Tighter Limits on U.S. Interest Deductibility Make U.S. an Outlier and Increase Pain of Rising Interest Rates

Taxes

As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States enacted a new limitation on interest deductions for businesses. While it is common for countries across the Organization for Economic Cooperation and Development (OECD) to set limits for interest deductions, starting this year, the U.S. became an outlier by using earnings before interest and taxes (EBIT) as the limit’s tax base.

The change effectively tightens the limit for U.S. firms just as interest rates are rising, creating a tax increase for many firms. A better approach would be to reconsider the potential economic fallout of this change and re-establish EBITDA as the interest limit, consistent with international norms.

Countries may limit interest deductions for several reasons: for example, to reduce tax avoidance through shifting of debt across borders from low-tax subsidiaries to related firms in high-tax jurisdictions, and to help equalize the tax treatment of debt-financed investment compared to equity financing (the expense of equity finance is generally non-deductible).

There are several types of limits for interest deductions, known as thin capitalization (henceforth thin cap) rules. One option is to limit deductions based on transfer pricing regulations that apply to interest rates. Other limits include safe harbor rules, which create a debt-to-equity ratio where the interest paid on debt exceeding the ratio is not deductible. Earnings stripping rules establish a limit based on a share of pre-tax earnings such as earnings before interest, taxes, depreciation, and amortization (EBITDA).

Several studies have shown that that thin cap rules

can have various adverse economic effects, such as less investment, decreased employment, and lower market values of firms. When designing thin-cap rules, countries are therefore facing a trade-off between adverse economic effects and limiting base erosion. At the same time, depending on the design of the rules, they might also decrease debt bias. If thin-cap rules are introduced to reduce the debt bias, however, measures that incentivize equity financing, such as allowances for corporate equity, can also be effective.

Under the U.S. federal tax code, businesses are permitted to deduct net interest payments for debt against their taxable income up to certain limits. From 2018 through 2021, the limit was set at 30 percent of EBITDA.

As of the beginning of this year, the net interest deduction limitation tightened to 30 percent of EBIT, dropping depreciation and amortization from the calculation. Put simply, this means a firm at the previous limit using EBITDA must reduce their deductions by 30 percent multiplied by their depreciation and amortization costs. This represents a significant tax increase for many firms—especially capital- and R&D-intensive firms with relatively high debt loads—and it comes at a perilous time with the economy weakening across several sectors due to rising interest rates (which itself subjects more firms to the limit).

This change also increases the tax barrier to new investment. Kyle Pomerleau at the American Enterprise Institute finds the tighter interest limitation increases marginal effective tax rates on new investment by 0.5 percentage points for corporations and 0.1 percentage points for pass-through businesses.

Looking across the OECD, the U.S. limit using EBIT stands out as an outlier. 26 OECD countries use EBITDA as an earnings stripping limit (see table below). Notably, no country in the OECD uses an EBIT-based limitation.

One reason many European countries have adopted a limit based on EBITDA is because of the European Union’s Anti-Tax Avoidance Directive, which established EBITDA as the shared definition for interest limitations across the EU as part of the base erosion and profit shifting (BEPS) project. The most common limit is set at 30 percent of EBITDA across the EU, along with separate safe harbor and transfer pricing rules.

While there is disagreement about the amount of interest that should be deductible, it is clear that the limit based on EBIT makes the U.S. an outlier compared to other countries across the OECD while imperiling many firms and raising the cost of new investment.

Policymakers should consider restoring EBITDA for the interest limitation threshold. Later, this could be made consistent with any chosen level of deductible interest.

