OVERVIEW OF THE TAX TREATMENT 

OF CORPORATE DEBT AND EQUITY 

Scheduled for a Public Hearing 

Before the 

SENATE COMMITTEE ON FINANCE 

on May 24, 2016 

Prepared by the Staff 

of the 

JOINT COMMITTEE ON TAXATION 

May 20, 2016 

JCX-45-16 
i 

CONTENTS 

Page

INTRODUCTION AND SUMMARY ........................................................................................... 1

I.   PRESENT LAW ....................................................................................................................... 4

A. General Rules ...................................................................................................................... 4

1. Issuer treatment of debt and equity ............................................................................... 4

2. Holder treatment of debt and equity ............................................................................. 7

3. Acquisitions and dispositions ..................................................................................... 12

B. Distinguishing Between Debt and Equity ......................................................................... 13

1. In general .................................................................................................................... 13

2. Regulatory authority pursuant to section 385 ............................................................. 15

C. Rules to Address Stripping of U.S. Corporate Tax Base in the Case of Nontaxed 

 Holders .............................................................................................................................. 17

1. Earnings stripping ....................................................................................................... 17

2. Tax treatment of certain payments to controlling exempt organizations .................... 18

D. Rules to Address Corporate Base Erosion Without Regard to Holder’s Tax Status ........ 19

1. Corporate equity reduction transactions ..................................................................... 19

2. Debt expected to be paid in equity .............................................................................. 20

3. Applicable high-yield discount obligations ................................................................ 21

4. Interest on certain acquisition indebtedness ............................................................... 22

E. Rules to Address Tax Arbitrage in the Case of Borrowing to Fund Untaxed Income ..... 23

1. Interest related to tax-exempt income ......................................................................... 23

2. Debt with respect to certain insurance products ......................................................... 25

3. Dividends received deduction reduction for debt-financed portfolio stock ................ 27

F. Rules to Match Timing of Tax Deduction and Income Inclusion Relating to Debt ......... 29

II. DATA WITH RESPECT TO DEBT AND EQUITY............................................................. 31

III. TAX INCENTIVES UNDER PRESENT LAW FOR FIRM CAPITAL STRUCTURE ....... 43

A. Tax Incentives for Debt .................................................................................................... 43

B. Comparison to Debt: Tax Incentives for Equity ............................................................... 52

C. Tax Incentives to Create Hybrid Instruments ................................................................... 54

D. Tax Incentives to Substitute Other Arrangements for Debt .............................................. 57

E. Financial Accounting and Other Considerations .............................................................. 58
1 

INTRODUCTION AND SUMMARY 

Introduction

The Committee on Finance of the Senate has scheduled a public hearing on May 24, 

2016, titled “Debt and Equity: Corporate Integration Considerations.” This document1

 has been 

prepared for that hearing by the staff of the Joint Committee on Taxation. 

The first part of this document presents an overview of Federal income tax rules relating 

to debt and equity, and some of the statutory limitations on the tax benefits of each. The 

overview includes the treatment of both issuers and holders, and the treatment of each in the 

event of a business downturn in which the instrument becomes worthless. 

The second part of this document presents data regarding nonfinancial business sector 

debt and equity and other business debt over several decades. 

The third part of this document discusses the tax incentives created by the present-law tax 

treatment of debt and equity. 

Summary

Business enterprises and their investors have business reasons to structure capital 

investment as either debt or equity. Investors may prefer varying levels of risk, and, for 

example, may seek different levels of priority in the event of the bankruptcy of the business. 

Businesses can issue interests to investors that have varying levels of control over the enterprise 

and degrees of participation in profitability or growth of the enterprise. 

The tax law generally contains no fixed definition of debt or equity. Taxpayers have 

considerable flexibility to design instruments treated as either debt or equity but which blend 

features traditionally associated with both. 

Differences in the Federal income tax treatment of debt and equity create incentives to 

use one or the other depending on the tax characteristics of the issuer and of the particular 

investor. In general, a corporate issuer is not subject to corporate tax on amounts that it deducts 

as interest on debt. By contrast, dividends, which are generally not deductible by the payor, 

come out of after-tax income of the corporation. 

Debt instruments can permit the accrual of the interest deduction along with the inclusion 

in income by the holder at a time prior to the payment of cash. Interest income may be taxed at a 

higher rate to a taxable holder than the holder’s dividends or capital gains (to which lower tax 

rates currently apply). However, some forms of debt investments are not subject to U.S. tax or 

are taxed at reduced rates in the hands of a tax-exempt or foreign investor. A number of special 

 1 This document may be cited as follows: Joint Committee on Taxation, Overview of the Tax Treatment of 

Corporate Debt and Equity (JCX-45-16), May 20, 2016. This document can also be found on the Joint Committee 

on Taxation website at www.jct.gov. 
2 

rules in the Code are designed to protect the corporate tax base by limiting the tax benefits that 

can be obtained from interest deductions. 

To the extent that debt finances assets that produce tax-exempt or otherwise tax-favored 

income, the interest deduction is available to offset other income taxed at higher rates. The 

resulting tax arbitrage can shelter otherwise taxable income. A number of special rules in the 

Code are directed at limiting this effect. 

In the event of financial difficulty, the discharge or restructuring of debt can cause the 

issuer to recognize discharge of indebtedness income or, alternatively, gain with respect to the 

satisfaction of nonrecourse indebtedness for less than the outstanding amount. The income tax 

treatment of debt discharge depends on whether the debt is recourse or nonrecourse, the nature of 

the borrower’s assets and of the borrowing, and the circumstances of the restructuring or 

discharge. In a number of instances, no current income is recognized, though tax attributes such 

as net operating losses, credits, or the basis of assets may be reduced. By contrast, the failure to 

pay dividends or return an equity investment in full does not cause income or gain to be 

recognized by the issuer. 

In classifying an instrument as debt or equity, many factors have been applied by courts. 

In general, a debt instrument requires a fixed obligation to pay a certain amount at a specified 

date. Debt instruments provide for remedies, including priorities in bankruptcy in the event of 

default. However, an instrument designated and respected as debt for tax purposes may have 

features that make it less likely to cause bankruptcy in the event of a downturn: for example, a 

delayed period before payment is due, the ability to miss scheduled payments over a period of 

time before default occurs, the ability to satisfy required payments with instruments other than 

cash, limits on the thin capitalization of the issuer, or ownership of the debt by equity owners 

who may be willing to modify its terms. Conversely, an instrument designated and respected as 

equity for tax purposes may have features that are more economically burdensome to the issuer, 

such as significantly increased dividend payment requirements after a specified period, puts and 

calls having the effect of requiring a cash redemption by a specified date, or provisions giving 

the holders certain corporate governance rights in the event scheduled payments are not made. 

Equity can be beneficial for tax purposes in certain cases. Although corporate 

distributions and sales of corporate stock subject the holder to tax in addition to any tax paid by 

the corporation, reduced tax rates apply to holders with respect to such distributions or gain. 

Dividends on corporate equity are largely excludable by corporate holders (currently resulting in 

a maximum 10.5-percent tax rate under the 70-percent dividends received deduction). For 

individual shareholders, both dividends and capital gains on the sale of corporate stock are 

generally subject to a maximum 23.8-percent rate (compared to the top individual rate of 

43.4 percent).2

 The present value of the shareholder-level tax on corporate earnings may be 

reduced to the extent earnings are retained and to the extent shareholders do not sell their stock. 

 2

 These 23.8- and 43.4-percent rates reflect the maximum individual rates plus the 3.8 percent tax under 

section 1411 on net investment income; they do not include the effect of any other tax provisions, such as the overall 

limitation on itemized deductions, on the effective marginal tax rate. 
3 

This second level of tax may be eliminated entirely to the extent non-dividend-paying stock is 

held until the death of the owner. 

The treatment of an instrument for purposes of financial reporting may differ from its 

Federal income tax treatment. These differences may result in more favorable overall business 

treatment when the benefits of debt or of equity for a Federal income tax purpose are combined 

with the benefits of a different treatment for financial reporting purposes. 
4 

I. PRESENT LAW 

A. General Rules 

1. Issuer treatment of debt and equity 

Interest and dividend payments 

Interest paid or accrued by a business generally is deductible, subject to a number of 

limitations.3 By contrast, dividends or other returns to equity generally are not deductible. 

Timing of interest deduction

Interest is deducted by a taxpayer as it is paid or accrued, depending on the taxpayer’s 

method of accounting. For all taxpayers, if an obligation is issued with original issue discount 

(“OID”), a deduction for interest is allowable over the life of the obligation based on a yield to 

maturity basis.4

 OID arises where the amount to be paid at maturity exceeds the issue price by 

more than a de minimis amount. 

Principal payments and return of equity capital

Principal payments on business debt generally are not deductible. The return of capital to 

investors in an equity investment likewise is not deductible. 

Receipt of cash upon issuance of debt or equity

The issuance of a debt or equity instrument for cash is not a taxable event to the issuer. 

Basis of assets purchased with debt or equity 

Purchased assets generally have a cost basis for purposes of determining deprecation or 

gain or loss on sale, regardless of whether the purchase was financed with debt (including 

nonrecourse debt) or equity. 

Nonpayments on equity compared to discharge or restructuring of indebtedness

If dividends are not paid on equity, or the capital contributed by an equity holder is not 

returned, there is generally no taxable income, gain, or other consequence to the issuer.5

 

 3

 Sec. 163(a). Some of these limitations are discussed below. 

4

 Sec. 163(e). But see sec. 267 (dealing in part with interest paid to a related or foreign party). 

5

 Under certain circumstances, an additional tax at the maximum individual rate on dividends (in addition 

to the corporate income tax) applies to certain unreasonably accumulated income and to certain undistributed 

income of a closely-held corporation whose income is largely passive. Secs. 531-537 and 541-547. 
5 

The effects to the issuer if debt is modified, cancelled, or repurchased depend on the type 

of debt, the nature of the holder, and whether or not the debt (or property given in exchange) is 

traded on an established securities market. If debt is cancelled, modified, or repurchased, the 

borrower generally realizes income from the discharge of indebtedness. Exceptions to this 

income inclusion are provided for bankruptcy and insolvency, for other situations including 

seller financing of purchased property, qualified farm indebtedness, qualified real property 

business indebtedness, and contributions of debt by an equity holder. The exceptions usually 

require the taxpayer to reduce tax attributes, such as net operating losses, or to reduce the basis 

of property.6

 If nonrecourse debt is satisfied by foreclosure on the assets securing the debt, the 

borrower generally realizes gain from the disposition of the assets for the amount of the debt 

(even if the assets are not worth that amount).7

 

Recourse indebtedness

If a taxpayer’s recourse debt8 is discharged, the taxpayer generally recognizes income 

from the discharge of indebtedness at that time.9 A satisfaction of the debt with property worth 

less than the debt,10 or a repurchase of debt for less than its face amount by the taxpayer or a 

related party, is treated as a discharge of the taxpayer’s debt to the extent of the difference 

between the outstanding debt and (generally) the value of the property.11 

A significant modification of a debt instrument is treated as the disposition of the old 

instrument in exchange for the new instrument.12 Such modifications include a change in the 

obligor, a change in terms or interest rate, a change in principal amount, and certain 

modifications of security. The modification of a debt instrument can thus cause the issuer to 

recognize discharge of indebtedness income, measured by the difference between the adjusted 

issue price of the old debt and the fair market value (or other applicable issue price) of the new 

debt.13 If the debt instrument is publicly traded or is issued in exchange for property (including 

 6

 Sec. 108. 

7

 Commissioner v. Tufts, 461 U.S. 300 (1983); cf., Crane v. Commissioner, 331 U.S. 1 (1947). 

8

 Recourse debt is debt for which the borrower is personally liable; upon default, the lender may seek to 

collect against the borrower. In contrast, nonrecourse debt is debt secured only by designated collateral. 

9

 Secs. 61 and 108. 

10 For example, if a creditor contributes its debt to a corporation and receives corporate stock in exchange, 

the corporation generally recognizes cancellation of indebtedness income to the extent the value of the stock given is 

less than the amount of the debt cancelled. However, if the debt was held by a person that was also a shareholder, 

the debt may be considered contributed in a nontaxable contribution to capital, not creating discharge of 

indebtedness income. 

11 Treas. Reg. sec. 1.61-12. 

12 Treas. Reg. sec. 1.1001-3. 

13 The discharge of indebtedness income is taken into income at the time of the exchange. The new debt 

may be deemed to be issued with original issue discount (to the extent the amount payable at maturity exceeds the 
6 

other debt) that is publicly traded, then the issue price of the new debt is deemed to be the fair 

market value of the debt or other property that is publicly traded.14 If neither the old nor the new 

debt instrument is traded on an established securities market, the issue price of the new debt is 

generally the stated principal amount unless there is inadequate stated interest (i.e., interest less 

than the Treasury rate for an instrument of comparable term).15 Thus, in traded situations, 

discharge of indebtedness income is likely to be recognized if troubled debt is modified or 

satisfied with other debt instruments. However, in private situations there may be no discharge 

of indebtedness income. 

As noted above, special rules allow a taxpayer not to recognize discharge of indebtedness 

income if the taxpayer is in bankruptcy or is insolvent. If the discharge of indebtedness occurs in 

a Title 11 bankruptcy case, the full amount of any debt discharged is excluded from income. If 

the taxpayer is insolvent, cancellation of debt income is excludable only to the extent of the 

insolvency. In either case, if the tax attributes subject to reduction are insufficient to cover the 

amount of the discharge, there is no inclusion of debt discharge income for the excess. In the 

case of an entity that is taxed as a partnership, the determination of whether the discharge occurs 

in a Title 11 bankruptcy case, whether the taxpayer is insolvent, and the reduction of tax 

attributes, all occur at the partner level. 

Tax attributes are generally reduced in the following order: (1) net operating losses, 

(2) general business credits, (3) minimum tax credits, (4) capital loss carryovers, (5) basis 

reduction of property, (6) passive activity loss and credit carryovers, and (7) foreign tax credit 

carryovers. A taxpayer may elect to apply the reduction first against the basis of depreciable 

property. 

Nonrecourse indebtedness 

Nonrecourse debt is subject to different rules than recourse debt.16 Because the taxpayer 

is not personally liable on the debt, there is no cancellation of indebtedness income. However, if 

the creditor forecloses or otherwise takes the property securing the debt, the borrower treats the 

transaction as a sale of the property for a price equal to the outstanding indebtedness (even if the 

 

issue price) that the issuer can deduct, which can offset the amount of debt discharge income, but the deductions 

occur in the future over the period of the new debt, while the income is recognized immediately. 

14 Thus, if a distressed debt instrument is modified and the transaction is treated as an exchange of the old 

instrument for the new one, the debtor can experience discharge of indebtedness income in the amount of the 

difference between the adjusted issue price of the old debt and its fair market value at the time of the modification. 

15 In certain “potentially abusive” cases, the principal amount of debt given in exchange for other property 

(including other debt) is the fair market value of the property exchanged. 

16 The distinction between recourse and nonrecourse debt may be less obvious than it would appear. 

Recourse debt might be issued by an entity that has limited liability and limited assets, while nonrecourse debt might 

be oversecured. 
7 

property securing the debt is worth less than the debt at the time of foreclosure).17 Such a 

transaction generally produces capital gain (rather than ordinary income) to the debtor. 

Purchase money financing

If discharged debt is seller-financing for a purchase of property by the debtor, and if the 

debtor is not insolvent or in a bankruptcy proceeding, then instead of income from the discharge 

of indebtedness, the debtor-purchaser has a purchase price reduction (which reduces the basis of 

the property acquired). 

2. Holder treatment of debt and equity 

Current income and sales of interests 

Taxable investors

Interest on debt is taxed to a taxable individual or corporate holder at the ordinary income 

tax rate of the holder (currently, up to 39.6 percent for an individual, and 35 percent for a 

corporation). Dividends paid by a taxable C corporation,18 are generally taxed to a taxable 

individual shareholder at a maximum rate of 20 percent. Such dividends are generally taxed to a 

C corporation shareholder at a maximum rate of 10.5 percent (or less, depending on the 

percentage ownership the corporate shareholder has in the issuing corporation).19 Gain on the 

sale of an equity interest in a C corporation or in an S corporation is generally capital gain. If the 

stock has been held for at least one year, such gain is generally taxable to a taxable individual 

shareholder at a maximum rate of 20 percent. Gain on the sale of C corporation stock is taxed to 

a corporate shareholder20 at regular corporate rates (generally 35 percent). Gain on the sale of an 

equity interest in a partnership is generally also capital gain of the partner, except for amounts 

 17 Commissioner v. Tufts, 461 U.S. 300 (1983); cf., Crane v. Commissioner, 331 U.S. 1 (1947). 

18 A C corporation is defined by reference to subchapter C of the Code (tax rules relating to corporations 

and shareholders) and is taxable as a separate entity with no deduction for dividends or other equity distributions. 

For purposes of the discussion in this document, such corporations are distinguished from certain corporations that 

meet specific tests relating to organization, function, assets, and income types and can deduct dividends and certain 

other equity distributions to shareholders (e.g., real estate investment trusts (“REITs”) or regulated investment 

companies (“RICs”)). 

19 The lower rate on dividends received by a corporate shareholder results from the corporate “dividends 

received deduction,” which is generally 70 percent of the dividend received if the shareholder owns below 

20 percent of the issuer, 80 percent of the dividend received if the shareholder owns at least 20 percent and less than 

80 percent of the issuer, and 100 percent of the dividend if the shareholder owns 80 percent of more of the issuer 

(sec. 243). A corporation subject to the maximum 35-percent corporate tax rate and entitled to a deduction equal to 

70 percent of a dividend would pay a maximum tax on the dividend of 10.5 percent (the 30 percent of the dividend 

that is taxable multiplied by the 35-percent tax rate). 

