Finance Theory Meets Tax Law: How a Risk-Based Rule Can Rationalize the Debt Versus Equity Distinction

Abstract

The debt-equity distinction in the corporate tax presents one of the most controversial and intractable puzzles in the tax law. The distinction is fundamental to the corporate tax as interest payments on debt are generally deductible by corporations, while dividend payouts on equity are not. But the consensus among tax experts is that the legal distinction between debt and equity lacks a basis in economics or a policy rationale: the distinction requires the IRS and judges to arbitrarily draw a dividing line among financial instruments that exist on a continuous spectrum of economic profiles. The result is that the law on the debt-equity distinction is infamous for its indeterminacy, which carries substantial costs for both taxpayers and the government. The tax reform in 2017 enacted a business interest deduction limitation which could have mitigated the distinction, but critics quickly observed a loophole in the provision that would likely render the limitation ineffective. A first-best solution to the debt-equity conundrum would require a fundamental change in the corporate tax; the best approaches would introduce an entirely new form of business taxation, one that removes the debt-equity distinction. But these reforms are costly and controversial, and unlikely to be adopted soon. Instead, I offer a novel, second-best solution to improve the administrability and certainty of the debt-equity distinction. Drawing on modern finance literature, I propose to use beta, a measure of systematic risk, to craft a general rule that would solve the line-drawing problem for an important subset of corporate financing transactions. Systematic risk is the type of risk that pervades the entire market rather than a particular stock or company, and finance theory posits that systematic risk drives investor behavior in the financial marketplace. Therefore, classifying a transaction as debt or equity based on its systematic risk minimizes inefficient behavioral distortions. Moreover, crafting an objective rule in lieu of a nebulous multi-factor standard reduces administrative costs associated with debt-equity planning and litigation. The innovative approach would estimate betas of a firm’s prototypical debt and equity, and classify a hybrid instrument according to the proximity of the instrument’s beta to the firm’s debt or equity benchmark. This paper demonstrates real world applications of the proposed beta rule using empirical data on two recent kinds of hybrid instruments.