Tax Deductibility of Business Interest Expense

As it considers revising the tax code, Congress should examine the distortions and inefficiencies created by the taxation of business interest expense.

Business interest expense is usually deductible on federal corporate tax returns with the exception of the following Section 163(j) limitations:

Generally, taxpayers can deduct interest expense paid or accrued in the taxable year. However, if the section 163(j) limitation applies, the amount of deductible business interest expense in a taxable year cannot exceed the sum of:

1. the taxpayer’s business interest income for the taxable year;
2. 30% of the taxpayer’s adjusted taxable income (ATI) for the taxable year; and
3. the taxpayer’s floor plan financing interest expense for the taxable year.

The 163(j) limitations create economic distortions and inefficiencies for at least the following reasons:

They create double taxation and distortions between taxes on interest expenses and taxes on interest receipts: Interest payments reflect a transaction between a borrower and a lender. The federal government taxes many transactions, but usually only once not twice. Thus, the federal government taxes salary and wage income of employees, but does not impose an additional tax on the employer; instead, employers are allowed to deduct fully labor expenses. But interest expenses are treated differently. The IRS collects taxes on all interest receipts but does not symmetrically exempt all interest expenses by making them deductible. The net effect for entities that do not receive full deductibility of tax expenses under 163(j) is a double taxation: certain interest expenses are paid from post-tax income, and the interest expense is then taxed again as interest receipts for the lender. In contrast, entities that have full deductibility of interest expense under 163(j) are taxed just once—through the tax on interest receipts. This situation leads to an effectively higher tax burden for certain corporate entities relative to other corporate entities.

They distort consequent investment decisions: The different tax treatments of interest expenses lead to different business decisions for otherwise similarly situated firms. Suppose that market conditions lead two firms to expand their networks with two options: (1) borrowing to purchase an expanded network or (2) leasing an expanded network and paying leasing fees. A firm not constrained by the 163(j) limitations may freely choose between these two options based on market prices with both lease payments and interest expense fully tax deductible. In contrast, a firm constrained by the 163(j) limitations will be far more likely to pursue the lease strategy since lease payments are fully deductible while interest payments are not.

They favor certain firms over others: Certain firms are more likely to be constrained by the 163(j) limitations. For example, in the technology sector, these include large communications firms as well as small start-ups. These tend to be highly indebted companies. In contrast, large Big Tech companies tend to have relatively little debt and are not constrained by 163(j). All of these firms compete against one another in some markets, and the 163(j) limitations ultimately favor some firms over others.

They favor one set of successful companies over another: The IRS could plausibly argue that 163(j) is meant to discourage borrowing by financially fragile or failing companies. But that is not how the parameters of Section 163(j) have been set. Some of the affected taxpayers in the communications industry are publicly traded corporations with sound financial statements that attract investments from both large and small investors. It makes no economic sense for the IRS to set parameters for 163(j) that benefit one set of financially successful firms while punishing another set of successful firms.

Their parameters are arbitrary: Even if there were an economic basis to limit deductibility of business interest expense under certain circumstances for certain taxpayers, the specific current parameters of 163(j) are arbitrary. Those parameters could be adjusted in any number of ways and be no more—and no less—defensible. Neither Congress nor the IRS has articulated exactly which types of business interest expenses it seeks to prevent from being tax deductible.

Full deductibility of business interest expenses—without the 163(j) exceptions—would eliminate the distortions and inefficiencies described above. It would likely have a small budgetary effect, if any.