20 A C corporation is not an eligible S corporation shareholder and therefore cannot own S corporation 

stock. 
8 

attributable to unrealized receivables and inventory items of the partnership, which are taxable as 

ordinary income.21

Net investment income tax

An additional tax is imposed on net investment income in the case of an individual, 

estate, or trust.22 In the case of an individual, the tax is 3.8 percent of the lesser of net investment 

income23 or the excess of modified adjusted gross income24 over the threshold amount. The 

threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the 

case of a married individual filing a separate return, and $200,000 in any other case.25 Thus, for 

taxpayers with modified adjusted gross income in excess of this threshold, the rate on certain 

capital gains and dividends is 23.8 percent and on interest is 43.4 percent.26

Timing of inclusion

Interest is generally taxable when received or accrued. If the original issue discount rules 

apply, interest generally is includable in income, and thus taxable, before any cash payment is 

received. Dividends generally are not taxable until actually or constructively received.27 In 

limited circumstances, however, certain preferred stock dividends may be accrued under rules 

similar to the rules for debt. Also, a shareholder may be treated as having received a dividend if 

his percentage stock ownership increases as a result of the payment of dividends to other 

shareholders.28 

 21 Sec. 751. 

22 Sec. 1411. 

23 Net investment income is the excess of (1) the sum of (a) gross income from interest, dividends, 

annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business 

that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or 

commodities, and (b) net gain (to the extent taken into account in computing taxable income) attributable to the 

disposition of property other than property held in the active conduct of a trade or business that is not in the trade or 

business of trading in financial instruments or commodities, over (2) deductions properly allocable to such gross 

income or net gain. 

24 Modified adjusted gross income is adjusted gross income increased by the amount excluded from 

income as foreign earned income under section 911(a)(1) (net of the deductions and exclusions disallowed with 

respect to the foreign earned income). 

25 These thresholds are not indexed for inflation. 

26 These 23.8- and 43.4-percent rates do not include the effect of any other tax provisions, such as the 

overall limitation on itemized deductions, on the effective marginal tax rate. 

27 See Treas. Reg. secs. 1.301-1(b) and 1.451-2(b). 

28 Sec. 305(c). Certain situations in which some shareholders receive cash and others experience an 

increase in their percentage ownership can also cause both groups of shareholders to be treated as receiving a 

dividend under that section. 
9 

Tax-exempt investors

A tax-exempt investor (e.g., a university endowment fund or a pension plan investor) is 

generally not taxed on investment interest, subject to certain unrelated business income tax 

(“UBIT”) rules for debt-financed income.29 This is true whether the debt is issued by a 

C corporation or by any other entity. 

Tax-exempt investors also are generally not subject to tax on the sale of C corporation 

stock, unless the stock investment is debt-financed. 

Tax-exempt equity investors in a partnership are treated as engaged directly in the trade 

or business of the partnership. To the extent a partnership is engaged in a trade or business that 

is an unrelated trade or business with respect to a tax-exempt investor, the tax-exempt investor is 

treated as engaged in the unrelated trade or business directly, and is taxed on its distributive 

share of partnership income from such business accordingly.30 Tax-exempt equity investors in 

an S corporation generally are taxed on their entire share of S corporation income or gain on the 

sale of the stock.31 

Foreign investors

Debt interests in U.S. entities 

Although U.S.-source interest paid to a foreign investor is generally subject to a 30-

percent gross basis withholding tax, various exceptions exist in the Code and in bilateral income 

tax treaties.32 Interest is generally derived from U.S. sources if it is paid by the United States or 

any agency or instrumentality thereof, a State or any political subdivision thereof, or the District 

of Columbia. Interest is also from U.S. sources if it is paid by a noncorporate resident or a 

domestic corporation on a bond, note, or other interest-bearing obligation.33 For this purpose, a 

noncorporate resident includes a domestic partnership which at any time during the year was 

 29 Secs. 512 and 514. In addition, as discussed in greater detail below, interest received by an exempt 

organization from a 50-percent controlled subsidiary is subject to UBIT. Sec. 512(b)(13). 

30 Sec. 512(c). 

31 Sec. 512(e). 

32 Where a foreign investor is engaged in a U.S. trade or business, any U.S.-source interest income or U.S.-

source dividend income (see “Equity interests in U.S. entities” below) derived from assets used in or held for use in 

the conduct of the U.S. trade or business where the activities of the trade or business were a material factor in the 

realization of such income are treated as effectively connected with that U.S. trade or business. Sec. 864(c)(2). 

33 Sec. 861(a)(1); Treas. Reg. sec. 1.861-2(a)(1). However, special rules apply to treat as foreign source 

certain amounts paid on deposits with foreign commercial banking branches of U.S. corporations or partnerships and 

certain other amounts paid by foreign branches of domestic financial institutions. Sec. 861(a)(1). 
10 

engaged in a U.S. trade or business.34 Additionally, interest paid by the U.S. branch of a foreign 

corporation is also treated as U.S.-source income.35 

Statutory exceptions to this general rule apply for interest on bank deposits as well as 

portfolio interest. Interest on bank deposits may qualify for exemption on two grounds, 

depending on where the underlying principal is held on deposit. Interest paid with respect to 

deposits with domestic banks and savings and loan associations, and certain amounts held by 

insurance companies, are U.S.-source income but are not subject to the U.S. withholding tax 

when paid to a foreign person, unless the interest is effectively connected with a U.S. trade or 

business of the recipient.36 Interest on deposits with foreign branches of domestic banks and 

savings and loan associations is not treated as U.S.-source income and is thus exempt from 

U.S. withholding tax (regardless of whether the recipient is a U.S. or foreign person).37 

Similarly, interest and original issue discount on certain short-term obligations is also exempt 

from U.S. withholding tax when paid to a foreign person.38 

Portfolio interest received by a nonresident individual or foreign corporation from 

sources within the United States is exempt from U.S. withholding tax.39 The term “portfolio 

interest” means any interest (including original issue discount) that is paid on an obligation that 

is in registered form and for which the beneficial owner has provided to the U.S. withholding 

agent a statement certifying that the beneficial owner is not a U.S. person. Portfolio interest, 

however, does not include interest received by a 10-percent shareholder,40 certain contingent 

interest,41 interest received by a controlled foreign corporation from a related person,42 or interest 

received by a bank on an extension of credit made pursuant to a loan agreement entered into in 

the ordinary course of its trade or business.43

U.S.-source interest payments that do not qualify for a statutory exemption from the 30-

percent withholding tax often are exempt from withholding under U.S. bilateral income tax 

 34 Treas. Reg. sec. 1.861-2(a)(2). 

35 Sec. 884(f)(1). 

36 Secs. 871(i)(2)(A), 881(d); Treas. Reg. sec. 1.1441-1(b)(4)(ii). 

37 Sec. 861(a)(1)(B); Treas. Reg. sec. 1.1441-1(b)(4)(iii). 

38 Secs. 871(g)(1)(B), 881(a)(3); Treas. Reg. sec. 1.1441-1(b)(4)(iv). 

39 Secs. 871(h), 881(c). In 1984, to facilitate access to the global market for U.S. dollar-denominated debt 

obligations, Congress repealed the withholding tax on portfolio interest paid on debt obligations issued by U.S. 

persons. See Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction 

Act of 1984 (JCS-41-84), December 31, 1984, pp. 391-92. 

40 Sec. 871(h)(3). 

41 Sec. 871(h)(4). 

42 Sec. 881(c)(3)(C). 

43 Sec. 881(c)(3)(A). 
11 

treaties. Many treaties, including, for example, those with Canada, Germany, and the United 

Kingdom, broadly eliminate the withholding tax on U.S.-source interest payments. The result is 

that large volumes of interest payments are exempt from withholding under the Code or a 

treaty.44

Equity interests in U.S. entities

A foreign equity investor’s receipt of U.S.-source dividend income from a U.S. domestic 

corporation is generally subject to a 30-percent gross basis withholding tax. Dividend income is 

generally sourced by reference to the payor’s place of incorporation such that dividends paid by 

a domestic corporation are generally treated as entirely U.S.-source income.45 As with interest, 

the 30-percent withholding tax on dividends received by foreign investors may be reduced or 

eliminated under U.S. bilateral income tax treaties. In general, the dividend withholding tax 

rates in treaties vary based on the percentage of stock of the dividend-paying company owned by 

the recipient of the dividend. Treaties typically provide lower withholding tax rates (e.g., five 

percent) at ownership levels of 10 percent and greater. Twelve treaties, including those with 

Germany, Japan, and the United Kingdom, eliminate the withholding tax on dividends in 

circumstances in which, among other requirements, the foreign treaty resident is a company that 

owns at least 80 percent (in the case of Japan, 50 percent) of the U.S. corporation paying the 

dividend.46

Foreign investors also are not generally subject to tax on the sale of C corporation 

stock.47 

In contrast, a foreign equity investor in a partnership is taxed on its distributive share of 

income effectively connected with the conduct of a U.S. trade or business, as if it had conducted 

that business directly. S corporations are not permitted to have foreign investors. 

Treatment if investment becomes worthless

A taxable holder of either debt or equity held as an investment generally recognizes a 

capital loss if the instrument is sold to an unrelated party at a loss.48 Capital losses can generally 

 44 Of the $293.7 billion of U.S.-source interest payments to foreign debtholders in 2013, $165.7 billion, or 

56.4 percent, was paid to recipients in countries that eliminate withholding tax by treaty. Forms 1042-S, Table 2, 

SOI and JCT staff calculations. 

45 Secs. 861(a)(2), 862(a)(2). 

46 These countries include Australia, Belgium, Denmark, Finland, France, Germany, Japan, Mexico, the 

Netherlands, New Zealand, Sweden, and the United Kingdom. 

47 Secs. 871 and 881, applicable to income not connected with a U.S. trade or business. The exemption 

does not apply to a foreign individual who is present in the United States for 183 days or more during the taxable 

year. Foreign investors may be subject to tax if the stock is a U.S. real property interest under the Foreign 

Investment in Real Property Tax Act of 1980 (“FIRPTA”). Sec. 897. 

48 Up to $50,000 of loss on certain small business company stock ($100,000 for a couple filing a joint 

return) can be deducted as an ordinary loss. Sec. 1244. 
12 

offset only capital gains; however, an individual may deduct up to $3,000 per year of capital loss 

against ordinary income. 

A taxable holder of investment equity or debt also generally realizes a capital loss if the 

instrument becomes worthless. Certain other transactions, such as liquidating a subsidiary,49 can 

permit recognition of a stock loss without a sale to an unrelated party. 

In certain circumstances, an individual holder of debt that is not a security may take an 

ordinary bad debt deduction.50 

3. Acquisitions and dispositions 

The Code permits certain corporate acquisitions and dispositions to occur without 

recognition of gain or loss, generally so long as only equity interests are received or any 

securities received do not exceed the amount surrendered.51 Similarly, the Code permits certain 

contributions and distributions of property to and from partnerships without tax if made with 

respect to an equity interest.52

A transfer of property to a corporation or partnership in exchange for debt of the entity is 

generally treated as a sale of the property.53 Gain or loss is recognized, except that loss may be 

deferred if the transfer is to a related party.54

 49 See sec. 267(a)(1), second sentence. 

50 Sec. 166. 

51 Secs. 351-368 and 1032. 

52 Secs. 721 and 731. 

53 Sec. 1001. Special rules may apply if the transfer is considered part of a larger transaction such as an 

otherwise tax-free corporate reorganization. 

54 Secs. 267 and 707. 
13 

B. Distinguishing Between Debt and Equity 

1. In general 

The characterization of an instrument as debt or equity for Federal income tax purposes is 

generally determined by the substance of the investor’s investment. An instrument’s 

characterization depends on the terms of the instrument and all the surrounding facts and 

circumstances analyzed in terms of economic and practical realities. Neither the form of the 

instrument nor the taxpayer’s characterization of the interest is necessarily determinative of the 

instrument’s treatment for Federal income tax purposes. Nonetheless, between the extremes of 

instruments that are clearly debt or clearly equity, taxpayers have some latitude to structure 

instruments incorporating both debt- and equity-like features (commonly referred to as “hybrid 

securities”).55

There is currently no definition in the Code or Treasury regulations that can be used to 

determine whether an interest in a corporation constitutes debt or equity for tax purposes. 

Moreover, the IRS ordinarily does not provide individual taxpayers with guidance on whether a 

particular interest in a corporation is debt or equity for tax purposes because, in its view, the 

issue is primarily one of fact.56 

In the absence of statutory or regulatory standards, a substantial body of Federal common 

law is the principal source of guidance for distinguishing between debt and equity. Courts 

generally agree that the proper characterization of an instrument requires a facts and 

circumstances analysis, the primary goal of which is to determine whether, in both substance and 

form, an instrument represents risk capital entirely subject to the fortunes of the venture 

(equity),57 or an unqualified promise to pay a sum certain on a specified date with fixed interest 

(debt).58 The determination of whether an instrument constitutes debt or equity is generally 

made by analyzing and weighing the relevant facts and circumstances of each case.59

 55 See Kraft Foods Co. v. Commissioner, 232 F.2d 118, 123 (2d Cir. 1956) (noting that “[t]he vast majority 

of these cases have involved ‘hybrid securities’ —instruments which had some of the characteristics of a 

conventional debt issue and some of the characteristics of a conventional equity issue.”). 

56 Rev. Proc. 2016-3, sec. 4.02(1), January 4, 2016. The IRS has identified factors to weigh in determining 

whether a particular instrument should be treated as debt or equity. See, e.g., Notice 94-47, 1994-1 C.B. 357. 

57 See, e.g., United States v. Title Guarantee & Trust Co., 133 F.2d 990, 993 (6th Cir. 1943) (noting that 

“[t]he essential difference between a stockholder and a creditor is that the stockholder’s intention is to embark upon 

the corporate adventure, taking the risks of loss attendant upon it, so that he may enjoy the chances of profit.”); and 

Farley Realty Corp. v. Commissioner, 279 F.2d 701 (2d Cir. 1960); Commissioner v. O.P.P. Holding Corp., 76 F.2d 

11, 12 (2d Cir. 1935) (noting that that the distinction between the shareholder and the creditor is that “[t]he 

shareholder is an adventurer in the corporate business; he takes the risk and profits from success [while] [t]he 

creditor, in compensation for not sharing the profits, is to be paid independently of the risk of success, and gets a 

right to dip into the capital when the payment date arrives”). 

58 See, e.g., Gilbert v. Commissioner, 248 F.2d 399, 402 (2d Cir. 1957) (noting that debt involves “an 

unqualified obligation to pay a sum certain at a reasonably close fixed maturity date along with a fixed percentage in 

interest payable regardless of the debtor’s income or the lack thereof.”); sec. 385(b)(1) (“a written unconditional 
14 

Courts have created differing (though generally similar) lists of factors60 to distinguish 

debt from equity with no one factor controlling or more important than any other.61 One 

commentator provides a list of thirty factors, along with the Circuit courts that have considered 

such factors.62 Another commentator groups the factors discussed in the cases into four 

categories: (1) those involving the formal rights and remedies of the parties; (2) those bearing on 

the genuineness of the alleged intention to create a debtor-creditor relationship; (3) those bearing 

on the reasonableness or economic reality of that intention (the risk element); and (4) those 

which are merely rhetorical expressions of a result, having no proper evidentiary weight in 

themselves.63

Some commonly cited factors considered, among others, are: 

1. whether there is an unconditional promise to pay a sum certain on demand or at a 

fixed maturity date in the reasonably foreseeable future; 

2. whether the holder possesses the right to enforce the payment of principal and interest; 

3. whether there is subordination to, or preference over, any indebtedness of the issuer, 

including general creditors; 

4. the intent of the parties, including the name given the instrument by the parties and its 

treatment for nontax purposes, including financial accounting, regulatory, and rating 

agency purposes; 

 

promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in 

money or money’s worth, and to pay a fixed rate of interest”); Treas. Reg. sec. 1.165-5(a)(3) (defines security as an 

evidence of indebtedness to pay a fixed or determinable sum of money); and sec. 1361(c)(5)(B) (straight-debt safe 

harbor for subchapter S purposes). 

59 John Kelley Co. v. Commissioner, 326 U.S. 489 (1943) (stating “[t]here is no one characteristic, not even 

the exclusion from management, which can be said to be decisive in the determination of whether the obligations are 

risk investments in the corporations or debts”). 

60 See, e.g., Fin Hay Realty Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968) (sixteen factors); 

Estate of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972) (thirteen factors); Roth Steel Tube Co. v. 

Commissioner, 800 F.2d 625 (6th Cir. 1986) (eleven factors); and United States v. Uneco Inc., 532 F.2d 1204 (8th 

Cir. 1976) (ten factors). 

61 Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969) (noting that “[t]he object of the inquiry is not to 

count factors, but to evaluate them”); and Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972) 

(noting that the factors are not of equal significance and that no one factor is controlling). 

62 Nathan R. Christensen, “The Case for Reviewing Debt/Equity Determinations for Abuse of Discretion,” 

University of Chicago Law Review, 2007, pp. 1313. 

63 Plumb, “The Federal Income Tax Significance of Corporate Debt: A Critical Analysis and a Proposal,” 

Tax Law Review, 1971, pp. 411-412. According to a study of 126 Tax Court opinions issued from 1955 to 1987, 

seven factors were found to be conclusive of debt classification 97 percent of the time. Robertson, Daughtrey & 

Burckel, “Debt or Equity? An Empirical Analysis of Tax Court Classification During the Period 1955-1987,” Tax 

Notes, 1990. 
15 

5. the issuer’s debt to equity ratio; 

6. whether the instrument holder is at risk of loss or has the opportunity to participate in 

future profits; 

7. whether the instrument provides the holder with the right to participate in the 

management of the issuer; 

8. the availability and terms of other credit sources; 

9. the independence (or identity) between the holders of equity and the holders of the 

instrument in question; 

10. whether there are requirements for collateral or other security to ensure the payment 

of interest and principal; and 

11. the holder’s expectation of repayment. 

