handbook-tb

Limiting interest deductionsSpecifically, in a low-interest rate environment, an enterprisemay be able prudently to carry a higher level of debt than it could in ahigher interest rate environment. For instance, the amount of incomerequired for a company (or an individual) to comfortably support aloan may be very different based on whether the loan carries an interestrate of 4 per cent or an interest rate of 12 per cent.Interestingly, countries have been reducing the levels of debt forwhich interest is deductible in recent years, even though interest rateshave fallen and therefore the amount of interest required to carry afixed amount of debt has likewise fallen. These reductions are soundonly if the consensus view of the maximum amount of appropriateinterest expense has declined even more sharply than the decline ininterest rates.Financial institutions: One challenge in determining appropriatedebt/equity ratios in the case of financial institutions is the fact thatsuch institutions differ significantly in their business models. Thesedifferences arise with respect to both funding (for example, banksthat rely on deposits versus banks that rely on short-term borrowingin the commercial paper markets) and the assets in which they invest(for example, readily marketable securities or credit card receivablesversus capital goods leased to customers). These differences in fundingand in assets are reflected in the marketplace; different financialinstitutions have significantly different debt/equity ratios.For a tax rule, this creates the challenge of whether to try toapply a single rule to all institutions (for example, a permissible ratioof 6:1 or 3:1) as a bright-line test, or whether to seek to permit differentratios based on different business models.Determining the disallowed interest: A mechanical, but sometimeschallenging, issue is how to determine the amount of interestthat should be disallowed in the event a taxpayer exceeds a permissibledebt/equity ratio. Presumably, the best approach is a form of proration,in which interest is disallowed based on the degree to which the enterpriseexceeds the debt/equity limitation. But that test may be easier todescribe than to apply.169