Tax Blog/Blawg

You might recall our prior post on the Wyden-Gregg tax reform proposal in which we discussed the proposed limitation on corporate interest deductions.  To summarize, the legislation would limit the deductibility of payments on corporate debt to the amount of the interest in excess of the annual rate of inflation, thereby discouraging the use debt to finance corporate operations.

We previously asked: “Why use inflation as the index for disallowing interest deductions, rather than simply disallowing, say, a fixed portion of the interest deduction?”  Thanks to the efforts of Greg ...

In her column last Monday, Lee Sheppard criticized Judge Holmes of the Tax Court for, as she put it, “strain[ing] to find a reason to hold for the taxpayer” in the recent case of Container Corp. v. Comm’r, 134. T.C. No. 5.  According to Ms. Sheppard, Judge Holmes "appears to have assumed equitable powers in deciding" the case, and "the tax law is the worse for it."

The basic issue in Container Corp. was whether guarantee fees paid by a U.S. corporation to its Mexican parent in respect of a debt guarantee provided by the parent should be treated as U.S.-source income (and therefore subject to withholding tax on payment to the Mexican parent).  Because the rules for sourcing income don't address how guarantees are to be treated, the court framed its analysis as whether the guarantee fees were more like interest (which is sourced to the location of the borrower) or more like services (which are sourced to the location of the provider).

Ms. Sheppard excoriated Judge Holmes for even contemplating that a debt guarantee could be treated as a service.  To her, it "[s]ounds pretty obvious" that the parent corporation was simply protecting its investment in the subsidiary, not providing a service to the subsidiary.

We previously discussed how the Wyden-Gregg bill proposes reducing interest deductions to the extent the interest simply compensates for inflation.  Inflation affects tax calculations in two ways.  First, it affects the dollar figures in the Code so that, for example, when your wages keep up with inflation, but you are pushed into a higher tax bracket, the resulting “bracket creep” is caused by inflation.  Second, when the value of your investment simply keeps pace with inflation and does no better, you still recognize a “gain” when you sell it.  Here, the measurement of real income has been distorted by inflation.

Many “bracket creep” issues are taken care of through section 1(f) of the Code, which adjusts dollar amounts in the Code to account for inflation.  But the Code has not generally corrected for the effects of inflation on the measurement of income.  A proposal made by the Treasury after the 1984 election would have broadly attacked the effects of inflation on income measurement.

To see an example illustrating the two ways inflation affects tax calculations as well as further discussion of the 1984 Treasury proposals, keep reading.