2. Regulatory authority pursuant to section 385 

Section 385 authorizes the Secretary of the Treasury to prescribe such regulations as may 

be necessary or appropriate to determine whether an interest in a corporation should be 

characterized as debt or equity (or as in part debt and in part equity) for Federal income tax 

purposes. Regulations prescribed under section 385 must set forth factors to be taken into 

account in determining in particular situations whether a debtor-creditor or a corporationshareholder relationship exists.64 These factors may include, among others, the following 

criteria: 

1. whether there is an unconditional written promise to pay on demand or on a specified 

date a sum certain in money in return for an adequate consideration in money or 

money’s worth, and to pay a fixed rate of interest; 

2. whether there is subordination to or preference over any indebtedness of the 

corporation; 

3. the corporation’s debt to equity ratio; 

4. whether the interest is convertible into stock of the corporation; and 

5. the relationship between the holdings of stock in the corporation and holdings of the 

interest in question. 

Section 385(c) provides that an issuer’s characterization of an instrument (at the time of 

issuance) is binding on the issuer and any holder, but not the Secretary. However, the holder of 

 64 Sec. 385(b). 
16 

an instrument may treat an instrument differently than the issuer provided the holder discloses 

the inconsistent treatment on his return.65 

On April 4, 2016, the Treasury promulgated proposed regulations under section 385.66 

Among other things, the regulations authorize the Commissioner to treat certain related-party 

interests in a corporation as part debt and part equity for Federal income tax purposes; provide 

rules that may treat an interest in an entity that is issued to a related party as, in whole or part, 

stock, if the interest is issued in a distribution or another transaction that has limited nontax 

effect or is issued to fund the transaction; and establish documentation requirements for certain 

related-party interests to be treated as debt for Federal income tax purposes. 

Previously, the Treasury had promulgated more comprehensive proposed regulations 

under section 385 in March 198067 and final regulations on December 31, 1980,68 with an 

effective date of April 30, 1981. The effective date was delayed twice.69 In 1982, the Treasury 

promulgated proposed amendments to the regulations.70 The effective date of the proposed 

amendments, and the final regulations, were again postponed.71 In 1983, the final regulations 

were withdrawn without ever having taken effect.72 

 65 For a brief description of the legislative background, see Joint Committee on Taxation, Present Law and 

Background Relating to Tax Treatment of Business Debt (JCS-41-11), July 11, 2011, pp. 18-19. 

66 81 F.R. 20912. The proposed regulations were first made available for public inspection on April 4, 

2016, and later published in the Federal Register on April 8, 2016. 

67 45 F.R. 18957. 

68 45 F.R. 86438. 

69 T.D. 7747, 45 F.R. 86438; T.D. 7774, 46 F.R. 24945; T.D. 7801, 47 F.R. 147. 

70 47 F.R. 164. 

71 T.D. 7822, 47 F.R. 28915. 

72 T.D. 7920, 48 F.R. 50711. One commentator suggests that the regulations were not finalized because 

tax planners could design instruments containing all of the essential features of equity but which qualify as debt 

under the regulations. As an example, he noted that an instrument would be classified as debt if its debt features 

accounted for more than half of its value and that, as a result of this rule, hybrid instruments such as adjustable rate 

convertible notes began appearing that provided for guaranteed payments having a present value just greater than 

half of the issue price, variable payments tied to the issuer’s common-stock dividends, and an option to convert 

these instruments into shares of the issuer’s stock. Adam O. Emmerich, “Hybrid Instruments and the Debt-Equity 

Distinction in Corporate Taxation,” University of Chicago Law Review, 1985, pp. 129-131. 
17 

C. Rules to Address Stripping of U.S. Corporate Tax Base 

in the Case of Nontaxed Holders 

A taxable corporation may reduce its Federal income tax through the payment of 

deductible amounts such as interest, rents, royalties, premiums, or management fees to an 

affiliate not subject to Federal income tax. Sheltering or offsetting income otherwise subject to 

Federal income tax in this manner is known as “earnings stripping.” Several provisions of 

present law limit taxpayers’ ability to strip earnings. Following is a brief description of certain 

rules designed to limit the ability of corporations to strip earnings using payments of interest. 

1. Earnings stripping 

Section 163(j) may disallow a deduction for disqualified interest paid or accrued by a 

corporation in a taxable year if two threshold tests are satisfied: the payor’s debt-to-equity ratio 

exceeds 1.5 to 1.0 (the safe harbor ratio); and the payor’s net interest expense exceeds 50 percent 

of its adjusted taxable income (generally, taxable income computed without regard to deductions 

for net interest expense, net operating losses, domestic production activities under section 199, 

depreciation, amortization, and depletion). Disqualified interest includes interest paid or accrued 

to: (1) related parties when no Federal income tax is imposed with respect to such interest;73

(2) unrelated parties in certain instances in which a related party guarantees the debt; or (3) to a 

REIT by a taxable REIT subsidiary of that trust.74 Interest amounts disallowed under these rules 

can be carried forward indefinitely.75 In addition, any excess limitation (i.e., the excess, if any, 

of 50 percent of the adjusted taxable income of the payor over the payor’s net interest expense) 

can be carried forward three years.76

The operation of these rules is illustrated by the following example. ForCo, a corporation 

organized in country A, wholly owns USCo, a corporation organized in the United States. 

ForCo’s investment in USCo stock totals $6.5 million. In addition, USCo has borrowed 

$8 million from ForCo and $5 million from Bank, an unrelated bank. In 2015, USCo’s first year 

of operations, USCo’s adjusted taxable income is $1 million (none of which is from interest 

income), and it also pays $400,000 of interest to ForCo and $300,000 of interest to the unrelated 

bank. Under the U.S.-country A income tax treaty, no tax is owed to the United States on the 

interest payments made by USCo to ForCo. 

 73 If a tax treaty reduces the rate of tax on interest paid or accrued by the taxpayer, the interest is treated as 

interest on which no Federal income tax is imposed to the extent of the same proportion of such interest as the rate 

of tax imposed without regard to the treaty, reduced by the rate of tax imposed by the treaty, bears to the rate of tax 

imposed without regard to the treaty. Sec. 163(j)(5)(B). 

74 Sec. 163(j)(3). 

75 Sec. 163(j)(1)(B). 

76 Sec. 163(j)(2)(B)(ii). 
18 

 USCo has a 2 to 1 debt-to-equity ratio (total borrowings of $13 million ($8 million + 

$5 million) and total equity of $6.5 million), so USCo’s deduction for the $700,000 

($400,000 + $300,000) of interest paid may be limited. 

 USCo’s disqualified interest is $400,000 (the amount of interest paid to a related 

party on which no Federal income tax is imposed). 

 USCo’s excess interest expense is $200,000 ($700,000 - ($1 million x 50%)). 

 Accordingly, USCo may deduct only $500,000 ($700,000 - $200,000) for interest 

expense in 2015. 

The $200,000 of excess interest expense may be carried forward and deducted in a 

subsequent tax year with excess limitation.77

2. Tax treatment of certain payments to controlling exempt organizations 

Although tax-exempt organizations described under section 501(c) are generally exempt 

from Federal income tax,78 such organizations may be subject to the unrelated business income 

tax (“UBIT”)79 on interest and other income received from the organization’s controlled 

subsidiaries.80 Section 512(b)(13) subjects interest income (as well as rent, royalty, and annuity 

income) to UBIT if such income is received from a taxable or tax-exempt subsidiary that is more 

than 50-percent controlled by the parent tax-exempt organization to the extent the payment 

reduces the net unrelated income (or increases any net unrelated loss) of the controlled entity 

(determined as if the entity were tax-exempt).81 

 77 For a brief description of the legislative background of section 163(j), see Joint Committee on Taxation, 

Present Law and Background Relating to Tax Treatment of Business Debt (JCS-41-11), July 11, 2011, pp. 21-23. 

78 Sec. 501(a). 

79 Secs. 511-514. In general, UBIT taxes income derived from a regularly carried on trade or business that 

is not substantially related to the organization’s exempt purposes. Certain categories of income—such as interest, 

dividends, royalties, and rent—are generally exempt from UBIT. Sec. 512(b)(1)-(3). For example, tax-exempt 

organizations are not taxed on interest income they receive from investments in debt or other obligations. 

80 Tax-exempt organizations subject to UBIT include those described in section 501(c) (except for 

U.S. instrumentalities and certain charitable trusts), qualified pension, profit-sharing, and stock bonus plans 

described in section 401(a), and certain State colleges and universities. Sec. 511(a)(2). Organizations liable for 

UBIT may be liable for alternative minimum tax determined after taking into account adjustments and tax 

preference items. 

81 In the case of a stock subsidiary, “control” means ownership by vote or value of more than 50 percent of 

the stock. In the case of a partnership or other entity, “control” means ownership of more than 50 percent of the 

profits, capital, or beneficial interests. In addition, present law applies the constructive ownership rules of 

section 318 for purposes of section 512(b)(13). Thus, a parent tax-exempt organization is deemed to control any 

subsidiary in which it holds more than 50 percent of the voting power or value, directly (as in the case of a first-tier 

subsidiary) or indirectly (as in the case of a second-tier subsidiary). 
19 

D. Rules to Address Corporate Base Erosion Without Regard 

to Holder’s Tax Status 

Several present law rules limit interest deductions in circumstances in which it appears a 

deduction would not be appropriate (e.g., because the instrument more closely resembles equity 

or because deductibility would otherwise allow an inappropriate reduction of the corporate tax 

base). The inappropriate reduction of the corporate tax base through the use of deductible 

payments or other planning techniques is commonly referred to as “base erosion.” Some 

limitations on the deductibility of interest expense are linked to whether the recipient of the 

interest is exempt from Federal income tax (e.g., the earnings stripping limitation of 

section 163(j)), while others consider whether the timing of the borrower’s deduction matches 

the timing of the lender’s corresponding income inclusion (e.g., the interest and OID rules of 

sections 267(a)(3) and 163(e)(3)). Other interest deduction limitations apply without regard to 

the holder’s tax status. Following is a brief description of some of these limitations. 

1. Corporate equity reduction transactions 

A net operating loss (“NOL”) is the amount by which a taxpayer’s business deductions 

exceed its income. In general, an NOL may be carried back two years and carried forward 

20 years to offset taxable income in such years.82 An NOL is first carried back to the earliest 

taxable year to which such loss may be carried, with any remaining NOL carried back to the next 

earliest taxable year and then forward to future taxable years.83 

Section 172(b)(1)(D) and (g) limit the NOL carryback of a C corporation involved in a 

corporate equity reduction transaction (a “CERT”) to the extent such NOL carryback is 

attributable to interest deductions allocable to the CERT and is incurred (1) in the taxable year in 

which the CERT occurs, or (2) in either of the two succeeding taxable years. The portion of the 

corporation’s NOL carryback that is limited is the lesser of (a) the corporation’s interest expense 

allocable to the CERT, or (b) the excess of the corporation’s interest expense in the loss 

limitation year over the average of the corporation’s interest expense for the three taxable years 

prior to the CERT taxable year. Any portion of an NOL that cannot be carried back under the 

provision may be carried forward as otherwise allowed. 

Except to the extent provided in regulations, interest is allocated to a CERT using the 

avoided cost method of allocating interest.84 That is, the amount of indebtedness treated as 

incurred or continued to finance the CERT is based on the amount of interest expense that would 

have been avoided if the CERT had not been undertaken and the amounts expended for the 

CERT were instead used to repay indebtedness. 

 82 Sec. 172(b)(1)(A). However, a taxpayer may elect waive the entire carryback period with respect to an 

NOL for a particular tax year. See sec. 172(b)(3). 

83 Sec. 172(b)(2). 

84 Sec. 172(g)(2)(B) (adopting the avoided cost method described in sec. 263A(f)(2)(A)(ii)). 
20 

A corporate equity reduction transaction means either a major stock acquisition or an 

excess distribution. A major stock acquisition is the acquisition by a corporation (or any group 

of persons acting in concert with such corporation) of stock in another corporation representing 

50 percent or more (by vote or value) of the stock of the other corporation.85 A major stock 

acquisition does not include a qualified stock purchase to which a section 338 election applies.86 

An excess distribution is the excess of the aggregate distributions and redemptions made by a 

corporation during the taxable year with respect to its stock (other than certain preferred stock 

described in section 1504(a)(4)), over the greater of (a) 150 percent of the average of such 

distributions and redemptions for the preceding three taxable years, or (b) 10 percent of the fair 

market value of the stock of such corporation as of the beginning of such taxable year. The 

amount of distributions and redemptions made by a corporation during a taxable year are reduced 

by stock issued by the corporation during the applicable period in exchange for money or 

property other than stock in the corporation. 

A corporation is treated as being involved in a CERT if it is either the acquired or 

acquiring corporation, or successor thereto (in the case of a major stock acquisition) or the 

distributing or redeeming corporation, or successor thereto (in the case of an excess 

distribution).87

2. Debt expected to be paid in equity 

Section 163(l) generally disallows a deduction for interest or OID on a debt instrument 

issued by a corporation (or issued by a partnership to the extent of its corporate partners) that is 

payable in equity of the issuer or a related party (within the meaning of section 267(b) or 

707(b)), or equity held by the issuer (or a related party) in any other person. 

For this purpose, debt is treated as payable in equity if a substantial amount of the 

principal or interest is mandatorily convertible or convertible at the issuer’s option into such 

equity (or the debt is part of an arrangement reasonably expected to achieve such a result).88 In 

addition, a debt instrument is treated as payable in equity if a substantial portion of the principal 

or interest is required to be determined, or may be determined at the option of the issuer or 

related party, by reference to the value of such equity (or the debt is part of an arrangement 

reasonably expected to achieve such a result).89 For this purpose, principal and interest is treated 

as required to be paid, converted, or determined if it may be required at the option of the holder 

 85 Sec. 172(g)(3)(A)(i) and (B). 

86 Sec. 172(g)(3)(B)(ii). A section 338 election allows taxpayers to treat a qualifying stock acquisition as 

an asset acquisition for Federal income tax purposes. 

87 For a brief description of the legislative background of the CERT provisions, see Joint Committee on 

Taxation, Present Law and Background Relating to Tax Treatment of Business Debt (JCS-41-11), July 11, 2011, p. 

26. 

88 Sec. 163(l)(3)(A) and (C). 

89 Sec. 163(l)(3)(B) and (C). 
21 

or a related party and there is a substantial certainty the option will be exercised.90 An exception 

is provided for debt issued by a dealer in securities (within the meaning of section 475) or a 

related party which is payable in, or by reference to, equity (not of the issuer or related party) 

held in its capacity as a dealer in securities.91

Application of section 163(l) to an instrument generally disallows the issuer’s interest or 

OID deductions, but the provision does not alter the treatment of amounts paid or accrued to the 

holder.92

3. Applicable high-yield discount obligations 

In general, the issuer of a debt instrument with OID may deduct the portion of such OID 

equal to the aggregate daily portions of the OID for days during the taxable year.93 However, in 

the case of an applicable high-yield discount obligation (an “AHYDO”) issued by a corporate 

issuer, (1) no deduction is allowed for the “disqualified portion” of the OID on such obligation, 

and (2) the remainder of the OID on any such obligation is not allowable as a deduction until 

paid by the issuer.94 

An AHYDO is any debt instrument if (1) the maturity date on such instrument is more 

than five years from the date of issue; (2) the yield to maturity on such instrument exceeds the 

sum of (a) the applicable Federal rate in effect under section 1274(d) for the calendar month in 

which the obligation is issued and (b) five percentage points, and (3) such instrument has 

significant original issue discount.95 An instrument is treated as having significant OID if the 

aggregate amount of interest that would be includible in the gross income of the holder with 

respect to such instrument for periods before the close of any accrual period (as defined in 

section 1272(a)(5)) ending after the date five years after the date of issue exceeds the sum of 

(1) the aggregate amount of interest to be paid under the instrument before the close of such 

accrual period, and (2) the product of the issue price of such instrument (as defined in 

sections 1273(b) and 1274(a)) and its yield to maturity.96 The disqualified portion of the OID on 

an AHYDO is the lesser of (1) the amount of OID with respect to such obligation or (2) the 

portion of the total return on such obligation which bears the same ratio to such total return as the 

 90 Sec. 163(l)(3). 

91 Sec. 163(l)(5). 

92 See H.R. Conf. Rep. 105-220. For a brief description of the legislative background of section 163(l), see 

Joint Committee on Taxation, Present Law and Background Relating to Tax Treatment of Business Debt (JCS-41-

11), July 11, 2011, pp. 27-28. 

93 Sec. 163(e)(1). For purposes of section 163(e)(1), the daily portion of the original issue discount for any 

day is determined under section 1272(a) (without regard to paragraph (7) thereof and without regard to 

section 1273(a)(3)). 

94 Sec. 163(e)(5). 

95 Sec. 163(i)(1). 

96 Sec. 163(i)(2). 
22 

disqualified yield (i.e., the excess of the yield to maturity on the obligation over the applicable 

Federal rate plus six percentage points) on such obligation bears to the yield to maturity on such 

obligation.97 The term “total return” means the amount which would have been the OID of the 

obligation if interest described in section 1273(a)(2) were included in the stated redemption to 

maturity.98 A corporate holder treats the disqualified portion of OID as a stock distribution for 

purposes of the dividend-received deduction.99 

4. Interest on certain acquisition indebtedness 

Section 279 denies a deduction for interest on corporate acquisition indebtedness. The 

limitation applies to interest in excess of $5 million per year incurred by a corporation with 

respect to debt obligations issued to provide consideration for the acquisition of stock, or twothirds of the assets, of another corporation, if each of the following conditions exists: (1) the 

debt is substantially subordinated;100 (2) the debt carries an equity participation feature101 (e.g., 

includes warrants to purchase stock of the issuer or is convertible into stock of the issuer); and 

(3) either the issuer is thinly capitalized (i.e., has a debt-to-equity ratio that exceeds 2 to 1)102 or 

projected annual earnings do not exceed three times the annual interest to be paid or incurred.103

 97 Sec. 163(e)(5)(C)(ii). 

98 Sec. 163(e)(5)(C)(ii). 

99 Sec. 163(e)(5)(B). For a brief description of the legislative background of the AHYDO rules, see Joint 

Committee on Taxation, Present Law and Background Relating to Tax Treatment of Business Debt (JCS-41-11), 

July 11, 2011, p. 29. 

