Interest Allocations Rules, Financing Patterns, and the Operations of U.S. Multinationals

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


International business operations pose special tax problems for multinational firms as well as for the governments that tax them. Multinational firms often centralize certain activities that generate returns in more than one country. For example, firms may borrow money in one country in order to deploy the funds elsewhere. Finns are entitled to claim tax deductions for interest costs, but 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 incomplete 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 examines the impact on firm behavior of the change in the U.S. interest allocation rules introduced by the Tax Reform Act of 1986. The 1986 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 some U.S.-based firms received tax deductions for interest expenses in the United States that enhanced their profits overseas. The 1986 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.