Paul L. Caron

Friday, November 5, 2021

Weekly SSRN Tax Article Review And Roundup: Elkins Reviews Hasen's Debt And Taxes

This week, David Elkins (Netanya, visiting NYU 2021-2022) reviews a new paper by David Hasen (Florida; Google Scholar), Debt and Taxes, 12 Columbia J. Tax L. 89 (2021).

Elkins (2018)

As indicated by its whimsical title, David Hasen’s well-written paper considers the tax treatment of debt. Under the standard view, in exchange for the loan proceeds, the borrower commits to paying the lender interest and, eventually, repaying the loan proceeds. Because of the obligation to repay, the borrower does not report income on receipt of the loan proceeds. The idea is that income is accession to wealth, and wealth, in turn, is assets minus obligations. Increasing one’s assets (i.e., the cash received) and one’s liabilities by the same amount does not cause any change to one’s wealth. Similarly, for the lender, the cash is replaced by the borrower’s obligation. Thus, while the composition of the lender’s assets undergoes a transformation, the value of the assets remains the same and the lender cannot deduct the loan proceeds.

Continuing with the standard view, the borrower takes a full fair-market-value basis in the cash borrowed. Therefore, if the borrower then uses the funds to purchase an asset, the borrower’s basis in the asset will be the same as the borrower’s basis in the cash. When the loan is eventually repaid, the borrower will not take a deduction, because the shrinkage of the borrower’s assets is exactly offset by the elimination of the obligation. If the borrower is released from the obligation without making a payment or by paying less than the face value of the debt, the difference is reportable as income (known as “cancellation of indebtedness”). Here the idea is that a shrinkage of liability without a corresponding shrinkage of assets results is an accession of wealth.

The standard view has been subject to a number of challenges. Perhaps the most fundamental is the charge that the borrower should not be entitled to take a basis in the borrowed funds, because the funds were paid for by an obligation in which the borrower had no basis. This would mean either that the receipt of the funds would be taxable or that use of the funds to purchase property or services would constitute an exchange of something in which the borrower has no basis for something of positive economic value. As in any other case in which a taxpayer receives something whose fair market value is greater than the taxpayer’s basis in whatever is surrendered in exchange, the difference constitutes (the realization of) a taxable gain. Other challenges concern the treatment of non-recource loans.

Professor Hasen argues that instead of viewing the loan as an exchange of cash for a future obligation to pay interest and repay principle, we should view it as analogous to a lease. When a lessee leases property, we do not say that the lessor transfers title to the property to the lessee in exchange for a promise to return the property and pay rent. Rather we say that what the lessor gave the lessee is the right to use the property for a limited time, title remaining in the hand of the lessor. Effectively, we view the lessor as detaching a use-period and transferring it the lessee. At the end of the use period, the lessee then has an obligation to return possession to the lessor, but has no obligation to return title to the lessor, because by that time the lessee’s rights have dissipated.

According to Professor Hasen, loans should be treated similarly. The borrower purchases from the lender the temporary right to use the funds. Thus, at the time the loan is made, there is no need to ask whether the borrower should include the amount in the funds in gross income: the borrower did not receive the funds but only the temporary use of the funds. Repayment of the principle is not a shrinkage of the borrower’s assets, as the money repaid did not belong to the borrower in the first place. While in most cases the “loan as lease” approach does not reach materially different results than does the standard view, Hasen argues that it offers a more satisfactory theoretical framework. One instance in which he indicated that it would make a practical difference is in the case of allocating basis credit among partners. Under the standard view, debt is allocated in accordance with the catastrophe theory: who would be left holding the bag if all the corporation’s assets suddenly became worthless? By contrast, under the loan as lease approach, debt would allocated to the person who economically bears the cost of the interest.

The article presents a fascinating new look at a central issue of income taxation.

Here’s the rest of this week’s SSRN Tax Roundup:

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