100 Subordinated to the claims of trade creditors generally, or expressly subordinated in right of payment of 

any substantial amount of unsecured indebtedness, whether outstanding or subsequently issued (sec. 279(b)(2)(A) 

and (B)). 

101 Convertible directly or indirectly into the stock of the issuing corporation or part of an investment unit 

or other arrangement which includes an option to acquire, directly or indirectly, stock in the issuing corporation (sec. 

279(b)(3)(A) and (B)). 

102 Sec. 279(b)(4)(A). 

103 Sec. 279(b)(4)(B). For a brief description of the legislative background of section 279, see Joint 

Committee on Taxation, Present Law and Background Relating to Tax Treatment of Business Debt (JCS-41-11), 

July 11, 2011, p. 30. 
23 

E. Rules to Address Tax Arbitrage in the Case of Borrowing 

to Fund Untaxed Income 

When debt is used to finance an investment that produces income exempt from tax, taxed 

at preferential rates, or carrying associated tax credits, the deduction for interest on the debt 

financing can be used to offset other unrelated income. In addition, certain leveraged 

transactions by entities exempt from tax may present the opportunity for taxpayers to engage in 

transactions under terms they otherwise may not have in the absence of such tax-exemption. 

These outcomes are commonly referred to as “tax arbitrage.” Following is a brief discussion of 

certain rules that attempt to limit the ability of taxpayers to engage in these types of transactions. 

1. Interest related to tax-exempt income 

Section 265 disallows a deduction for interest on indebtedness incurred or continued to 

purchase or carry obligations the interest on which is wholly exempt from Federal income tax 

(“tax-exempt obligations”). This rule applies to tax-exempt obligations held by individual and 

corporate taxpayers. The rule also applies to certain cases in which a taxpayer incurs or carries 

indebtedness and a related person acquires or holds tax-exempt obligations.104 Generally, there 

are two methods for determining the amount of the disallowance. One method disallows interest 

deductions to the extent a taxpayer’s borrowing can be traced to its holding of tax-exempt 

obligations. A second method disallows interest deductions based on the percentage of a 

taxpayer’s assets comprised of tax-exempt obligations. 

The interest expense disallowance rules are intended to prevent taxpayers from engaging 

in tax arbitrage by deducting interest on indebtedness that is used to purchase tax-exempt 

obligations, so that the interest is available to offset other taxable income of the taxpayer. 

In general

Debt is traced to tax-exempt obligations if the proceeds of the indebtedness are used for, 

and are directly traceable to, the purchase of tax-exempt obligations. For example, this rule 

applies if tax-exempt obligations are used as collateral for indebtedness. In general terms, the 

tracing rule applies only if the facts and circumstances establish a sufficiently direct relationship 

between the borrowing and the investment in tax-exempt obligations. 

Within the general framework of section 265, there are special rules for individuals, 

dealers in tax-exempt obligations, corporations that are not dealers, and certain financial 

institutions. 

 104 Section 7701(f) provides that the Secretary of the Treasury will prescribe regulations necessary or 

appropriate to prevent the avoidance of any income tax rules that deal with the use of related persons, passthrough 

entities, or other intermediaries in (1) the linking of borrowing to investment, or (2) diminishing risks. See 

H Enterprises International, Inc. v. Commissioner, T.C. Memo. 1998-97, aff’d. 183 F.3d 907 (8th Cir. 1999) 

(section 265(a)(2) applies where a subsidiary borrows funds on behalf of a parent and the parent uses the funds to 

buy, among other investments, tax-exempt securities). 
24 

Corporations that are not dealers in tax-exempt obligations

In the case of a business that is not a dealer in tax-exempt obligations, if there is direct 

evidence of the purpose to purchase or carry tax-exempt obligations with the proceeds of 

indebtedness, then no interest on the indebtedness is deductible. In the absence of such direct 

evidence, the IRS provides specific inference rules. Generally, the purpose to purchase or carry 

tax-exempt obligations will not be inferred with respect to indebtedness incurred to provide 

funds for an active trade or business unless the borrowing is in excess of business needs.105 In 

contrast, the purpose to carry tax-exempt obligations will be inferred (unless rebutted by other 

evidence) where a taxpayer could reasonably have foreseen at the time of purchasing tax-exempt 

obligations that indebtedness would have been incurred to meet future economic needs of an 

ordinary, recurrent variety.106 

De minimis exception

In the absence of direct evidence linking an individual taxpayer’s indebtedness with the 

purchase or carrying of tax-exempt obligations, taxpayers other than dealers may benefit from a 

de minimis exception.107 The IRS takes the position that it ordinarily does not infer a purpose to 

purchase or carry tax-exempt obligations if a taxpayer’s investment therein is “insubstantial.”108 

A corporation’s holdings of tax-exempt obligations are presumed to be insubstantial if the 

average adjusted basis of the corporation’s tax-exempt obligations is two percent or less of the 

average adjusted basis of all assets held in the active conduct of the corporation’s trade or 

business. 

If a corporation holds tax-exempt obligations (e.g., installment obligations) acquired in 

the ordinary course of business in payment for services performed for, or goods supplied to, 

State or local governments, and if those obligations are nonsalable, the interest deduction 

disallowance rule generally does not apply.109 The theory underlying this rule is that a 

corporation holding tax-exempt obligations in these circumstances has not incurred or carried 

indebtedness for the purpose of acquiring those obligations. 

 105 Rev. Proc. 72-18, 1972-1 C.B. 419, 1972, as modified by Rev. Proc. 87-53, 1987-2 C.B. 669, 1987. 

See sec. 6.01. 

106 Ibid. at sec. 6.02. 

107 Ibid. at sec. 3.05 (which provides that the insubstantial holding safe harbor is not available to dealers in 

tax-exempt obligations). 

108 Ibid. at sec. 3.05.

109 Ibid. at sec. 6.03.
25 

Financial institutions

After taking into account any interest disallowance rules under general rules applicable to 

other taxpayers,110 section 265(b)(2) disallows a portion of a financial institution’s otherwise 

allowable interest expense that is allocable to tax-exempt interest. The amount of interest that is 

disallowed is the pro-rata amount of interest expense that equals the ratio of the financial 

institution’s average adjusted bases of tax-exempt obligations acquired after August 7, 1986, to 

the average adjusted bases of all the taxpayer’s assets (the “pro-rata rule”).111 This allocation 

rule is mandatory and cannot be rebutted by the taxpayer. A financial institution, for this 

purpose, is any person who accepts deposits from the public in the ordinary course of such 

person’s trade or business and is subject to Federal or State supervision as a financial institution, 

or is a bank as defined in section 585(a)(2). 

2. Debt with respect to certain insurance products 

No Federal income tax generally is imposed on a policyholder with respect to the 

earnings under a life insurance contract112 (“inside buildup”).113 Further, an exclusion from 

Federal income tax is provided for amounts received under a life insurance contract paid by 

reason of the death of the insured (“death benefits”).114

Present law imposes limitations on the deductibility of interest on debt with respect to life 

insurance contracts. These limitations address the potential for arbitrage that could arise in the 

event that deductible interest expense relates to amounts excludable as inside buildup or as death 

benefits under a life insurance contract. 

 110 Including section 265(a) (see sec. 265(b)(6)(A) and Joint Committee on Taxation, General Explanation 

of the Tax Reform Act of 1986, (JCS-10-87), p. 563). Section 265(b)(6)(B), however, specifies that the disallowance 

rule of section 265 is applied before the capitalization rule of section 263A (relating to the capitalization of certain 

expenditures, including interest as discussed above). 

111 Sec. 265(b). 

112 By contrast to the treatment of life insurance contracts, if a deferred annuity contract is held by a 

corporation or by any other person that is not a natural person, the income on the contract is treated as ordinary 

income accrued by the contract owner and is subject to current taxation. The contract is not treated as an annuity 

contract (sec. 72(u)). 

113 This favorable tax treatment is available only if a life insurance contract meets certain requirements 

designed to limit the investment character of the contract (sec. 7702). Distributions from a life insurance contract 

(other than a modified endowment contract) that are made prior to the death of the insured generally are includible 

in income, to the extent that the amounts distributed exceed the taxpayer’s basis in the contract for purposes of 

determining income taxes, other than those imposed on insurance companies such distributions generally are treated 

first as a tax-free recovery of basis, and then as income (sec. 72(e)). In the case of a modified endowment contract, 

however, in general, distributions are treated as income first, loans are treated as distributions (i.e., income rather 

than basis recovery first), and an additional 10-percent tax is imposed on the income portion of distributions made 

before age 59 1/2 and in certain other circumstances (sec. 72(e) and (v)). A modified endowment contract is a life 

insurance contract that does not meet a statutory “7-pay” test, i.e., generally is funded more rapidly than a policy that 

would provide paid-up future benefits after the payment of seven annual level premiums (sec. 7702A). 

114 Sec. 101(a). 
26 

Interest paid or accrued with respect to the contract

No deduction is allowed for any amount paid or accrued on debt incurred or continued to 

purchase or carry a single premium life insurance, annuity, or endowment contract (the “single 

premium” deduction limitation).115 A contract is treated as a single premium contract if 

substantially all the premiums on the contract are paid within a period of four years from the date 

on which the contract is purchased or if an amount for payment of a substantial number of future 

premiums is deposited with the insurer.116 

In addition, no deduction is allowed for any amount paid or accrued on debt incurred or 

continued to purchase or carry a life insurance, annuity, or endowment contract pursuant to a 

plan of purchase that contemplates the systematic direct or indirect borrowing of part or all of the 

increases in the cash value of the contract (either from the insurer or otherwise).117 Several 

exceptions are provided for this rule. The deduction denial does not apply if (1) no part of four 

of the annual premiums due during the initial seven year period is paid by means of such debt; 

(2) if the total amounts to which the provision would apply in a taxable year do not exceed $100; 

(3) if the amounts are paid or accrued because of financial hardship; or (4) if the indebtedness is 

incurred in connection with the taxpayer’s trade or business.118 

Finally, no deduction is allowed for interest paid or accrued on any debt with respect to a 

life insurance, annuity, or endowment contract covering the life of any individual,119 with a key 

person insurance exception.120 

Pro rata interest deduction limitation

A pro rata interest deduction disallowance rule also applies. This rule applies to interest 

for which a deduction is not disallowed under the other interest deduction disallowance rules 

relating to life insurance including, for example, interest on third-party debt that is not with 

respect to a life insurance, annuity, or endowment contract. Under this rule, in the case of a 

taxpayer other than a natural person,121 no deduction is allowed for the portion of the taxpayer’s 

 115 Sec. 264(a)(2). 

116 Sec. 264(c). 

117 Sec. 264(a)(3). 

118 Sec. 264(d). 

119 Sec. 264(a)(4). 

120 This provision limits interest deductibility in the case of such a contract covering any individual in 

whom the taxpayer has an insurable interest under applicable State law when the contract is first issued, except as 

otherwise provided under special rules with respect to key persons and pre-1986 contracts. Under the key person 

exception (sec. 264(e)), otherwise nondeductible interest may be deductible, so long as it is interest paid or accrued 

on debt with respect to a life insurance contract covering an individual who is a key person, to the extent that the 

aggregate amount of the debt does not exceed $50,000. Other special rules also apply. 

121 See sec. 264(f)(5). 
27 

interest expense that is allocable to unborrowed policy cash values.122 Interest expense is 

allocable to unborrowed policy cash values based on the ratio of (1) the taxpayer’s average 

unborrowed policy cash values of life insurance, annuity and endowment contracts, to (2) the 

sum of the average unborrowed cash values of life insurance, annuity, and endowment contracts, 

plus the average adjusted bases of other assets. 

Under the pro rata interest disallowance rule, an exception is provided for any contract 

owned by an entity engaged in a trade or business, if the contract covers only one individual who 

is an employee, officer, director, or 20-percent owner of the entity of the trade or business.123 

The exception also applies to a joint-life contract covering a 20-percent owner and his or her 

spouse. 

An employer may exclude the death benefit under a contract insuring the life of an 

employee if the insured was an employee at any time during the 12-month period before his or 

her death, or if the insured is among the highest paid 35 percent of all employees. Notice and 

consent requirements must be satisfied.124

3. Dividends received deduction reduction for debt-financed portfolio stock 

In general, a corporate shareholder is allowed a deduction equal to (1) 100 percent of 

certain qualifying dividends received from a corporation in the same affiliated group as the 

recipient;125 (2) 80 percent of the dividends received from a corporation if it owns at least 

20 percent of the payee’s stock (by vote and value); and (3) 70 percent of dividends received 

from other corporations.126 The purpose of the dividends received deduction is to reduce 

multiple corporate-level taxation of income as it flows from the corporation that earns it to the 

ultimate noncorporate shareholder. 

However, if dividends are paid on debt-financed stock, the combination of the dividends 

received deduction and the interest deduction would enable corporate taxpayers to shelter 

unrelated income. Therefore, section 246A generally reduces the 80-percent and 70-percent 

dividends received deduction so that the deduction is available, in effect, only with respect to 

 122 Sec. 264(f). This applies to any life insurance, annuity, or endowment contract issued after June 8, 

1997. 

123 Sec. 264(f)(4). 

124 For a brief description of the legislative background of a limitation on the deductibility of interest with 

respect to single premium life insurance contracts, see Joint Committee on Taxation, Present Law and Background 

Relating to Tax Treatment of Business Debt (JCS-41-11), July 11, 2011, pp. 37-38. 

125 Sec. 243(a)(3) and (b). An affiliated group generally consists of a common parent corporation and one 

or more other corporations at least 80 percent of the stock of which (by vote and value) is owned by the common 

parent or another member of the group. 

126 Sec. 243. Section 245 allows a 70-percent, 80-percent and 100-percent deduction for a specified 

portion of dividends received from certain foreign corporations. Section 244 allows a dividends received deduction 

on certain preferred stock of public utilities. 
28 

dividends attributable to that portion of the stock which is not debt-financed.127 Under 

regulations prescribed by the Secretary, any reduction in the amount allowable as a dividends 

received deduction under the rule is limited to the amount of the interest allocable to the 

dividend.128

Section 246A applies to dividends on “debt-financed portfolio stock” of the recipient 

corporation. Stock of a corporation is portfolio stock unless specifically excluded. Stock is not 

portfolio stock if, as of the beginning of the ex-dividend date for the dividend involved, the 

taxpayer owns stock (1) possessing at least 50 percent of the total combined voting power of all 

classes of stock entitled to vote, and (2) having a value equal to at least 50 percent of the value of 

all the stock, of such corporation.129 Portfolio stock is debt-financed if there is a direct 

relationship between indebtedness and the portfolio stock. The provision does not incorporate 

any allocation or apportionment formula or fungibility concept.130

 127 The reduction of the dividends received deduction may be viewed as a surrogate for limiting the interest 

deduction. 

128 Sec. 246A(e). Treasury has not yet issued regulations under section 246A. 

129 The 50-percent threshold is reduced to 20 percent if five or fewer corporate stockholders own, directly 

or indirectly, stock possessing at least 50 percent of the voting power and value of all the stock of such corporation. 

This rule was intended to exempt certain corporate joint ventures from the provision. See, Joint Committee on 

Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (JCS-41-84), 

December 31, 1984. 

130 For a brief description of the legislative background of section 246A, see Joint Committee on Taxation, 

Present Law and Background Relating to Tax Treatment of Business Debt (JCS-41-11), July 11, 2011, p. 42. 
29 

F. Rules to Match Timing of Tax Deduction and Income 

Inclusion Relating to Debt 

Statutory limitations on the deductibility of interest expense apply in some cases in which 

an immediate deduction would produce a mismatching of income and expense. If the full 

interest deduction is not permitted on a current basis, the deduction may be disallowed, deferred 

until a later time, or capitalized into the basis of related property. 

Special rules apply to a debt instrument issuer’s deduction for accrued but unpaid 

interest, and accrued OID, owed to certain related foreign persons. These rules are generally 

designed to match the issuer’s deduction with the holder’s corresponding income inclusion. 

Accrued but unpaid interest

A number of rules limit deductions for losses, expenses, and interest with respect to 

transactions between related persons. In the case of unpaid stated interest and expenses of 

related persons, where, by reason of a payee’s method of accounting, an amount is not includible 

in the payee’s gross income until it is paid, but the unpaid amounts are deductible currently by 

the payor, the amount generally is allowable as a deduction when such amount is includible in 

the gross income of the payee.131 This rule is intended to prevent the mismatch of, for example, 

a deduction for interest accrued by a taxpayer on the accrual method of accounting that is 

payable to a related person on a cash method of accounting. In the absence of this rule, the 

issuer would take a deduction upon accrual of the obligation to pay interest (whether or not the 

interest was actually paid), but a related holder would not take the interest into income until it is 

paid. 

U.S.-source “fixed or determinable annual or periodical” income, including dividends, 

interest, rents, royalties, and other similar income, is subject to a 30-percent gross-basis 

withholding tax when paid to a foreign person.132 This withholding tax can create a mismatch 

where, for example, a U.S. accrual-method taxpayer borrows amounts from a foreign 

corporation. In the absence of a special rule, the U.S. taxpayer would be allowed a deduction for 

accrued interest annually even if no interest were actually paid, and the foreign corporate lender 

would be subject to the 30-percent gross-basis withholding tax only when the interest was paid. 

