The Tax Treatment of Interest and the Operations of U.S. Multinationals

Kenneth A. Froot
James R. Hines Jr., University of Michigan Law School


The taxation of multinational corporations entails a number of complications beyond those that accompany ordinary business taxation. One of the most complex and important aspects of taxing multinational firms is the treatment of interest expenses. Multinational firms may borrow money in one country in order to deploy the funds elsewhere. Firms are entitled to claim tax deductions for their interest costs, but the countries in which they borrow may not permit all of the associated interest expenses to be deducted against local income for tax purposes. The method used to calculate allowable interest tax deductions can, in tum, affect financing choices and operating decisions. American tax law permits only partial deductibility of the interest expenses of multinational firms. U.S. law specifies rules that determine the extent to which interest costs incurred by multinational firms in the United States can be deducted for tax purposes against U.S. income. These rules are often changed, the last major change occurring in 1986. This paper describes the impact on firm behavior of the change in the U.S. interest allocation rules introduced by the Tax Reform Act of 1986. The act significantly reduced the tax deductibility of the U.S. interest expenses of certain American multinational corporations. Congress changed the law in 1986 because it was concerned that U.S.-based firms received tax deductions for interest expenses on borrowing undertaken in the United States to enhance their profits overseas. The act introduced a new formula for multinational firms to use in calculating the fraction of their interest expenses that can be deducted against taxable income in the United States.