Interest Deduction Limitation Rules in OECD Countries, as of 2022
Country Interest Deduction Limitations
Australia Interest deductions allowed if they are returns on “debt interests,” incurred when gaining non-capital income, and when compliant with other thin capitalization rules   1.5:1 debt-to-equity ratio applies to general entities and 15:1 for financial entities   Exemption for limitations for deductions worth $2 million or less
Austria Interest limitation rule applies for “excessive borrowing costs,” i.e., costs greater than €3 million and greater than 30% of adjusted EBITDA
Arm’s length standard applicable
No formal safe harbor rule, but informal 4:1 debt-to-equity ratio applies
Belgium Interest deductions limited to the higher of €3 million or 30% of EBITDA
5:1 debt-to-equity ratio applies to intragroup loans
1:1 debt-to-equity ratio applies to receivables from shareholders or directors, managers, and liquidators
Canada For tax years beginning after 2022 and before 2024, corporate interest deductions will be limited to 40% of EBITDA, and for tax years after 2023, deductions will be limited to 30% of EBITDA   1.5:1 debt-to-equity ratio for tax years beginning after 2012
Czech Republic Interest deductions limited to the higher of 80 million Kč or 30% of EBITDA
4:1 debt-to-equity ratio (6:1 debt-to-equity ratio for certain financial services companies) applies
Denmark Interest deduction limited to 30% of EBITDA, a minimum deduction of DKK 22.3 million is allowed   Interest deductions are limited to 2.3% of assets to the extent net financing costs exceed 21.3 million kr   4:1 debt-to-equity ratio applies
Other rules can apply
Estonia For multinational firms, interest deductions limited to the higher of €3 million or 30% of EBITDA
Finland Intragroup interest expense limited to 25% of the company adjusted taxable income (“taxable EBITD,” which includes taxable income and adds back interest expenses and tax depreciation). Subject to certain exceptions
Interest expense does not exceed the interest income derived by the company that pays
Net interest expense up to €500,000 fully deductible
Company equity/assets ratio is equal to or greater than the group ratio
Net interest expenses between non-related parties limited to €3 million
France Interest deductions limited to the higher of €3 million or 30% of EBITDA
Different limits apply to related-party debt, and banking & credit institutions
Germany Interest deductions limited to the higher of €3 million or 30% of EBITDA
Carryforwards allowed
Taxpayer is not part of a group of companies
Taxpayer cannot demonstrate that the equity ratio of the borrower is not more than 2 percentage points below worldwide group’s equity ratio
Greece Net interest deduction limitation in certain categories of interest if it exceeds €3 million or 30% of EBITDA after tax adjustments   Excess amount of non-deductible interest expenses can be carried forward indefinitely for future years
Hungary Excess borrowing costs are deductible up to 30% of EBITDA
Standalone entities are exempted as borrowing costs under €3 million
Loans concluded before June 2016 are subject to the previous thin-cap rules and a 3:1 debt to equity ratio applies instead
Iceland Interest deductions limited to 30% of EBITDA
Rule does not apply if total interest paid does not exceed 100 million kr
Ireland As of January 1, 2022, Ireland restricts corporation interest deductions to 30% of tax-adjusted EBITDA in compliance with the Anti-Tax Avoidance Directive by the European Union   New rules do not apply to loans concluded before June 17, 2016, and there is an exemption for taxpayers with net borrowing costs under  €3 million
Israel No thin capitalization rules and no specific debt-to-equity ratio requirements for interest deductions.
Italy Interest deductions limited to 30% of EBITDA
Japan Corporation deductible net interest expense is limited to 20% of EBITDA, adjusted to exclude extraordinary income or loss Exemptions apply for those with net interest expenses of less than ¥20 million Carryforwards allowed for up to seven years
Latvia Interest deductions limited to 30% of EBITDA for deduction exceeding €3 million (certain financial institutions exempt) 4:1 debt-to-equity ratio applies for deduction up to €3 million (certain financial institutions exempt)
Lithuania Interest deductions limited to €3 million or 30% of EBITDA 4:1 debt-to-equity ratio applies
Rule does not apply if entity’s debt-to-equity ratio is not (or at most 2 percentage points) lower than the group-consolidated ratio
Luxembourg Interest deductions limited to the higher of €3 million or 30% of EBITDA
Mexico Limits of 30% of adjusted taxable income (adding interest, depreciation, amortization, and pre-operative expenses) and Mex$20 million in total interest expense apply 3:1 debt-to-equity ratio for interest payments between related parties
Netherlands Interest deductions limited to the higher of €1 million or 20% of EBITDA
Norway Interest deductions limited to 25% of EBITDA if deduction exceeds 25 million kr
Poland Interest deductions limited to 30% of EBITDA if deduction exceeds zł3 million
Portugal Interest deductions limited to the higher of €1 million or 30% of EBITDA
Slovak Republic Interest deductions limited to 25% of EBITDA (financial institutions exempted)
Slovenia 4:1 debt-to-equity ratio applies
South Korea 2:1 debt-to-equity ratio (6:1 for financial institutions) applies. Interest deductions limited to 30% of EBITDA (financial institutions exempt)
Spain Interest deductions limited to 30% of EBITDA if deduction exceeds €1 million
Sweden Interest deductions limited to 30% of EBITDA if deduction exceeds 5 million kr
Switzerland Debt-to-equity ratios apply and vary by asset class
Turkey 3:1 debt-to-equity ratio (6:1 for financial institutions) applies
United Kingdom Interest deductions limited to 30% of EBITDA if deduction exceeds £2 million
United States Interest deductions limited to the sum of business interest income, 30% of adjusted taxable income, and floor plan financing interest

Source: Bloomberg Tax, “Country Guides: Anti-Avoidance Provisions – Thin Capitalization/Other Interest Deductibility Rules”; and PwC, “Worldwide Tax Summaries: Corporate – Group taxation,” “Worldwide Tax Summaries: Corporate – Deductions,” Tax Foundation, “International Tax Competitiveness Index, 2022.”

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