The Code directs the Treasury Secretary to issue regulations applying the matching principle in 

this circumstance and other circumstances involving payments to related foreign persons.133 

With respect to stated interest and other expenses owed to related foreign corporations, Treasury 

regulations require a taxpayer to use the cash method of accounting in deducting amounts owed 

to related foreign persons (with an exception for income of a related foreign person that is 

 131 Sec. 267(a)(2). 

132 Secs. 871, 881, 1441, and 1442. 

133 Sec. 267(a)(3)(A). 
30 

effectively connected with the conduct of a U.S. trade or business and that is not exempt from 

taxation or subject to a reduced rate of taxation under a treaty obligation).134 

A foreign corporation’s foreign-source active business income generally is subject to 

U.S. tax only when such income is distributed to any U.S. person owning stock of such 

corporation. Accordingly, a U.S. person conducting foreign operations through a foreign 

corporation generally is subject to U.S. tax on the foreign corporation’s income only when the 

income is repatriated to the United States through a dividend distribution. However, certain antideferral regimes may cause the U.S. person to be taxed on a current basis in the United States 

with respect to certain categories of passive or highly mobile income earned by the foreign 

corporations in which a U.S. person holds stock. The main anti-deferral rules are the controlled 

foreign corporation (“CFC”) rules of subpart F135 and the passive foreign investment company 

(“PFIC”) rules.136 Section 267(a)(3)(B) provides special rules for items payable to a CFC or a 

PFIC. In general, with respect to any item payable to a related CFC or a PFIC, deductions for 

amounts accrued but unpaid (whether by U.S. or foreign persons) are allowable only to the 

extent that the amounts accrued by the payor are, for U.S. tax purposes, currently includible in 

the income of the direct or indirect U.S. owners of the related foreign corporation under the 

relevant inclusion rules. Deductions that have accrued but are not allowable under this special 

rule are subsequently allowed when the amounts are actually paid. 

Original issue discount 

Rules similar to those discussed above apply in the case of OID on debt instruments held 

by a related foreign person. In such case, section 163(e)(3)(A) disallows a deduction for any 

portion of such OID until paid by the issuer (the “related-foreign-person rule”).137 This relatedforeign-person rule does not apply to the extent that the OID is effectively connected with the 

foreign related person’s conduct of a U.S. trade or business (unless such OID is exempt from 

taxation or is subject to a reduced rate of taxation under a treaty obligation).138 

In the case of any OID debt instrument held by a related foreign person which is a CFC 

or a PFIC, deductions for accrued but unpaid OID are similarly allowable only to the extent that 

such OID is, for U.S. tax purposes, currently includible in the income of the direct or indirect 

U.S. owners of the related foreign corporation.139 

 134 Treas. Reg. sec. 1.267(a)-3(b)(1) and (c). 

135 Secs. 951-965. 

136 Secs. 1291-1298. 

137 Sec. 163(e)(3)(A). 

138 Sec. 163(e)(3)(A). 

139 Sec. 163(e)(3)(B). For a brief description of the legislative background of section 163(e)(3), see Joint 

Committee on Taxation, Present Law and Background Relating to Tax Treatment of Business Debt (JCS-41-11), 

July 11, 2011, p. 45. 
31 

II. DATA WITH RESPECT TO DEBT AND EQUITY 

The following tables show selected data related to business debt, equity, and interest 

expense. 

Table 1 provides an overall picture of the growth of nonfinancial corporate, household, 

and federal debt as a share of Gross National Product (“GNP”) from 1985 to 2015. Nonfinancial 

corporate debt has grown more modestly than either household debt or Federal debt. 

Nonfinancial corporate debt as a share of GNP has grown less than 10 percentage points since 

1984, while household debt has grown about 25 percentage points and Federal debt has more 

than doubled. 
32 

Table 1.−Corporate, Household, and Federal Debt, as a Percentage 

of Gross National Product (“GNP”), 1985-2015 

Year 

Corporate1 Debt as a 

Percentage of GNP 

Household Debt as a 

Percentage of GNP 

Federal Debt as a 

Percentage of GNP 

1985 37.5 53.1 40.3 

1986 40.5 56.2 43.6 

1987 42.1 57.1 44.6 

1988 42.9 58.4 44.9 

1989 43.2 58.9 44.9 

1990 43.0 60.0 47.1 

1991 40.7 61.4 50.7 

1992 38.7 61.1 53.1 

1993 38.9 61.9 54.8 

1994 39.4 62.7 54.2 

1995 40.2 64.0 53.9 

1996 39.9 64.9 53.4 

1997 40.8 65.1 51.0 

1998 42.8 66.5 48.3 

1999 44.5 68.2 45.1 

2000 45.2 69.7 39.6 

2001 45.0 73.3 38.8 

2002 43.6 77.9 40.2 

2003 41.7 83.4 41.9 

2004 40.4 87.4 42.5 

2005 39.8 90.7 42.4 

2006 40.6 95.1 41.7 

2007 43.3 96.9 41.6 

2008 44.3 94.1 49.5 

2009 42.3 94.5 61.0 

2010 39.8 89.1 69.4 

2011 40.5 84.4 74.0 

2012 41.0 81.5 78.4 

2013 42.1 79.8 81.0 

2014 43.3 78.8 82.0 

2015 44.6 78.3 83.5 1 Debt securities and loans of domestic nonfinancial corporations. 2 Household debt includes debt of personal trusts, nonprofit organizations, partnerships and sole proprietorships. 

Sources: Debt levels from The Board of Governors of the Federal Reserve System Financial Accounts of the United 

States: Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts, March 10, 2016, Table D.3. GNP 

levels from the U.S. Bureau of Economic Analysis via the Federal Reserve Bank of St. Louis, March 25, 2016, 

available at https://research.stlouisfed.org/fred2/data/GNPA.txt. JCT staff calculations. 
33 

Table 2 shows the distribution of holdings of corporate equity and bonds by type of 

holder for the years 1995, 2005, and 2015. Over that 20-year period, the share of corporate 

equities held directly by the households and nonprofit organizations sector has declined by 

15 percentage points, though the decline has leveled off in recent years. Private pension funds 

and government retirement funds also directly hold a smaller share of corporate equities than 

they once did. Regulated investment companies, including mutual funds, closed-end funds, and 

exchange-traded funds, show the largest growth in their share of ownership of corporate equities 

over the period. The household sector and private pension funds own the substantial majority of 

these shares, partially offsetting the decline in direct ownership of corporate equities by these 

groups. Foreign investors have steadily increased their holdings of corporate equities, owning 

nearly triple the share in 2015 that they held in 1995. 

Over the same 20-year period, the share of corporate and foreign bonds held by the 

households and nonprofit organizations has fallen from 20 percent to less than three percent, 

offset by a nearly identical increase in the share of bonds held by regulated investment 

companies. Insurance companies have been replaced by foreign investors as the largest holders 

of corporate bonds. Foreign investors, regulated investment companies (including mutual 

funds), and insurance companies each held roughly one-quarter of corporate bonds in 2015. 

Other domestic financial companies held a smaller share of bonds over the 20-year period, led by 

declines in holdings by finance companies and brokers and dealers. The other notable change is 

the share of corporate bonds held by government sponsored enterprises, which grew from 

approximately one percent of holdings in 1995 to 5.7 percent in 2005 before falling below onepercent in 2015. 
34 

Table 2.−Holdings of Corporate Equity and Bonds, 1995, 2005, and 2015 

(Year End Balances in Billions of Dollars) 

 1995 2005 2015 

 

Year 

End 

Balance 

Percent

of 

Total 

Year 

End 

Balance 

Percent 

of 

Total 

Year 

End 

Balance 

Percent

of 

Total 

Total corporate equities1 8,481 100.0 20,601 100.0 35,687 100.0 

Households and nonprofit organizations 4,434 52.3 8,014 38.9 13,311 37.3 

Federal, State, and local governments 26 0.3 116 0.6 214 0.6 

Private depository institutions 19 0.2 63 0.3 101 0.3 

Insurance companies 443 5.2 1,360 6.6 2,087 5.8 

Private pension funds 1,218 14.4 2,359 11.5 2,363 6.6 

Government retirement funds 754 8.9 1,846 9.0 2,555 7.2 

Regulated investment companies2 1,068 12.6 4,566 22.2 9,183 25.7 

Government sponsored enterprises 0 0.0 0 0.0 0 0.0 

Other domestic financial companies3

 34 0.4 158 0.8 167 0.5 

Foreign investors 485 5.7 2,118 10.3 5,707 16.0 

 

Total corporate and foreign bonds4 3,085 100.0 8,236 100.0 11,732 100.0 

Households and nonprofit organizations 617 20.0 692 8.4 296 2.5 

Federal, State, and local governments 39 1.3 131 1.6 184 1.6 

Private depository institutions 186 6.0 760 9.2 682 5.8 

Insurance companies 990 32.1 2,088 25.3 2,786 23.7 

Private pension funds 241 7.8 288 3.5 711 6.1 

Government retirement funds 190 6.2 338 4.1 567 4.8 

Regulated investment companies2

 232 7.5 994 12.1 2,974 25.3 

Government sponsored enterprises 30 1.0 466 5.7 65 0.6 

Other domestic financial companies3

 204 6.6 652 7.9 335 2.9 

Foreign investors 355 11.5 1,804 21.9 3,116 26.6 

1

 Corporate equities are shares issued by domestic corporations, or issued by foreign corporations and purchased by U.S. 

persons. It includes shares of publicly traded C corporations and closely held S corporations and C corporations. It does not

include mutual fund shares. 

2

 Regulated investment companies include mutual funds, closed-end funds, and exchange-traded funds. 3 Other domestic financial companies include finance companies, real estate investment trusts, brokers and dealers, holding 

companies, and funding corporations. 

4

 Corporate bonds include bonds issued by U.S. corporations, or issued by foreign corporations and purchased by U.S. persons. 

Other types of debt, including trade debt, mortgages, and bank loans, are excluded. 

Source: The Board of Governors of the Federal Reserve System Financial Accounts of the United States: Flow of Funds, 

Balance Sheets, and Integrated Macroeconomic Accounts, Historical Annual Tables 1995-2004, and 2005-2015, March 10, 2016, 

Tables L.213 and L.223, and JCT staff calculations. 
35 

Table 3 shows debt-to-net-worth ratios of nonfinancial corporations from 1985 to 2015. 

These measures are similar to debt-to-equity ratios for financial accounting purposes. Debt 

includes debt securities such as commercial paper and corporate bonds and bank loans. Net 

worth is measured as the value of assets minus all liabilities. In addition to debt securities and 

loans, liabilities include trade payables, taxes payable, foreign direct investment in the United 

States and miscellaneous liabilities. For the first series, both financial and nonfinancial assets are 

measured at market value. The second series measures financial assets at market value and 

nonfinancial assets, including real estate, equipment, intellectual property products, and 

inventories, at historical cost. Since market value generally exceeds historical costs, the debt 

ratios in the second series exceed those in the first series. The two series generally move 

together, except for periods of volatility in the market value of real estate. 
36 

Table 3.−Debt-to-Net-Worth Ratios of Nonfinancial Corporations, 

1985-2015 

Year 

Ratio of Debt to 

Net Worth 

(Market Value) 

Ratio of Debt to 

Net Worth 

(Historical Cost) 

1985 36.57 68.55 

1986 40.18 73.48 

1987 42.10 75.96 

1988 43.27 78.05 

1989 45.17 81.74 

1990 46.98 80.25 

1991 47.02 73.99 

1992 49.88 72.66 

1993 50.76 70.60 

1994 50.37 70.03 

1995 49.90 68.31 

1996 49.41 64.98 

1997 46.06 64.62 

1998 45.74 64.93 

1999 46.09 63.83 

2000 43.20 60.58 

2001 44.93 60.74 

2002 43.61 59.69 

2003 41.57 56.60 

2004 37.03 54.24 

2005 35.29 53.38 

2006 34.54 53.88 

2007 34.60 57.22 

2008 40.45 63.91 

2009 43.14 55.63 

2010 38.41 51.30 

2011 38.36 52.80 

2012 38.99 54.43 

2013 36.71 53.44 

2014 36.03 53.76 

2015 35.51 54.24 

 Source: The Board of Governors of the Federal Reserve 

 System Financial Accounts of the United States: Flow of 

 Funds, Balance Sheets, and Integrated Macroeconomic 

 Accounts, Historical Annual Tables 1985-1994, 1995-2004,

 and 2005-2015, March 10, 2016, Table B.103. 
37 

Table 4 shows interest expense and taxable income of nonfinancial corporations from 

1987 to 2012 as reported on corporate income tax returns. For this purpose, nonfinancial 

corporations are corporations other than those in the finance and insurance industry based on the 

primary business activity code reported on the tax return. The table also shows the interest 

expense as a percentage of taxable income before interest expense and corporate bond interest 

rates. Though interest expense fluctuates with the level of debt and interest rates, this percentage 

appears to primarily reflect the effects of the business cycle, as the percentage has peaks in 1990 

and 2001, when taxable income declined. In addition to business cycle effects, other changes in 

tax policy that have an impact on taxable income affect this percentage. For example, bonus 

depreciation lowers otherwise reported taxable income and potentially increases otherwise 

reported taxable income in later years. 
38 

Table 4.−Interest Expense and Taxable Income of Nonfinancial Corporations, 

1987-2012 

Year 

Interest Expense 

(Billions of dollars) 

Taxable Income 

(Billions of 

dollars) 

Interest as a percent 

of taxable income 

before interest 

Corporate 

bond 

interest rate1

1987 314.9 261.0 54.7 9.38 

1988 256.5 323.3 44.2 9.71 

1989 309.7 306.2 50.3 9.26 

1990 483.4 297.9 61.9 9.32 

1991 309.0 269.2 53.4 8.77 

1992 270.7 276.3 49.5 8.14 

1993 253.4 312.3 44.8 7.22 

1994 270.6 379.2 41.6 7.96 

1995 311.3 418.0 42.7 7.59 

1996 331.1 473.2 41.2 7.37 

1997 365.4 502.8 42.1 7.26 

19982 621.7 549.5 53.1 6.53 

1999 626.1 580.1 51.9 7.04 

2000 797.4 637.5 55.6 7.62 

2001 781.8 526.0 59.8 7.08 

2002 621.0 483.0 56.3 6.49 

2003 568.9 551.2 50.8 5.67 

2004 596.9 694.1 46.2 5.63 

2005 771.8 1,013.7 43.2 5.24 

2006 1,036.1 1,069.0 49.2 5.59 

2007 1,185.7 1,044.7 53.2 5.56 

2008 987.8 862.2 53.4 5.63 

2009 713.4 762.6 48.3 5.31 

2010 1,020.4 883.0 53.6 4.94 

2011 595.3 872.1 40.6 4.64 

2012 569.7 1,003.0 36.2 3.67 

1 Corporate bond interest rate is the average rate on corporate Aaa bonds published by Moody’s Investor Services. 2 Results before 1998 are not directly comparable to those in 1998 and later due to changes in the IRS classification of financial 

and nonfinancial corporations. 

Sources: JCT staff tabulations, IRS Statistics of Income Corporation Income Tax Returns (various years). Corporate bond 

interest rates are from Council of Economic Advisors, Economic Report of the President, February 2016, Table B-25. 
39 

Table 5 shows interest and net income for corporations (other than S corporations, RICs, 

and REITs), S corporations, and partnerships from 1995 to 2012, and also shows the interest 

expense as a percentage of net income before interest expense. These data reflect similar 

business cycle effects as noted above, as well as showing a significant downward trend for 

S corporations in interest expense as a percentage of net income before interest expense. Table 5 

also shows that C corporations’ interest expense, in the aggregate and as a percentage of net 

income before interest expense, exceeds the comparable figures for partnerships and 

S corporations throughout this period. These data reflect the larger size of the C corporate 

sector, but C corporations may also have a Federal income tax incentive to incur debt, as interest 

is deductible in determining the corporate tax. By contrast, partnerships and S corporations are 

not subject to an entity-level tax. 

Table 5 illustrates that partnership interest expense, in the aggregate and as a percentage 

of net income before interest expense, has exceeded S corporation interest since 2002. Among 

other factors, these differences may reflect the difference in tax rules for determining basis of 

partners’ and S corporation shareholders’ equity interests, respectively. 
40 

Table 5.−Interest Expense and Net Income of Nonfinancial Business Entities, 

1995-2012 

 

Corporations Other than 

S Corporations, 

RICs, and REITs 

 S Corporations Partnerships 

 Year 

Interest 

Expense 

(Billions 

of 

dollars) 

Net 

Income 

(Billions 

of 

dollars) 

Interest as a 

Percentage 

of Net 

Income 

before 

Interest 

 

Interest 

Expense 

(Billions 

of 

dollars) 

Net 

Income 

(Billions 

of 

dollars) 

Interest as a 

Percentage 

of Net 

Income 

before 

Interest 

Interest 

Expense 

(Billions 

of 

dollars) 

Net 

Income 

(Billions 

of 

dollars) 

Interest as a 

Percentage 

of Net 

Income 

before 

Interest 

1995 296.2 383.3 43.6 26.3 74.3 26.1 18.2 62.3 22.6 

1996 314.9 421.8 42.7 25.1 89.7 21.9 20.1 75.5 21.0 

1997 347.1 441.2 44.0 29.6 103.3 22.3 24.0 73.3 24.7 

19981 588.5 434.0 57.6 33.3 169.9 16.4 30.9 83.2 27.1 

1999 590.3 435.5 57.5 35.8 184.2 16.3 34.8 95.1 26.8 

2000 754.7 414.6 64.5 42.7 184.7 18.8 41.9 117.7 26.3 

2001 736.6 200.9 78.6 45.1 175.3 20.5 43.2 117.7 26.8 

2002 585.7 177.2 76.8 33.3 169.5 16.4 44.5 181.4 19.7 

2003 535.1 319.6 62.6 33.9 195.0 14.8 44.0 195.8 18.3 

2004 561.8 546.8 50.7 35.0 252.9 12.2 46.8 248.8 15.8 

2005 727.1 1183.2 38.1 44.7 324.6 12.1 56.3 348.3 13.9 

2006 977.3 1022.2 48.9 58.7 359.2 14.1 69.1 385.0 15.2 

2007 1110.7 928.3 54.5 66.1 367.4 15.3 77.0 360.7 17.6 

2008 919.3 579.4 61.3 59.1 286.3 17.1 82.2 239.5 25.6 

2009 657.1 368.4 64.1 47.6 248.5 16.1 72.0 202.5 26.2 

2010 549.8 721.2 43.3 42.8 308.4 12.2 70.7 306.7 18.7 

2011 545.7 687.3 44.3 39.8 345.7 10.3 67.7 406.1 14.3 

2012 520.6 876.0 37.3 38.4 439.7 8.0 68.7 442.5 13.4 

1 Results before 1998 are not directly comparable to those in 1998 and later due to changes in the IRS classification of financial 

and nonfinancial corporations. 

