the debt-equity distinction affects the corporate income tax, and we show that if ownership financed entirely by risk-free obligations is treated as equity and risk-free obligations by themselves are treated as debt, then a corporate tax providing for interest deductibility burdens only rents, under the assumption that the zero-price risk-premium is not burdened by an income tax. This result could be achieved using the current definitions of debt and equity by making an allowance for corporate equity (ACE) equal to a hypothetical pre-tax risk-free return on equity, and restricting the interest deduction to the same hypothetical return on total debt capital. This would achieve a result similar to that proposed in the Mirrlees Review for a deduction for the normal return to corporate capital.
We consider particularly the case of financial institutions, and we find that improvements in the classification of debt and equity could eliminate tax-based impediments to instruments such as total loss-absorbing capacity capacity (TLAC) obligations that may help satisfy capital regulatory requirements and reduce systemic risk.