The question: who may deduct interest?
When borrowing funds, multiple companies within a group of related companies commonly become parties to the group’s debt agreements. Financing a group’s activities in this way raises the question: Which company within the group can claim a tax deduction for the interest on the debt?
Why it matters
The group’s income tax profile may be significantly impacted by which group members may claim the interest deductions. The impact often results from different members of the group being subject to different tax return filing requirements. For example:
- Different state tax filings: Some members of the group may be subject to income tax in states that do not tax some other members of the group.
- Different federal income tax filings: Some members of the group may be required to file federal income tax returns separately from other group members. For example, some group members may be corporations while other are partnerships.
- Different foreign tax filings: Similarly, some members of the group may be subject to income tax imposed by countries that do not tax other members of the group.
Interest deduction issue in CCA 202141007
In a recently released email Chief Counsel Advice, CCA 202141007, the IRS explained a plan to contest one corporation’s claimed tax deduction for the entire amount of a multi-corporation group’s interest expense, even though that one corporation paid the entire amount of interest itself. The corporation paying and deducting the interest had left the consolidated group of corporations that had incurred liability on the debt.
As noted in the email CCA, an interest deduction is available only for a taxpayer that is an obligor on a debt. The taxpayer in the CCA was, like its former fellow group members, liable on the debt in question (a federal income tax debt). The CCA states, however, that the taxpayer’s deduction should be challenged because the taxpayer sought to claim a deduction for more than its proportionate share of the debt. However, the CCA did not address how the taxpayer’s proportionate share of the debt should be determined.
When can a particular group member claim a tax deduction for interest expense?
Generally, a taxpayer may deduct interest paid or accrued on its debt.1 However, the taxpayer only may deduct such interest if the taxpayer is ‘primarily liable’ for payment on the debt.2 Primary liability typically refers to unconditional liability, meaning the creditor can require the obligor to make payments on the debt without another obligor first defaulting on payment of the debt.
Many borrowings have multiple obligors, or co-obligors. A co-obligor is generally allowed to take an interest deduction with respect to its share of the debt, or to the extent that the obligor actually paid the interest.3 The co-obligor may take the interest deduction for interest payments it made, regardless of whether the obligor received the direct benefits of the initial debt.4 Whether and to what extent one co-obligor has the right to seek reimbursement from another co-obligor might affect the co-obligor’s ability to maintain interest deductions, as noted in the CCA.5 Since co-obligors’ rights under state law may vary in this regard, it can be helpful to put a legal agreement in place between the group entities regarding their respective shares of a liability.6
Many debt agreements, such as modern-day bank debt agreements, designate multiple guarantors that each have unconditional joint and several liability to make payments to the creditors as the payment become due. Economically speaking, guarantors of this sort are equivalent to co-obligors. Other types of guarantee arrangements may require the creditor to take collection activity against the obligor before any liability on the part of the guarantor may arise; a guarantor of this sort, without liability on the debt, generally should not claim any tax deduction for the interest expense. Although this Alert, like CCA 202141007, does not focus on intercompany debt between company group members, intercompany debt can also be used to fund various group companies and position them to claim tax deductions for interest.
Conclusion
Related companies that share the economic burden of making debt payments to creditors should closely examine which company or companies may claim tax deductions for interest. The analysis and decision-making in these situations may be complex, so we recommend that companies consult with their tax advisors in this regard.
1Section 163(a).
2See, e.g., Reg. section 1.163-7(a); Nelson v. Comm’r, 281 F.2d 1 (5th Cir. 1960).
3See, e.g., Koppers Co. v. Comm’r, 8 T.C. 886 (1947); Larson v. Comm’r, 44 B.T.A. 1094 (1941); Rev. Rul. 71-179, 1971-1 C.B. 58.
4See, e.g., Larson, supra; GCM 34506 (May 26, 1971).
5Tax authorities differ regarding the extent (if any) to which these reimbursement rights, or rights of contribution, should affect the determination of which taxpayer may deduct interest expense. Compare, e.g., Smith v. Comm’r, 84 T.C. 889 (1985), Rev. Rul. 71-179, 1 C.B. 58, and Rev. Rul. 71-268, 1971-1 C.B. 58 (generally disregarding rights to recover from co-obligors) with Koppers v. Comm’r, 8 T.C. 886 (1947) and Abdalla v. Comm’r, 69 T.C. 697 (1978), aff’d, 647 F.2d 487 (5th Cir. 1981) (generally requiring attention to rights to recover from co-obligors). In addition, to the extent that these rights of contribution are relevant, the results under state law may differ from state to state (and may be unclear in some states).
6This type of agreement may be referred to by various names (such as Contribution Agreement or Agency Agreement), and one subject the agreement should focus on is the various companies’ respective shares of their shared legal liability.
