Indebted to Yourself

About six years ago, I found myself quoting “The Sopranos” to a group of tax professionals in Rio de Janeiro.

“It’s like Paulie in Sopranos said, ‘I’d rather face five guys with guns than something I can’t see,’” I said while moderating a panel at the 2017 International Fiscal Association Annual Congress.

The actual quote is “I’d rather face ten guys with shivs than something I can’t see,” which the seemingly indestructible Paulie Walnuts laments while grappling with a cancer diagnosis in Season 6. I toned it down a bit for a tax conference.

What I was talking about was actually intercompany debt. The point I was trying to make (maybe not too well) was that something about the invisible, difficult-to-conceptualize concept of loans within a corporate group–especially those that create tax-deductible interest–tends to raise tax authorities’ suspicions.

A lot of international tax controversy involves patents or other intellectual properties, the weird intangibles that create a lot of confusion among tax administrations and taxpayers alike. But you can at least kind of visualize the concept of this kind of intangible, even if you can’t actually see it. When it comes to intercompany debt, what even is it? Most laypeople would probably be surprised to learn that it’s allowed at all. (And indeed, some tax experts argue that it shouldn’t.)

This is something that’s been on my mind for a while–at least since last year, when the limit on the deductibility of business interest enacted by the Tax Cuts and Jobs Act automatically tightened, as one of the “triggers” in the design meant to cut its cost, which Congress is supposed to fix sometime before the end of 2025.

In 2021, the limit in IRC 163(j) was generally 30% of a taxpayer’s taxable income, measured as its earnings before interest, taxes, depreciation and amortization, or EBITDA. (Another interest of Paulie’s.) EBITDA is an age-old concept, prized by accountants as a good measure of profit in many contexts. But since last year, the limit was tightened to only 30% earnings before interest and taxes (EBIT)–not including the carveout for depreciation and amortization. Many corporate taxpayers claim this is especially onerous to many businesses who rely on a lot of debt financing. (While it’s seen as an anti-abuse rule, 163(j) applies to interest on both intercompany debt as well as debt to third parties.)

If an offset can be found, it wouldn’t seem that returning to the EBITDA rate would be very controversial. After all, before 2017 there was no limit at all, and the looser limit is still within the Organization for Economic Cooperation and Development’s recommended range, in a standard created as part of its 2015 Base Erosion and Profit Shifting project. (Although the tighter limit is also within the recommended range too.)

Regardless, there are growing signs of a fight. Sen. Elizabeth Warren, D-Mass., included the proposed loosening among a group of “giveaways” she blasted during a Senate Finance Committee hearing on “Tax Dodging Schemes.”

The 2017 legislative change came after 2016 rules from the Obama Administration, which created new requirements for intercompany loans, both for documentation and qualitative restrictions, under IRC Section 385, a previously seldom-used provision that seemingly gives the U.S. Treasury Department board authority to define the difference between equity and debt. (Debt creates tax-deductible interest while equity does not.)

Those rules followed what seemed at the time like a rush of corporate inversions in the U.S., when companies use a merger with a smaller foreign entity as a way to establish tax residency outside of the U.S. for the overall corporate group. Many iconic American brands like Burger King, Pfizer and Walgreens considered inversions during this period, although many ultimately backed out. Intercompany debt played a big role in this–once companies are inverted they can use intercompany debt to build up tax-deductible interest payments in the United States, and taxable income abroad. When they were U.S.-parented companies, this maneuver would have been automatically blocked by Subpart F.

Since the rules were announced there have been very few corporate inversions–although opinions are predictably divided over whether credit is due to Obama’s rules or the TCJA.

So, as you can see, intercompany debt is a pretty big deal.

In theory, all of these transactions are governed by the arm’s-length principle, the global standard that mandates that all related-party transactions be priced at what independent parties would pay. But how does that apply to debt, anyways? Interest is supposed to recognize risk to a lender, but how much risk could there be when both the lender and the borrower are controlled by the same company? Does the arm’s-length standard require you to ignore that part? Are you supposed to price it in somehow?

It might be tempting to say that intercompany debt is an accounting fiction used for tax planning, not something “found in nature.” But that’s harder to claim after the 385 saga. Treasury had to refine the rules after learning that they could ensnare “cash pooling,” a routine corporate practice in which surpluses are collected and distributed to different departments to meet daily cash needs. Turns out, companies do loan to themselves, both for the short-term and the long-term, not necessarily motivated by taxes. (And even if the lending is motivated by taxes, that’s not necessarily a violation of the arm’s-length standard–since plenty of third-party lending is arguably motivated by the valuable interest deductions, another reason why policymakers argue that they need to be capped.)

All of these angels-on-a-pin distinctions are why the preferred, OECD-recommended approach is a hard percentage-based limit. But hard limits can generate difficult-to-answer questions too, especially because they’re often essentially arbitrary.

Presuming that the interest deduction limitation is worked out in the 2025 tax negotiations, it could require a hefty price which could take some trimming around the edges. Given everything else that’s expected to converge then, who knows how big a priority it will be. It could just be a chip in the game–but it’s a big chip.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

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LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• Despite some recent high-profile debacles, crypto continues to be one of the hottest areas in international tax, and one that's constantly evolving. Often, by the time governments get around to writing rules about it, the assets can look totally different. The OECD announced last Friday that 48 countries--including the U.K., U.S., as well as most members of the European Union--have agreed to implement global tax transparency standards for crypto-assets by 2027. This is part of the overall financial exchange information that has proven to be very successful in tracking potential tax evasion, and the exchange of crypto information will work in a similar way. You can read the standard, released in June, here.
• Sometimes, it's hard to remember that the OECD does international tax work other than the digital tax Pillars. On Thursday it released a discussion draft of new changes to its model treaty, relating to the definition of permanent establishment in connection to "exploration and exploitation of extractible natural resources." In other words, how much time/manpower do you need to spend in a given jurisdiction exploring potential natural resources before you've created a taxable presence there? Some really fascinating questions here that seem as opposite from digital economy taxation as can be, yet still involves many of the same issues.
• Assistance to developing countries in their efforts to battle tax avoidance is becoming a bigger and bigger part of the international tax discussion. This is especially true as the United Nations continues to encroach on the OECD's traditional role as the global tax rule-setter. One of these initiatives, the Platform for Collaboration on Tax--jointly sponsored by the UN, OECD, International Monetary Fund and the World Bank--issued its 2023 progress report on Wednesday. Definitely worth a look.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Stuntman, first appearing in Stuntman #1 in 1946. A circus acrobat who becomes a crimefighter after his partners are murdered--kind of like a teenager I know--Stuntman was co-created by future comics god Jack Kirby.

Contact the author at amparkerdc@gmail.com.