Source: JCT staff tabulations, IRS Statistics of Income Corporation Income Tax Returns (various years). 
41 

Table 6 shows data for interest expense and net income for all corporations, separated 

into those with annual business receipts either above or below $5 million. The data on interest 

expense as a percentage of net income before interest expense again appear to reflect business 

cycle effects of the 2000-2001 economic slowdown, regardless of the size of corporations. 

Table 6.−Interest Expense and Net Income of Nonfinancial Corporations 

by Size of Corporation, 

1995-2012 

 

Corporations with Business Receipts 

under $5,000,000 

Corporations with Business Receipts 

over $5,000,000 

 Year 

Interest 

Expense 

(billions 

of dollars) 

Net 

Income 

(billions 

of dollars) 

Interest as a 

Percentage 

of Net 

Income 

before 

Interest 

Interest 

Expense 

(billions of 

dollars) 

Net 

Income 

(billions of 

dollars) 

Interest as a 

Percentage 

of Net 

Income 

before 

Interest 

1995 25.3 24.4 50.9 286.0 433.0 39.8 

1996 25.5 29.0 46.8 305.6 478.3 39.0 

1997 26.7 34.0 44.0 338.6 507.9 40.0 

19981 37.2 37.3 49.9 584.5 515.7 53.1 

1999 37.7 33.2 53.2 588.3 535.1 52.4 

2000 41.0 11.6 77.9 756.4 537.0 58.5 

2001 43.6 5.9 88.1 738.2 329.6 69.1 

2002 34.9 5.7 86.0 586.1 310.9 65.3 

2003 34.1 30.1 53.1 534.9 446.9 54.5 

2004 34.4 55.2 38.4 562.5 1,037.6 35.2 

2005 38.1 96.2 28.4 733.7 1,351.9 35.2 

2006 41.3 95.1 30.3 994.8 1,206.5 45.2 

2007 54.2 122.3 30.7 1,131.5 1,113.5 50.4 

2008 53.5 60.8 46.8 934.2 765.0 55.0 

2009 48.2 42.9 52.9 665.2 545.9 54.9 

2010 46.5 89.8 34.1 555.9 913.3 37.8 

2011 41.7 94.3 30.6 553.7 887.1 38.4 

2012 41.4 134.0 23.6 528.3 1,122.8 32.0 1 Results before 1998 are not directly comparable to those in 1998 and later due to changes in the IRS classification of financial 

and nonfinancial corporations. 

Note: Includes all active corporations filing a corporate income tax return, including S corporations, C corporations, RICs, and 

REITs. 

Source: JCT staff tabulations, IRS Statistics of Income Corporation Income Tax Returns (various years). 

Table 7 reports gross dividends paid by nonfinancial corporations from 1985 through 

2014. To get a sense of how much of the profits of the corporations are distributed to 

shareholders, the table also shows profits before and after taxes on corporate income. For the 

entire period, dividends averaged 55.7 percent of pretax profits and 77.1 percent of after-tax 

profits. The percentage of profits distributed as dividends tends to rise in recession years, 
42 

perhaps reflecting a desire to maintain dividend levels even in years in which net income 

declines. There also appears to have been a reduction in the dividend distribution rate in the 

most recent decade as dividends averaged only 51.9 percent of pretax profits and 68.1 percent of 

after-tax profits for the period 2005 through 2014.

Table 7.−Dividends, Profits, and Taxes of Nonfinancial Corporations, 

1985-2014

Year 

Gross Dividends 

Paid of Domestic 

Nonfinancial 

Corporations 

Profits before 

Taxes on 

Corporate 

Income 

Taxes on 

Corporate 

Income 

Profits after 

Taxes on 

Corporate 

Income 

Dividends as 

a Percentage 

of Pretax 

Profits 

Dividends as 

a Percentage 

of After-Tax 

Profits 

1985 99.4 205.0 71.1 133.9 48.5 74.2

1986 103.7 170.4 76.2 94.2 60.9 110.1

1987 106.1 222.5 94.2 128.3 47.7 82.7

1988 127.9 264.5 104.0 160.5 48.4 79.7

1989 147.9 244.0 101.2 142.8 60.6 103.6

1990 158.5 238.3 98.5 139.8 66.5 113.4

1991 162.8 232.4 88.6 143.8 70.1 113.2

1992 174.9 257.1 94.4 162.7 68.0 107.5

1993 185.3 309.1 108.0 201.1 59.9 92.1

1994 198.8 397.9 132.4 265.5 50.0 74.9

1995 223.4 452.0 140.3 311.7 49.4 71.7

1996 250.2 488.9 152.9 336.0 51.2 74.5

1997 278.3 527.1 161.4 365.7 52.8 76.1

1998 299.2 486.4 158.7 327.7 61.5 91.3

1999 284.4 489.6 171.4 318.2 58.1 89.4

2000 313.4 451.2 170.2 281.0 69.5 111.5

2001 299.3 325.3 111.2 214.1 92.0 139.8

2002 305.1 359.5 97.1 262.4 84.9 116.3

2003 349.2 496.3 132.9 363.4 70.4 96.1

2004 430.8 700.2 187.0 513.2 61.5 83.9

2005 471.1 1,004.6 271.9 732.7 46.9 64.3

2006 550.8 1,180.1 307.7 872.4 46.7 63.1

2007 576.9 1,093.5 293.8 799.7 52.8 72.1

2008 582.2 880.3 227.4 652.9 66.1 89.2

2009 490.4 752.5 177.8 574.7 65.2 85.3

2010 509.9 1,039.2 220.6 818.6 49.1 62.3

2011 535.8 1,009.0 228.8 780.2 53.1 68.7

2012 624.8 1,241.4 266.7 974.7 50.3 64.1

2013 630.7 1,323.2 284.6 1,038.6 47.7 60.7

2014 676.9 1,366.1 316.2 1,049.9 49.5 64.5

Source: The Board of Governors of the Federal Reserve System Financial Accounts of the United States: Flow of Funds, 

Balance Sheets, and Integrated Macroeconomic Accounts, Historical Annual Tables 1985-1994, 1995-2004, and 2005-2015, 

March 10, 2016, Tables F.3 and S.5.a and JCT staff calculations.
43 

III. TAX INCENTIVES UNDER PRESENT LAW 

FOR FIRM CAPITAL STRUCTURE 

This section describes incentives issuers and holders have to use debt, to use equity, to 

create hybrid instruments blending aspects of each, to substitute for debt economically similar 

arrangements, and also discusses financial accounting and related considerations.140 

A. Tax Incentives for Debt 

Incentive for corporate leverage 

Although returns to debt investment (interest) are generally deductible by a borrowing 

business, returns to equity investment (e.g., dividends on equity) are not. This tax distinction is 

particularly important to C corporations because only such entities are taxed at the entity level. 

For a C corporation, the after-tax effect of debt financing is more favorable than equity financing 

because of the deductibility of interest. 

Example 1:141 Corporation X is in the 35-percent tax bracket and wants to raise 

$100 million of additional capital. Corporation X may issue either debt with a 5-percent interest 

rate, or preferred stock with a 5-percent dividend. Assume that, after raising the capital, 

Corporation X earns $10 million and pays $5 million to the new investors. If the $100 million 

raised is in the form of debt, Corporation X may deduct the $5 million paid to the investors, 

leaving cash after tax of $3.25 million.142 If the $100 million is in the form of preferred stock, 

cash available to Corporation X after tax is only $1.50 million.143 Figure 1, below, depicts the 

results of this Example 1. 

 140 A description of tax incentives passthrough entities have to use debt versus equity is beyond the scope 

of this document. For a recent description, see Joint Committee on Taxation, Present Law and Background Relating 

to Tax Treatment of Business Debt (JCX-41-11), July 11, 2011. 

141 The examples are simplified to assume that the top 35-percent corporate rate applies to all income 

(rather than the graduated rates) and that the rates of return on (i.e., the cost of) equity and debt are the same. 

142 Gross income of 10, less 5 distributed to the debt holders, less corporate tax of 1.75 (.35 x (10-5)). 

143 Gross income of 10, less 5 distributed to the preferred shareholders, less corporate tax of 3.50 (.35 x 

10). 
44 

Corporation X

Shareholder

A

Shareholder

B

50% 50%

C corporation needs $100M additional capital to expand its business.

Assume the corporation earns $10M and pays corporate tax at 35% rate. 

Loan Results:

Gross income = $10M

Interest expense = $5M 

Taxable income = $5M ($10 - $5 deductible interest) 

Corporation pays corporate tax of $1.75M ((10-5)*35%)

After-tax cash = $3.25M 

Shareholder

A

Shareholder

B

Preferred shareholder

Bank 

$5M Interest

Preferred Stock Results:

Gross income = $10M 

Dividend paid = $5M

Taxable income = $10M (dividend not deductible) 

Corporation pays corporate tax of $3.50M (10*35%)

After-tax cash = $1.50M 

$100M 

Preferred Stock

$100M Loan

5% Bank Loan 5% Preferred Stock

Corporation X

Figure 1.–Financing Additional $100M Investment: Debt vs. Preferred Stock with Third Party Investor

$5M 

Dividend

Figure 2, below, demonstrates the results of the $100 million investment if, instead of 

involving a third party bank or preferred shareholder, the current shareholders of Corporation X 

finance the $100 million investment themselves. Notwithstanding the fact that individual 

shareholders pay Federal income tax at a higher rate on interest (43.4 percent)144 than on 

dividends (23.8 percent),145 the total tax paid by Corporation X and the shareholders combined is 

less if the investment is debt financed. In addition, the tax savings associated with the interest 

deduction results in a greater net return from the $100 million debt financed investment 

($5.31 million)146 than results from the preferred stock investment ($4.95 million).147 

 144 This includes the maximum individual income tax rate of 39.6 percent plus the net investment income 

tax rate of 3.8 percent. It does not include the effect of any other tax provisions, such as the overall limitation on 

itemized deductions, on the effective marginal tax rate. 

145 This includes the maximum tax rate on qualified dividend income (which is the same as the maximum 

individual tax rate on capital gains) of 20 percent plus the net investment income tax rate of 3.8 percent. It does not 

include the effect of any other tax provisions, such as the overall limitation on itemized deductions, on the effective 

marginal tax rate. 

146 Net return on the investment financed with debt is equal to the gross income ($10 million) less 

corporate taxes paid ($1.75 million) and less individual taxes paid ($2.17 million on interest and $0.77 million on 

common stock dividends). 
45 

Corporation X

Shareholder

A

Shareholder

B

Same facts as Figure 1, but current shareholders provide additional capital and the corporation distributes all

after-tax cash for the year as a dividend on the common stock.

Assume shareholders are in the 43.4% tax bracket. 

Loan Results:

Gross income = $10M 

Interest expense = $5M ($2.5M paid to each)

Taxable income = $5M ($10 - $5 deductible interest) 

Corporation pays corporate tax of $1.75M ((10-5)*35%)

Together, Shareholder A and B pay individual tax

• on interest of $2.17M (5*43.4%) and

• on dividends of $0.77M ((10 – 5 – 1.75)*23.8%)

Total Tax Paid = $4.69M

Net Return from $100M Investment = $5.31M

Preferred Stock Results:

Gross income = $10M

Pref. dividend paid = $5M ($2.5M paid to each)

Taxable income = $10M (dividends not deductible) 

Corporation pays corporate tax of $3.50M (10*35%)

Together, Shareholder A and B pay individual tax

• on preferred dividend of $1.19M (5*23.8%) and

• on common dividend of $0.36M ((10 – 5 –

3.50)*23.8%)

Total Tax Paid = $5.05M

Net Return from $100M Investment = $4.95M

5% Shareholder Loan 5% Preferred Stock

$2.5M Interest

+ $1.625M Common Dividend

$50M 

Loan

Figure 2.–Financing Additional $100M Investment: Debt vs. Preferred Stock with Current Shareholders

$50M 

Loan

Corporation X

Shareholder

A

Shareholder

B

$2.5M Pref. Dividend

+ $0.75M Common Dividend

$50M

Pref. Stock

$50M

Pref. Stock

$2.5M Pref. Dividend

+ $0.75M Common Dividend

$2.5M Interest

+ $1.625M Common Dividend

Corporate transactions that substitute debt for equity may increase earnings per share

The effect of using debt rather than equity to capitalize a corporation means that a 

corporation may increase its after-tax earnings per share simply by substituting debt for equity 

capitalization. The accounting effect of allocating all after-tax earnings to a smaller pool of 

equity shares than before the transaction is magnified for a corporate issuer because the interest 

deduction from the substitution of debt for equity itself increases after-tax earnings. A common 

transaction in which this occurs is a leveraged buyout, which is an acquisition of corporate stock 

using debt imposed at the corporate level to provide the cash to buy out the former shareholders. 

Another common transaction is a corporation’s redemption of its own stock with cash from the 

proceeds of a corporate borrowing (without any acquisition of corporate stock by an unrelated 

firm or its shareholders), or other corporate distributions to shareholders financed through 

corporate borrowing. 

Example 2:

148 Corporation X is in the 35-percent tax bracket, and has outstanding 

2.6 million shares of common stock and no debt. Corporation X has annual income of 

 147 Net return on the investment financed with preferred stock is equal to the gross income ($10 million) 

less corporate taxes paid ($3.50 million) and less individual taxes paid ($1.19 million on preferred stock dividends 

and $0.36 million on common stock dividends). 

148 Examples 2, 3, and 4 are highly simplified. They assume a corporation with zero leverage that becomes 

highly leveraged in transactions substituting debt for equity. In considering stock price, the examples do not take 
46 

$40 million on which it pays Federal income tax of $14 million ($40 million multiplied by 

35 percent), resulting in net after-tax income of $26 million ($40 million less $14 million). 

Earnings per share are $10 ($26 million divided by 2.6 million shares). The stock has a market 

value of $80 per share (eight times after-tax earnings). 

A buyout fund offers $312 million in cash for all the outstanding Corporation X stock 

($120 cash per share, 50 percent more than the current market value). The acquisition is funded 

with $42 million of the buyout fund’s own cash, and the remaining $270 million is raised by 

issuing notes paying eight percent interest to be secured by Corporation X’s assets. Taxable 

shareholders who sell to the buyout fund recognize gain or loss on the sale of their shares. 

Even if the annual pre-tax income of Corporation X after the buyout is unchanged, its 

taxes are significantly reduced by the deduction of the interest ($270 million x 8 percent = 

$21.6 million) paid to its bondholders. The reduction of Corporation X’s income taxes by 

$7.56 million ($21.6 million multiplied by 35 percent) caused by the interest deduction produces 

an additional $7.56 million for the investors. The buyout fund that invested $42 million of 

equity obtains an after-tax return in the first year of $11.96 million, a 28.5-percent return on its 

equity investment.149 

Example 3: Assume the same initial facts as in Example 2. Instead of being acquired in 

a leveraged buyout, Corporation X issues bonds to borrow $270 million at eight percent interest, 

and repurchases $270 million of its shares (approximately 87 percent of the outstanding shares) 

at a redemption price of $120 per share, 50 percent more than the price at which the stock had 

been trading on the market. Taxable shareholders recognize gain or loss on the redemption of 

their shares. The resulting reduction in Corporation X’s income taxes of $7.56 million 

($21.6 million multiplied by 35 percent) exactly pays for the increased returns to the bondholders 

plus the remaining shareholders (after the transaction, $33.56 million in interest paid to the 

bondholders and after-tax earnings of the corporation150 equals the $26 million of earnings 

 

into account whether the stock price before the transaction may have reflected an expectation of eventual leverage. 

Also, the examples do not consider what level of debt may be considered optimal from a business standpoint for a 

particular business or industry, or how this may affect stock price (for example, if a corporation has debt in excess of 

the general level of debt of other businesses within its industry, this may result in a lower stock price as investors 

may infer that there are fewer assets available for distribution to shareholders in the event of bankruptcy or default). 

149 The transaction redistributed the operating income of Corporation X, including the benefit of the 

$7.56 million reduction in corporate income taxes. Before the transaction, Corporation X had total annual operating 

income of $40 million, bearing corporate income tax of $14 million and producing after-tax corporate earnings of 

$26 million ($10 per share, for a market value at eight times earnings of $80 per share). After the transaction, 

Corporation X continues to have total annual operating income of $40 million. $21.6 million is paid as interest to the 

new bondholders, resulting in taxable income of $18.4 million from which $6.44 million of corporate income tax is 

paid, and $11.96 million remains as after-tax corporate earnings of the corporation in the hands of the new 

shareholder that invested $42 million. 

