Business Interest Deduction Limitation Policy

As part of the Tax Cuts and Jobs Act (TCJA) of 2017, the United States introduced new limits on interest deductions for businesses. Although countries of the Organization for Economic Co-operation and Development (OECD) generally set interest deduction limits, starting this year, the United States uses earnings before interest and taxes (EBIT) as the tax base for the limit, which has become an anomaly.

The change effectively tightened restrictions on U.S. corporations at the same time as interest rates rose, leading to higher taxes for many. A better approach would be to reconsider the potential economic impact of this change and reset EBITDA as an interest limit to comply with international norms.

Countries may limit interest deductions for a number of reasons: for example, to reduce tax avoidance by moving debt across borders from low-tax subsidiaries to related companies in high-tax jurisdictions, and to help balance the tax treatment of debt-financed investments in equity financing (equity financing generally not deductible).

There are several types of interest deduction restrictions, known as thin capitalization (hereinafter referred to as thin capitalization) rules. One option is to limit the deduction under the transfer pricing regulations applicable to the interest rate. Other restrictions include the safe harbor rule, which creates a debt-to-equity ratio in which interest payments on debt above that ratio are not deductible. The profit stripping rule sets a limit based on the share of profit before taxes, such as earnings before interest, taxes, depreciation and amortization (EBITDA).

Several studies have shown that the thin-cover rule

There could be various adverse economic effects, such as reduced investment, reduced employment, and a decline in the market value of businesses. Thus, when designing thin-cap rules, countries face a trade-off between adverse economic impacts and limiting tax base erosion. At the same time, depending on the design of the rules, they may also reduce debt bias. However, measures that incentivize equity financing (such as corporate equity allowances) may also be effective if weakening rules are introduced to reduce debt bias.

Under U.S. federal tax law, businesses can deduct net interest payments on debt from their taxable income within certain limits. From 2018 to 2021, the cap is set at 30% of EBITDA.

As of the start of the year, the net interest deduction limit was tightened to 30% of earnings before interest and taxes, removing depreciation and amortization from the calculation. In short, this means that companies using EBITDA must multiply their deduction by 30% of their depreciation and amortization cost under the previous limit. For many companies, this represents a substantial increase in taxes—especially capital and R&D-intensive firms with relatively high debt loads—and it comes at a dangerous time, as rising interest rates lead to economic weakness across multiple sectors ( This in itself pushes more companies to the limit).

The change also raises the tax barrier for new investments. Kyle Pomerleau of the American Enterprise Institute found that tighter interest limits increased the marginal effective tax rate on new investments by 0.5 percentage point for corporations and 0.1 percentage point for pass-through businesses.

Looking at the OECD, the U.S. restriction on the use of EBIT stands out. 26 OECD countries use EBITDA as the earnings stripping limit (see table below). It is worth noting that none of the OECD countries use limits based on EBIT.

One of the reasons for the adoption of EBITDA-based limits in many European countries is the EU’s Anti-Avoidance Directive, which established EBITDA as a common definition of interest limits across the EU, as part of the Base Erosion and Profit Shifting (BEPS) project. In the EU, the most common limit is 30% of EBITDA, with separate safe harbor and transfer pricing rules.

While there is disagreement over the amount of interest that should be deducted, it is clear that the EBIT-based limit makes the US an outlier compared with other OECD countries, while endangering many companies and raising the cost of new investments.

Policymakers should consider reverting EBITDA to the interest limit threshold. This can then be aligned with any chosen level of deductible interest.