Until recently, the high US corporate tax rate and regime governing interest deductibility had provided a clear incentive for multinationals (particularly, non-US multinationals) to push interest expense into the United States wherever possible. US tax reform has significantly changed and complicated this analysis.
The reduction in the rate of tax in the United States from 35 percent to 21 percent, a rate that is closer to or even below that of many other major economies, removes much of the incentive to have interest deductions in the United States. In addition, the new interest limitation rules in section 163(j) could render existing structures positively inefficient by denying deductions in the United States for intra-group interest expense whilst the corresponding receipt remains taxable elsewhere. Similarly, the addition of the Base Erosion and Anti-Abuse Tax (the BEAT), which can impose additional US federal income tax liability with respect to certain related party interest expense, provides another disincentive for having certain interest deductions in the United States.
Section 163(j) limits interest expense to 30 percent of a group’s earnings before interest, taxes, depreciation and amortization (EBITDA). In adopting such a rule, the United States is following in the footsteps of many other advanced economies, including Germany, Spain, Italy and, most recently, the United Kingdom, which adopted a similar limitation in April 2017. The EU Anti-Tax Avoidance Directive (ATAD) will also require all member states to adopt similar rules from January 2019, unless they can establish that they already have equally effective domestic rules. While ATAD, similar to 163(j), imposes a limit on interest deductions of 30 percent of EBITDA, it also permits member states to allow a higher level of interest deductions by reference to the position of the worldwide group: either by allowing additional interest deductions in the relevant country up to the level of the worldwide group’s interest to EBITDA ratio (if it is higher than 30 percent), or by allowing full deductions for interest if the local entity’s equity-to-asset ratio is at least 98 percent of that of the worldwide group. Many groups may now therefore have much greater capacity to deduct interest expense outside, rather than within, the United States, particularly where the group as a whole is highly leveraged.
Many groups which have pushed interest expense into the United States may want to reconsider their optimum capital structure in light of these changes.