150 Interest and earnings available to the bondholders and remaining shareholders after the transaction are 

equal to the interest paid on the bonds of $21.6 million ($270 million x 8 percent) plus after-tax earnings of 

$11.96 million. Similar to Example 2, after-tax earnings of $11.96 million in Example 3 are equal to annual income 

of $40 million less interest expense of $21.6 million less corporate income tax of $6.44 million (($40 million – 

$21.6 million) x 35 percent). 
47 

before the transaction plus $7.56 million in reduced income taxes). Depending on whether the 

increased returns are paid to taxable bondholders and shareholders, there may or may not be an 

increase in investor-level income taxes paid. 

Example 4: Assume the same initial facts as in Example 2. Instead of engaging in a 

leveraged buyout or a stock redemption, Corporation X borrows $270 million at eight percent 

interest and distributes the proceeds pro rata to its shareholders. Each share receives 

approximately $104, or almost 30 percent more than the price at which the stock had been 

trading on the market. The distribution is, in general, a taxable distribution to shareholders that 

are subject to tax. After the distribution, the earnings per share of Corporation X are $4.60 

($11.96 million divided by 2.6 million shares outstanding). If the stock will sell for eight times 

after-tax earnings, the stock price would be $36.80.151

Interest deductions may create a negative income tax rate for corporate income when 

combined with depreciation deductions, credits, preferential rates, or tax exemption of the 

earnings financed with debt

Interest deductions for borrowing, combined with the tax benefits associated with specific 

assets, may produce excess interest deductions that may be used to offset other income of the 

taxpayer. Thus, a taxpayer may have an incentive to incur debt so that deductible interest 

expense, in combination with other deductions such as depreciation or amortization, may shelter 

or offset the taxpayer’s income. For example, if the purchase of depreciable assets is debt 

financed, the taxpayer may be able to acquire more assets than without incurring debt. The tax 

impact of leveraging the acquisition of depreciable or amortizable assets may result in a greater 

amount of deductible depreciation or amortization, as well as deductible interest expense, for the 

taxpayer. 

For example, assume Corporation X is in the 35-percent tax bracket. Corporation X 

borrows $1,000,000 in Year One at a six percent interest rate to purchase a new piece of 

equipment for $1,000,000. The equipment is classified as three-year property under the modified 

accelerated cost recovery system (“MACRS”) that it is subject to the 200-percent declining 

balance method of depreciation using the half-year convention.152 Therefore, the first year 

depreciation deduction is $333,300; the second year depreciation deduction is $444,500; the third 

year depreciation deduction is $148,100; and the fourth year depreciation deduction is $74,100. 

Corporation X has earnings before interest, taxes, depreciation, and amortization (“EBITDA”) 

attributable to the new equipment of $300,000 annually in each of Years One, Two, Three, and 

Four.153 

 151 Thus, although it may have appeared that most, if not all, of the value of the stock would be depleted as 

a result of the borrowing, a significant portion of the value remains because of the tax benefits from the leveraged 

transaction. 

152 For this example, assume that the property is acquired in a year in which bonus depreciation does not 

apply and that a section 179 election is not made. 

153 After the fourth year, the equipment is no longer productive. Assuming a six percent cost of capital, the 

net present value of this $300,000 annual income stream over the four-year period is $1,039,532, which is greater 
48 

Table 8.–Depreciable Investment with Leverage 

Year 1 Year 2 Year 3 Year 4

EBITDA 300,000 300,000 300,000 300,000

Interest Expense (60,000) (60,000) (60,000) (60,000)

MACRS Depreciation (333,300) (444,500) (148,100) (74,100)

Taxable Income/(Loss) (93,300) (204,500) 91,900 165,900

Tax/(Refund) (32,655) (71,575) 32,165 58,065

The year-by-year taxable income or operating loss resulting from the acquisition of this 

equipment is detailed in Table 7, above. Corporation X may deduct interest expense of $60,000 

annually on the debt incurred to acquire the equipment. As a result of the deductions for 

depreciation and interest expense, in Year One, Corporation X reports a loss for income tax 

purposes of $93,300. At a 35-percent tax rate, this creates a tax benefit of $32,655 that 

Corporation X may use to offset a tax liability from other current year income (i.e., shelter that 

other income from current tax) or to carry forward (or back) against future (or past) tax liability 

of the corporation. Likewise in Year Two, Corporation X records an income tax benefit of 

$71,575. In Years Three and Four, Corporation X has positive tax liabilities of $32,165 and 

$58,065.154 

If one computes the net present value155 of the tax liabilities (positive and negative) over 

the four-year recovery period of the equipment, the result is a negative $21,509 and an average 

tax rate on the initial investment of negative 2.2 percent (negative $21,509 divided by 

$1,000,000). For this reason, some analysts observe that the combination of interest deductions 

and depreciation deductions may create negative tax rates on the income from investment.156 

Alternatively, Corporation X could have financed the acquisition of the equipment 

without borrowing, for example, through the use of retained earnings. The year-by-year taxable 

income or operating loss resulting from an equity financed acquisition is detailed in Table 8, 

below. Because the purchase is equity financed, Corporation X has no deductible interest 

expense with respect to the income generated by the equipment. In Years One and Two, 

Corporation X reports a loss for income tax purposes of $33,300 and $144,500, respectively. In 

 

than the $1,000,000 purchase price of the equipment. Therefore, Corporation X may consider acquiring the 

equipment independent of the associated tax benefits. 

154 This example assumes that tax losses generated in Years One and Two are not carried forward to reduce 

taxable income in Years Three and Four. 

155 Discounted at six percent. 

156 Congressional Budget Office, Taxing Capital Income: Effective Rates and Approaches to Reform, 

October 2005, and Congressional Budget Office, Computing Effective Tax Rates on Capital Income, December 

2006. 
49 

Years Three and Four, Corporation X reports taxable income of $151,900, and $225,900, 

respectively.157 If one computes the net present value of the tax liabilities (positive and negative) 

over the four-year life of the equipment, the result is a positive $51,258 and an average tax rate 

on the initial investment of 5.1 percent ($51,258 divided by $1,000,000). The difference in the 

present values of the net tax liabilities in each example is the present value of four years of 

$60,000 in interest expense deductions valued at the 35-percent corporate tax rate ($72,767). 

Table 9.−Depreciable Investment Without Leverage 

Year 1 Year 2 Year 3 Year 4

EBITDA 300,000 300,000 300,000 300,000

MACRS Depreciation (333,300) (444,500) (148,100) (74,100)

Taxable Income/(Loss) (33,300) (144,500) 151,900 225,900

Tax/(Refund) (11,655) (50,575) 53,165 79,065

Negative effective rates may also result from the use of debt by a domestic corporation to 

finance a foreign acquisition. A domestic corporation may incur interest expense that is related 

to income eligible for deferral. Present law provides detailed rules for the allocation of expenses 

between U.S.-source and foreign-source income.158 These rules do not, however, affect the 

timing of the expense deduction; rather, for a domestic corporation, they apply principally for 

purposes of determining the foreign tax credit limitation. Thus, a domestic corporation may 

claim a current deduction, even for expenses that it incurs to produce tax-deferred income 

through a foreign subsidiary. By reducing the amount of tax imposed on currently taxable 

income, these interest expense deductions enhance the benefits of the existing deferral regime by 

yielding low, and in some cases negative, effective tax rates on that income.159

 157 This example assumes that tax losses generated in Years One and Two are not carried forward to reduce 

taxable income in Years Three and Four. 

158 Sec. 864. 

159 Note that present law imposes limitations on interest deductions in particular circumstances in which 

the underlying debt funds assets that produce untaxed income. For example, present law imposes a pro rata interest 

deduction limitation on financial institutions for interest expense that is allocable to tax-exempt interest, and 

imposes a somewhat similar pro rata interest deduction limitation on interest expense allocable to the unborrowed 

cash values of life insurance policies and annuity and endowment contracts held by entities other than natural 

persons. Secs. 265(b) and 264(f), respectively. A similar concept applies limiting the dividends received deduction 

for debt financed portfolio stock (sec. 246A). These rules address particular situations, however, and do not address 

other situations in which untaxed income of other types could be funded by leverage, the interest on which is 

deductible. For a more detailed discussion of these limitations, see Joint Committee on Taxation, Present Law and 

Background Relating to Tax Treatment of Business Debt (JCX-41-11), July 11, 2011. 
50 

Borrowing as a monetization of asset value 

If a taxpayer borrows money, the amount borrowed generally is not considered income. 

This is true even if the borrowing is secured by the taxpayer’s appreciated assets, and even if the 

borrowing is nonrecourse, so that only the assets are subject to the debt and neither the taxpayer 

nor his business is otherwise liable. The borrowing is not considered income or a sale of the 

assets unless and until the borrower experiences difficulties that require the debt to be 

restructured, or defaults, so that debt is in effect cancelled without repayment of the borrowing in 

full or the assets are taken by the borrower in a foreclosure.160 If none of these events occur, the 

amount borrowed generally is not income and does not cause any gain recognition because the 

taxpayer is considered still potentially liable for the debt and not to have received an 

unencumbered economic benefit. 

Notwithstanding the fact that the borrowed amount generally is not income, the borrower 

may use the proceeds of borrowing to buy assets whose debt financed purchase price basis is 

depreciable (thus offsetting taxable income) and is used to determine whether a sale or other 

taxable disposition of the asset produces a taxable gain or a deductible loss.161 

Timing of debt deductions and inclusions 

In general 

Interest on a debt instrument is generally deductible by the issuer (and includible by the 

holder) when the interest is paid or accrued. However, in certain cases the deduction (and 

inclusion) occurs prior to the time of payment. Tax-exempt or foreign holders that do not pay 

tax on interest income are indifferent to the consequence of including interest income for tax 

purposes prior to the receipt of cash. As in the case of any other interest payments to tax 

indifferent parties, the issuer deducts the interest expense and no tax is imposed on the holder. 

The value of the deduction is increased to the extent it is allowed before payment. 

Original issue discount

When the amount to be paid at the maturity of a debt instrument exceeds the issue price 

by more than a minimal amount, a portion of the amount to be paid at maturity is treated as 

interest accruing on a constant yield basis over the life of the instrument as OID. This results in 

deemed interest being deductible by the issuer and includable by the holder prior to any payment 

of cash. Even in the case of significant OID subject to the AHYDO rules, there is no limit on the 

deduction if the instrument ceases to have significant OID by the end of the fifth year after it is 

issued.162 

 160 These situations are discussed below. 

161 See sec. 1012; Crane v. Commissioner, 331 U.S. 1 (1947); and Waddell v. Commissioner, 86 T.C. 848 

(1986). 

162 See I.D.3. above for a discussion of when a debt instrument is treated as having significant OID. 
51 

Issuer treatment if an instrument is troubled and is modified, or cancelled 

In the event an investment loses value or becomes worthless, the tax consequences to the 

issuer vary significantly depending on whether the instrument is debt or equity. In general, if 

debt is forgiven or restructured, a taxable issuer experiences either cancellation of indebtedness 

income or gain on the taking of property in foreclosure. By contrast, failure to pay dividends or 

to return equity capital to investors does not result in income to the issuer. 

In some situations, retaining significant debt may have permitted a taxpayer to receive 

cash without tax when the business prospered, thereby benefitting from deferral. A subsequent 

default may require the taxpayer to recognize income and incur a tax obligation at that later 

(perhaps economically less opportune) time. However, a number of rules permit nonrecognition 

of income, including rules relating to discharge of indebtedness in bankruptcy or to the extent of 

insolvency.163 Such rules possibly mitigate a potential disincentive to use debt financing. 

 163 See sec. 108. 
52 

B. Comparison to Debt: Tax Incentives for Equity 

Equity of a C corporation may bear more than one level of tax if the C corporation pays 

corporate tax on its nondeductible dividends or other stock distributions, and a taxable investor 

also pays tax on the dividend or other equity distribution. However, in some cases, this double 

tax effect is mitigated by deferral (e.g., if the shareholder does not receive a dividend or sell the 

stock until years after the corporate earnings arise). The double tax effect may disappear entirely 

for stock held until the death of a shareholder to the extent the stock does not pay dividends and 

the appreciation in value of the stock (due to retained earnings or otherwise) obtains a stepped up 

basis at death. This may create an incentive to retain earnings. The effect is also mitigated if 

shareholder level income from enhanced corporate value is taxed to the shareholder at a lower 

tax rate than is available on other forms of income. 

Equity may permit a corporate holder to obtain a dividends received deduction or an 

individual holder to obtain a favorable tax rate 

A corporation that owns stock in another corporation is generally allowed a dividends 

received deduction164 that in effect excludes between 70 percent and 100 percent of the dividend 

from the recipient’s income. The percentage of the deduction increases depending upon the 

recipient corporation’s percentage ownership of dividend paying corporation.165 At the lowest 

percentage deduction, applicable to stock ownership of less than 20 percent, the maximum tax 

rate on dividends received is currently 10.5 percent.166 

Individual holders of corporate equity are currently eligible for a maximum 23.8 percent 

tax rate on qualified dividend income (compared to the maximum 43.4 percent rate on interest 

income), as well as a maximum rate of 23.8 percent on long-term capital gain from the sale of 

stock. 

A corporate issuer that has significant losses or tax-exempt income and that does not 

expect to be able to use an interest deduction may nevertheless have “earnings and profits” that 

cause distributions to be treated as dividends.167 Such a corporation may have an incentive to 

 164 A number of special rules apply to limit use of the corporate dividends received deduction. The 

deduction is not allowed if the holder has not held the stock, at risk, for a specified time, or if the payor is a foreign 

corporation whose earnings were not subject to U.S. tax. The deduction is reduced to the extent the stock was debt 

financed by the holder. The basis of the stock with respect to which the dividend was paid must be reduced for 

certain dividends, to prevent the allowance of a loss on disposition of stock from which earnings have been extracted 

without tax. 

165 The deduction is equal to 100 percent for dividends received by a corporation that owns at least 

80 percent of the vote and value of the payor stock; 80 percent for dividends received by a corporation that owns 

20 percent or more of the stock but less than 80 percent, and 70 percent for ownership below that threshold. 

Sec. 243. 

166 The 35-percent maximum corporate tax rate multiplied by the 30 percent of the dividend that is taxable. 

167 “Earnings and profits” is a concept directed at identifying economic income of a corporation, generally 

for purposes of determining whether distributions to shareholders should be treated as dividends or as a return of 

capital. Earnings and profits include tax-exempt income and certain other income on which no tax has been paid 
53 

issue equity to provide a corporate holder with a dividends received deduction (or a taxable 

individual shareholder with a beneficial rate on dividends), even though the earnings did not bear 

corporate-level tax prior to distribution. 

In addition, even a corporation that expects to have entirely taxable income may be able 

to obtain a lower cost of capital on at least part of its capital structure by issuing stock to those 

investors that are eligible for the lower rates on dividend income but would not receive the lower 

rates on interest income (e.g., U.S. taxable individuals or corporations). 

 

due to accelerated depreciation. Sec. 312. In addition, the Code requires a dividend paid out of current year 

earnings and profits to be treated as a dividend, even if the corporation has loss carryforwards that will cause it to 

have no taxable income (and no net accumulated earnings and profits) as of the end of the year in which the 

dividend is paid. 
54 

C. Tax Incentives to Create Hybrid Instruments 

Taxpayers have significant flexibility to create economically similar instruments and 

categorize them either as debt or equity. In general, instruments are not bifurcated into part debt 

and part equity,168 and the categorization as one type of instrument or the other applies across the 

board for all tax purposes. Taxpayers may have incentives to create instruments with hybrid 

features (i.e., features of both debt and equity)169 either solely for Federal income tax purposes, 

or because of additional benefits that may occur if the instrument is classified in a different 

manner for other purposes, including financial reporting, regulatory capital, or foreign tax 

purposes. 

For example, issuers may seek to structure an instrument offering many of the attributes 

of equity while still providing an interest deduction. Some investors may seek debt-like 

protections while allowing for the possibility of sharing in the earnings or appreciation of a 

business. Instruments characterized as debt for tax purposes that have significant equity-like 

features may mitigate the economic risks of high leverage. For example, a debt instrument 

having a longer term that permits deferral of cash interest or principal payments, or an instrument 

that allows final payment of interest or principal (or both) in an amount of issuer stock rather 

than cash, may provide some cushion against an issuer’s default and bankruptcy. Similarly, debt 

instruments held by a shareholder of the issuer could be perceived by third parties as equity-like 

to the extent the debt-holding shareholders are less likely to exercise their rights as creditors and 

drive a troubled issuer into bankruptcy. Such shareholders may instead voluntarily cancel or 

restructure the debt to avoid bankruptcy and preserve the potential for the corporation to improve 

its performance, ultimately increasing their overall return through their return to equity. 

To the extent debt provides interest deductions, but also some flexibility to prevent 

bankruptcy, and lacks covenants that inhibit operations, it may be viewed in the marketplace as a 

less risky capital structure than other, more restrictive debt. 

C corporation shareholder debt

Although identity of ownership of a corporation’s debt and equity is one common law 

factor against classification as debt, there is no prohibition against such ownership. In the case 

of a C corporation, since interest payments eliminate the corporate level tax on the share of 

earnings that are interest rather than dividends, if the shareholders are also lenders to the 

corporation, they are able to extract corporate returns with only a single level of tax. Also, as 

noted previously, it is possible that outside lenders may perceive shareholder debt as less likely 

to drive a company into bankruptcy, when compared to debt owed to an unrelated party, because 

 168 But see the discussion above in I.B.2. regarding the recently proposed regulations under section 385. 

169 See, e.g., Commissioner v. H.P. Hood & Sons, Inc., 141 F.2d 467, 469 (1st Cir. 1944) (“It is clear that a 

common stock is a proprietary interest on which dividends are paid and a bond is a debt on which interest is paid. 

