One key provision of the Build Back Better Act (H.R. 5376)—what will be section 163(n) of the tax code—protects the U.S. tax base by ending the practice in which multinational corporations take excessive interest deductions against U.S. taxable income that do not reflect commensurate investment in U.S. markets. Section 163(n) is projected to raise $27.9 billion during the budget window—a significant amount towards building back better. Section 163(n) should be maintained as a matter of fairness to domestic-focused businesses and U.S. working families, as well as to ensure that the international tax reform included in Build Back Better works to comprehensively reduce the incentive to shift profits and offshore investment.
Section 163(n) Stops Unfair Erosion of the U.S. tax base
The Problem:
- Current rules incentivize multinational corporations to treat a disproportionate amount of borrowed funds as “U.S. debt,” allowing them to take excessive interest deductions against their U.S. taxable income.
- Combined with the ability to move highly mobile profits around to low-tax jurisdictions, multinational companies are able to unfairly increase their after-tax profits while simultaneously eroding the U.S. tax base. Businesses that only serve the U.S. market cannot do this. This is unfair to these local businesses, and it punishes working families who are ultimately left bearing the burden of an eroded tax base.
What does Section 163(n) do?
- Generally speaking, Section 163(n) allows a US taxpayer to deduct interest in the US if they are earning their income here – if they are earning their income in foreign countries, then some of those interest deductions should be taken in the foreign country, not the U.S. Technically, for U.S. taxpayers that are part of an international group, they can take U.S. interest deductions in any given year equal to 110% of the amount the taxpayer would take if the taxpayer’s net U.S. debt expenses were essentially proportionate to the ratio of the taxpayer’s U.S. earnings (specifically, “EBITDA”) to its global EBITDA. This decreases the incentive to disproportionately allocate debt to U.S. taxpayers to lower U.S. taxes.
- If Section 163(n) looks familiar, that’s because it was initially proposed by Republicans in drafting the 2017 Tax Cuts and Jobs Act, and only got dropped after intense corporate lobbying. That lobbying also resulted in allowing deductions in the United States with respect to income booked outside the United States and exempted from U.S. tax, which might be considered an opaque subsidy that further encourages abusive debt practices in the U.S.
- Companies can properly allocate their debt to their income-generating activities and avoid 163(n) issues.
- 163(n) also prevents the US from subsidizing foreign tax collections as might happen if companies are incentivized to appear more profitable in foreign tax jurisdictions because debt interest deductions are taken here.
Section 163(n) Works as Part of Comprehensive International Tax Reform to Stop Profit Shifting and Offshoring
Section 163(n) is a Well-Targeted Compliment to Taxpayer Friendly Reforms in Build Back Better: Section 163(n) should be viewed as one component of comprehensive international reform needed in the Build Back Better Act to deter profit-shifting and offshoring, including in light of taxpayer friendly provisions included in the Act. In implementing GILTI, expense allocation rules for determining foreign tax credits were put in to place to partially prevent the U.S. from effectively subsidizing foreign tax payments. In some circumstances, multinationals can lose the “full” benefit afforded by allocating interest deductions to foreign income due to these rules. Under the Build Back Better Act, U.S. taxpayers subject to GILTI can allocate indirect expenses (including interest) entirely to U.S. income when calculating foreign tax credits. This very taxpayer favorable change increases available foreign tax credits and lowers the U.S. tax base. Without reasonable limitations, however, the taxpayer favorable allocation rules in Build Back Better will encourage abusive interest deduction practices by multinationals in the U.S.[1] Section 163(n) is narrowly tailored and needed to temper the additional tax break for multinationals provided under the Build Back Better Act—including those that are subject to current U.S. taxation under GILTI or otherwise.
Section 163(n) Also Addresses a Key Gap in Build Back Better for Foreign Multinationals:
- Section 163(n) is necessary to ensure that all taxpayers taking advantage of U.S. markets are deterred from stripping the U.S. tax base. For example, foreign-parented multinationals that are not subject to the BEAT or GILTI may have increased incentive to (and undue advantage from) abuse excessive interest deductions in the U.S. without section 163(n). Not surprisingly, these are many of the very firms lobbying against section 163(n) to protect a potentially unearned advantage.
- Example: Assume a U.S. taxpayer is subject to a 21% tax rate, but that the taxpayer is part of a large international group. The large international group has arranged all of its offshore profits to have an effective tax rate of 5%. The taxpayer is not subject to the global intangible low-taxed income (GILTI) tax because it has a foreign parent, and the taxpayer is not subject to the base-erosion and anti-abuse tax (BEAT) because it does not satisfy the gross receipt test (despite having a substantial U.S. presence). The taxpayer borrows funds in the U.S. For each net dollar of interest expense the U.S. taxpayer takes against U.S. income, it is saving $.21 in taxes. If the taxpayer appropriately allocated interest to its international investments, it would only save $.05 in taxes per $1 of interest allocated. The taxpayer is obviously incentivized to abuse the U.S. tax base, allocating as much interest as possible to U.S. income under flexible rules currently available, while funding the generation of profits offshore. Taxpayers are also incentivized to abandon the U.S. as their tax residence.
Section 163(n) Won’t Impact Small Businesses: Notably, section 163(n) does not apply to small taxpayers. For example, net interest expense has to average $12 million over 3 years for the provision to apply. Even for a company paying a very high interest rate of 10% that would require a debt facility or similar equal to $120 million.
Borrowers Will Continue to Raise Debt Capital in the U.S.:
Borrowers will continue to access U.S. debt capital markets because:
- Debt is more affordable in U.S. markets for U.S. parented entities (that is, rates are lower). That current U.S. tax policy makes debt even “cheaper” in the U.S. is arguably a poorly targeted subsidy.
- Lenders want centralized access to adequate collateral and the predictability of U.S. law. These provisions actually increase the incentive to grow investment (i.e., collateral) and earnings in the U.S., meaning that it is unlikely that borrowers will “move” borrowing offshore and freeze up debt markets.
- Section 163(n) is not restrictive so long as taxpayers borrowing in the U.S. internally manage their debt, including to allocate interest expense against foreign earnings to the extent appropriate.
Conclusion: Proposed section 163(n) of the tax code under the Build Back Better Act should be maintained in spite of corporate lobbying to discourage the continued erosion of the U.S. tax base and as a matter of fairness to domestic businesses and America’s working families.
[1] Unlike a similar “group ratio rule” proposed by the Organization for Economic Cooperation and Development (OECD), section 163(n) does not apply to increase the domestic interest deduction available to taxpayers. However, section 163(n) is appropriate in light of the taxpayer friendly allocation rules included in the Build Back Better Act discussed above, which may otherwise encourage abusive practices and are not contemplated in OECD best practices, making arguments relying on these recommendations to discourage implementation of section 163(n) misplaced.