Of More Than Usual Interest: The Taxing Problem of Debt Principal

Leverage is an essential but often troubling component of the U.S. market. The financial crisis highlighted the risks and complexity of a leverage web that includes flesh-and-blood people from all walks of life and paper people from all corners of the business and investment world. In the tax area, the potentially problematic incentive effects of interest deductibility have long engaged a wide array of tax commentators and policymakers. While interest deductibility rightly receives widespread scrutiny, a more comprehensive approach to leverage is needed. This Article focuses on the surprisingly complicated tax treatment of cash (and cash equivalent) borrowings. This Article highlights that the current tax treatment of debt principal used to finance business and investment deductions yields favorable tax timing mismatches for taxpayers and thereby theoretically amplifies any distortions caused by the deductibility of debt interest. The tax system’s current approach to debt-financed tax benefits reflects reactive responses to particular forms of tax avoidance. The current system’s reliance on a factor drawn from tax avoidance case law—likelihood of repayment—has led to an inherently flawed set of tax rules. For example, the at-risk rules identify nonrecourse debt as problematic and then impose timing limitations on tax benefits financed only with that debt type even though potential timing distortions are embedded in all cash borrowings. Thus, the at-risk rules treat nonrecourse debt as simultaneously bona fide and suspect, yet whether an agreement constitutes bona fide debt still must be determined using a facts-and circumstances, case-by-case analysis. The resulting tax rules relating directly to debt principal are confusing and inconsistent. The rules also invite extensive tax planning, whether legitimate or avoidant. The main tax problems relating to debt principal—the timing distortion and the possibility of sham debt—should be addressed as distinct issues with priority given to the timing issue. Giving renewed attention to resolving the timing distortion would facilitate a comprehensive approach to debt and would also have the likely side benefit of making sham debt less attractive. This Article examines multiple proposals for directly limiting timing benefits. Solving timing distortions for even simple cash debt is quite difficult. Thus, this Article details a more accurate, more complex reform avenue but also suggests a simpler, rougher justice one as well. The more complex approach rations the use of borrowed basis while the simpler approach utilizes a deferral charge. In addition, this Article briefly reviews (and rejects) two other possibilities—treating all debt as lacking basis and treating cash equivalent debt as income on receipt. If it is not currently possible to implement broader reform proposals, incremental reform that distinguishes more carefully between the underlying timing distortion and tax avoidance behavior could bring greater coherence to the taxing problem of debt principal