Between the two extremes, however, there have grown diverse types of securities with many overlapping 

characteristics. Some of these myriad variations have, no doubt, been developed to meet fundamental business 

needs. Others have been mere window dressing to catch the eye of the purchasing public.”). 
55 

shareholders may have an incentive to cancel or restructure such debt in order to preserve their 

future equity interest should the company become troubled. 

In the case of a corporation controlled by shareholders where a tax treaty reduces the rate 

of gross-basis withholding tax on interest paid by that corporation, the earnings stripping 

limitations of section 163(j) permit such controlling shareholders to maintain a 1.5 to 1 debt to 

equity ratio and to receive up to half of the corporate earnings as interest payments (assuming the 

debt is respected). The amount of the one-half of earnings that may deducted as interest to 

shareholders that are also creditors is computed before depreciation and other deductions that, 

after interest deductions, will further reduce corporate tax. Even if shareholders are not taxexempt, there is still a motivation to have shareholders also own corporate debt to eliminate the 

corporate-level tax in cases where the shareholders are not corporate entities (for example, in the 

case of a corporation that is owned by private equity fund that is a partnership of individuals, or 

in the case of any other closely held corporation). This is because the corporate level interest 

deduction results in only one level of tax. Thus, it may be that domestically- and foreign-owned 

companies have equal incentives to reduce their corporate level tax with interest deductions to 

controlling shareholders. Any U.S. tax savings for a foreign-owned company as compared to a 

domestically-owned company may appear at the shareholder level to the extent no tax is paid on 

the interest income under applicable treaties or otherwise. 

Corporate interest deductions on certain hybrid instruments170

A corporation may issue debt that is convertible to corporate equity. Such an instrument 

could be viewed as part debt and part equity, with the amount paid to the corporation attributed, 

in part, to the fixed interest debt instrument, and, in part, to the conversion feature. Treasury 

regulations and rulings provide inconsistent results for similar types of instruments, depending 

upon how the conversion feature is structured. If an instrument is simply convertible into stock 

of the issuer or a related party, the amount of interest deduction that is considered the economic 

equivalent of a payment on the amount attributable to the conversion feature is denied. 

Under an IRS ruling,171 if the instrument is not automatically convertible at a specific 

price, but rather is convertible only if one or more contingencies are satisfied (e.g., only if 

corporate earnings or share prices change by a specified threshold amount), then the rules for 

determining the market comparable for interest deduction purposes allow the instrument to be 

treated as if it did not have a conversion feature, thus allowing more interest to be deducted in 

advance of actual payment. Depending on the point at which the fixed conversion price is set, 

compared to the conditions of the contingency, the two instruments could be economically very 

similar. The IRS has solicited comments on whether such approach allowing deductible interest 

to be determined as if there were no contingency should be extended beyond contingent 

convertible bonds. Commentators have expressed different views and have noted other 

 170 A description of the structuring of hybrid instruments, as well as hybrid instrument advantages in crossborder investment, is beyond the scope of this document. For a recent description, see Joint Committee on Taxation, 

Present Law and Background Relating to Tax Treatment of Business Debt (JCX-41-11), July 11, 2011. 

171 Rev. Rul. 2002-31, 2002-1 C.B. 1023. 
56 

inconsistencies in the treatment of potentially similar instruments that offer a debt holder the 

opportunity to participate in corporate growth or appreciation.172 The inconsistencies in 

treatment may allow taxpayers to select the more favorable treatment through proper structuring 

of the instrument. 

A corporation also may issue debt that is, under certain circumstances, payable in 

corporate equity. Section 163(l) denies interest deductions for such instruments. The IRS has 

ruled that certain hybrid instruments are not within the scope of this denial.173 

 172 See, e.g., David P. Hariton, “Conventional and Contingent Convertibles: Double or Nothing,” Tax 

Notes vol. 96 no. 1 (July 1, 2002), p. 123; Jeffrey Strnad, “Taxing Convertible Debt,” 56 Southern Methodist 

University Law Review 399 (2003); Jeffrey Strnad, “Laboring in the Pin Factory: More on Taxing Convertible 

Debt,” 56 Southern Methodist University Law Review 471 (2003); Dana L. Trier and Lucy V. Farr, “Rev. Rul. 2002-

31 and the Taxation of Contingent Convertibles, Parts 1 and 2,” Tax Notes vol. 95 no. 13 (June 24, 2002), p. 1963 

and Tax Notes vol. 96 no.1 (July 1, 2002), p. 105; Edward D. Kleinbard, Erika W. Nijenhuis and William L. McRae, 

“Contingent Interest Convertible Bonds and the Economic Accrual Regime,” Tax Notes vol. 95 no. 13 (June 24, 

2002), p. 1949; and Edward D. Kleinbard, “Taxing Convertible Debt: A Layman’s Perspective,” 56 Southern 

Methodist University Law Review 453 (2003). 

173 See, e.g., Rev. Rul. 2003-97, 2003-34 I.R.B. 380. 
57 

D. Tax Incentives to Substitute Other Arrangements for Debt 

Corporate equity owners can extract a stream of earnings from the corporation in a form 

that is deductible to the corporation (and thus does not bear corporate level tax) through 

transactions other than debt. For example, property to be used in the corporate business may be 

held outside the corporation and leased to the corporation. In this scenario, the corporation 

deducts the lease payments, the property owners pay one level of tax on the rent received, and 

appreciation in the assets remains outside of the corporation and is not subject to corporate tax. 

Similarly, the equity owners of a corporation may extract other streams of earnings in a 

form that is deductible to the corporation by performing services to the corporation and 

extracting fees. Private equity owners of a corporation, for example, may require the corporation 

to pay them fees for management services, which are generally deductible by the corporation. 

In situations where interest deductions may be limited, such arrangements could 

substitute for debt. 

Tax-exempt organizations generally are subject to unrelated business income tax 

(“UBIT”) on the receipt of deductible payments (such as rent, royalties, or interest) from entities 

the organization controls.174 However, deductible payments may be shared between taxable and 

tax-exempt organizations in other ways. For example, taxable entities controlled by tax-exempt 

organizations may bear deductible costs (e.g., for shared office space or employees) that may 

otherwise be allocated to the controlling tax-exempt organization. 

 174 See sec. 512(b)(13). UBIT generally applies to income derived from a trade or business regularly 

carried on by the organization that is not substantially related to the performance of the organization’s tax-exempt 

functions. Certain types of income are specifically exempt from UBIT, such as dividends, interest, royalties, and 

certain rents, unless derived from debt financed property or from certain 50-percent controlled subsidiaries. 

Secs. 511-515. 
58 

E. Financial Accounting and Other Considerations 

Treatment of an instrument under rules other than tax rules may also affect the issuer. 

For example, the treatment as debt or equity under U.S. Generally Accepted Accounting 

Principles (“GAAP”) for financial reporting purposes may affect the issuer of financial 

statements in multiple ways. Similarly, the treatment for regulatory capital purposes is important 

to a financial institution subject to such requirements. The treatment by a ratings agency that 

rates the issuer’s stock or bonds is also a consideration. This section describes general 

considerations under GAAP.175

Consequences of debt classification

The classification of an instrument as debt for financial reporting purposes generally will 

have an impact on the computation of the company’s net income. In general, any instrument 

treated as debt for financial reporting purposes will have an actual or imputed interest expense 

component. This interest expense must be taken into account in deriving net income and, 

therefore, earnings per share (generally determined by dividing net income by the weightedaverage number of shares issued and outstanding).176 Furthermore, some companies are required 

to meet interest coverage ratios177 pursuant to covenants agreed to in existing loan documents.178 

The more interest expense a company is deemed to have, the more pressure may be put upon that 

company to generate sufficient earnings to avoid being in violation of these debt covenants. 

The classification of an instrument as a debt instrument will also increase that entity’s 

leverage ratios.179 These ratios are an important metric often used by lenders to determine 

whether an enterprise may obtain additional future financing, how expensive that financing will 

be (e.g., incremental debt may reduce the issuer’s credit rating), as well as whether that 

enterprise is in compliance with its debt covenants under existing obligations. 

 175 The Financial Accounting Standards Board (“FASB”) establishes and interprets the financial 

accounting standards that govern GAAP and are used by publicly traded companies within their annual reports filed 

with the Securities and Exchange Commission (“SEC”). Companies that are not publicly traded often provide 

financial statements prepared in accordance with GAAP to investors and creditors. 

176 See Accounting Standards Codification (“ASC”) 260, Earnings Per Share. 

177 The interest coverage ratio is a measure of the number of times a company could make the interest 

payments on its debt with its earnings before interest and taxes (“EBIT”). In general, the lower the interest coverage 

ratio, the higher the company’s debt burden, and the greater the possibility of bankruptcy or default. The formula 

for the interest coverage rate is: EBIT divided by interest expense. 

178 Debt covenants generally are agreements between a company and its creditors requiring or forbidding 

certain actions of the company. For example, a company may be required under a covenant to limit other borrowing 

or to maintain a certain level of leverage. 

179 In general, the leverage ratio is a measure of the amount of equity in comparison to debt or the amount 

of earnings in comparison to debt. Although there are variations on the formula used, one leverage ratio, the debtto-equity ratio, is computed as follows: (short-term debt plus long-term debt) divided by equity. 
59 

From a balance sheet perspective, an instrument classified as debt will generally be 

recorded at its face or principal value (i.e., generally the amount to be repaid upon maturity of 

the obligation),180 with any accrued but unpaid interest also accounted for as a liability. The 

financial statement disclosure requirements with respect to debt vary depending on its nature.181 

Consequences of equity classification

To the extent an instrument is classified as equity for financial reporting purposes, such a 

classification will generally not have the same impact on net income, interest coverage, and 

leverage ratios. Rather than being treated as interest expense, a payment on equity is generally 

treated as a dividend which is taken into account as a reduction to the company’s retained 

earnings, rather than as a reduction to net income. Although payments on equity do not reduce 

net income, the issuance of an equity instrument generally will still have a dilutive impact on 

earnings per share (since the denominator, number of shares issued and outstanding, increases, 

while the numerator, net income, is not impacted by the additional equity issuance).182 Unlike 

debt, the issuance of equity will have no impact on the interest coverage ratio and will decrease 

leverage ratios. From a balance sheet perspective, equity will generally be recorded at fair value 

(i.e., generally the amount of the proceeds received).183

Financial accounting classification as either debt or equity

As with the Federal income tax rules, the classification of an instrument as debt (i.e., a 

liability) or equity for financial reporting purposes can be a challenging area for the issuers of 

financial statements. Financial reporting rules generally define liabilities, including debt 

instruments, as “probable future sacrifices of economic benefits arising from present obligations 

of a particular entity to transfer assets or provide services to other entities in the future as a result 

of past transactions or events.”184 In general, a liability has three essential characteristics: 

 180 If the proceeds received do not equal the amount due at maturity, the debt instrument has been issued at 

a discount or premium. ASC 470, Debt, provides guidance on accounting and reporting for debt, and ASC 835, 

Interest, provides guidance on recording debt discounts or premiums. 

181 See ASC 470, Debt. 

182 Under GAAP, companies are required to report basic earnings per share and are often also required to 

report diluted earnings per share. Diluted earnings per share measures the performance of an entity over the 

reporting period, while also giving recognition to all potentially dilutive common shares that are outstanding during 

the period. The calculation of diluted earnings per share requires a series of assumptions to be made about 

potentially dilutive securities being converted into common stock. See ASC 260, Earnings Per Share. Given the 

prevalence of potentially dilutive securities, much of the complexity in the GAAP rules for earnings per share 

computations relates to this issue. 

183 See ASC 505, Equity. See also ASC 810, Consolidation, for requirements regarding the presentation 

and disclosure of noncontrolling interests. 

184 FASB Concepts Statement No. 6, Elements of Financial Statements (“Con. 6”), par. 35. Although the 

FASB Concepts Statements do not establish generally accepted accounting standards, they are intended to serve the 

public interest by setting the objectives, qualitative characteristics, and other concepts that guide the selection of 
60 

a) it embodies a present duty or responsibility to one or more other entities that entails 

settlement by probable future transfer or use of assets at a specified or determinable 

date, on occurrence of a specified event, or on demand; 

b) the duty or responsibility obligates a particular entity, leaving it little or no discretion 

to avoid the future sacrifice; and 

c) the transaction or other event obligating the entity has already happened.185

Solely with respect to financial instruments (and not contracts to provide services or other 

types of contracts), FASB defines an obligation as a conditional or unconditional duty or 

responsibility to transfer assets or to issue equity shares.186

In contrast, in the case of a business enterprise, financial reporting rules generally define 

equity as the ownership interest in the enterprise stemming from ownership rights (or the 

equivalent) and involving a relation between the enterprise and its owners as owners rather than 

as employees, suppliers, customers, lenders, or in some other nonowner role.187 Since equity 

ranks after liabilities as a claim to or interest in the assets of the enterprise, it is a residual 

interest: (a) equity is the same as net assets, the difference between the enterprise’s assets and its 

liabilities, and (b) equity is enhanced or burdened by increases and decreases in net assets from 

nonowner sources, as well as investments by owners and distributions to owners.188 An 

enterprise may have several classes of equity (e.g., one or more classes of common or preferred 

stock) with different degrees of risk stemming from different rights to participate in distributions 

of enterprise assets or different priorities of claims on enterprise assets in the event of 

liquidation.189 Even so, all classes of equity depend at least to some extent on the enterprise’s 

profitability for distributions of enterprise assets, and no class of equity carries an unconditional 

 

economic phenomena to be recognized and measured for financial reporting purposes and its display in financial 

statements or related means of communicating information to those who are interested. Furthermore, Concepts 

Statements guide the FASB in developing sound accounting principles, and provide the FASB and its constituents 

with an understanding of the appropriate content and inherent limitations of financial reporting. Financial 

Accounting Standards Board, “FASB Home: Standards: Concepts Statements,” 

http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156317989. 

185 Ibid. at par. 36. 

186 ASC 480-10-20, Distinguishing Liabilities from Equity: Overall: Glossary. 

187 Con. 6, par. 60. 

188 Ibid. 

189 Ibid. at par. 62. An equity security is defined as any security representing an ownership interest in an 

entity (e.g., common, preferred, or other capital stock) or the right to acquire (e.g., warrants, rights, and call options) 

or dispose of (e.g., put options) an ownership interest in an entity at fixed or determinable prices. The term “equity 

security” does not include any of the following: a) written equity options, b) cash-settled options on equity 

securities or options on equity-based indexes, or c) convertible debt or preferred stock that by its terms either must 

be redeemed by the issuing entity or is redeemable at the option of the investor. ASC 320-10-20, Debt and Equity 

Securities: Overall: Glossary. 
61 

right to receive future transfers of assets from the enterprise except in liquidation, and then only 

after liabilities have been satisfied.190

Although the distinction between debt and equity is clear in concept, it can be obscured in 

practice as securities issued by business enterprises may have characteristics of both debt and 

equity in varying degrees.191 Additionally, the names given to these securities may not be 

reflective of their essential nature. By way of example, a bond may be viewed as a classic 

illustration of a debt instrument. Nonetheless, the traditional distinction between stocks and 

bonds has become blurred through the increased use of instruments with characteristics of both 

debt and equity. For example, convertible bonds have both liability and residual interest 

characteristics. Additionally, preferred stock may have characteristics more reflective of debt, 

such as maturity amounts and dates at which it must be redeemed for cash.192 

The mixed characteristics of these securities have historically made accounting for them 

under GAAP a challenge.193 Convertible bonds typically give their holder the right to exchange 

the bond for common stock under certain stipulated terms. In circumstances in which these 

instruments may be settled wholly or partly in cash, GAAP requires the issuer of the instrument 

to split the instrument into its debt and equity components.194 The issuer accomplishes this by 

first valuing the debt component and then subtracting this value from the total proceeds received 

to derive the equity component. 

In other cases, GAAP requires financial instruments with some characteristics of debt and 

equity to be classified as a liability. An example is a mandatorily redeemable financial 

instrument such as mandatorily redeemable preferred stock.195 These instruments are structured 

such that they embody an unconditional obligation requiring the issuer of the instrument to 

redeem it by transferring its assets at a specified or determinable date (or dates) or upon an event 

that is certain to occur. 

The FASB and International Accounting Standards Board (“IASB”) are undertaking a 

joint project to develop a comprehensive standard on financial instruments with characteristics of 

 190 Ibid. 

191 Ibid. at par. 55. 

192 Ibid. 

193 Although U.S. tax rules generally treat an instrument as all debt or all equity, the recently proposed 

regulations under section 385 treat, in certain cases, an interest in a corporation as part debt and part equity. See 

discussion above at I.B.2. 

194 See ASC 470-20, Debt: Debt with Conversion and Other Options. 

195 See ASC 480-10-25, Distinguishing Liabilities from Equity: Overall: Recognition. 
62 

equity, liabilities, or both. Among other goals, this guidance is expected to revisit the definition 

of liabilities mentioned above.196 

 196 Prior to the project becoming a joint effort between the FASB and IASB, the FASB issued a report with 

its preliminary views in November 2007 soliciting comments. This report recommended an approach that would 

classify an instrument as equity if it (1) is the most subordinated interest in an entity, and (2) entitles the holder to a 

share of the entity’s net assets after all higher priority claims have been satisfied. All other instruments, including 

forward contracts, options and convertible debt, would be classified as liabilities or assets. Financial Accounting 

Standards Board, Preliminary Views: Financial Instruments with Characteristics of Equity (No. 1550-11), 

November 2007. Although several comment letters were received that critiqued various aspects of the FASB report, 

an update to these preliminary views has not yet been released. An exposure draft addressing targeted 

improvements to the recognition and measurement of liabilities and equity is targeted for release by the FASB 

before the end of the second quarter of 2016.