U.S. companies could encounter higher borrowing costs under a congressional tax plan that would reverse a 29-year-old policy making it easier for other countries’ residents to invest in U.S. corporate debt.

Senate Finance Committee Chairman Max Baucus has proposed ending what's known as the portfolio interest exemption. If the change were enacted, some non-U.S. investors would have to pay withholding taxes of as much as 30 percent when they receive interest from U.S. corporations.

The proposal would alter global capital markets, particularly for investment funds based in the Cayman Islands and investors from nations such as Brazil that lack tax treaties with the U.S. that eliminate or reduce the withholding tax. Investors from major economies such as the U.K. and Germany would pay no tax.

“What we’re doing is just shooting borrowing costs up,” said David Shapiro, founder of Shapiro Tax Law LLC in Philadelphia, who represents businesses structuring cross-border investments.

The Baucus proposal is far from becoming law. It’s a three-paragraph section of a 71-page draft of international tax changes. Many business groups oppose the international proposals, which are embedded in a larger effort to revamp the tax code that has been stalled by broader political conflict.

‘More difficult’

Baucus and Dave Camp, his House Republican counterpart, are “still going to give it the old college try” to advance tax-code changes in 2014, said Pamela Olson, a top Treasury tax policy official in the George W. Bush administration who now leads the Washington national tax office of PricewaterhouseCoopers LLP. “It’s not impossible but it becomes increasingly more difficult.”

The portfolio interest issue is being watched closely by tax lawyers and financial industry lobbyists because it could emerge later.

Corporations had a total of $9.3 trillion of outstanding corporate debt as of the second quarter of 2013, according to the Securities Industry and Financial Markets Association. As of June 2012, 19 percent of U.S. corporate and other debt outside of Treasuries and government agency debt was foreign-owned, according to the Treasury Department.

Baucus, a Montana Democrat, hasn’t publicly cited a justification for the change or an estimate of how much revenue it would generate for the federal government.

Tax avoidance

The plan is designed to reduce the gap between how the tax code treats debt and equity and to prevent tax avoidance by U.S. residents who receive income through foreign intermediaries, said a Democratic aide for the Finance Committee who spoke on condition of anonymity to explain the rationale.

The effects on U.S. tax collections and the corporate debt market probably will be relatively small, in part because the treaties eliminate the withholding tax for major trading partners, a second Democratic Finance Committee aide said.

Baucus’s proposal on portfolio interest, released Nov. 19, came as a surprise, said Payson Peabody, managing director and tax counsel at SIFMA, the trade group whose directors includes executives from Morgan Stanley and Goldman Sachs Group Inc.

“It’s not something that we’ve seen from any other source, of the various groups that are working on tax reform,” he said. “This has been settled law for a very long time, and I think repealing the exception outright would be disruptive for corporate debt markets.”

Withholding taxes

Under current law, non-U.S. investors don’t face withholding taxes when they buy bonds issued by U.S. corporations. The change, which wouldn’t affect Treasury bonds or bills, would set the rate at 30 percent.

The proposal would take effect only for debt issued more than a year after it becomes law, though that date could move further into the future because of the need to write regulations, the aides said. The proposal wouldn’t affect short-term debt, defined as obligations of 183 days or less.

Investors from nations such as the U.K., Canada and Germany would experience little if any change, because of tax treaties that eliminate the withholding tax. Investors from countries including Australia and China would pay 10 percent under tax treaties.

Investors from countries that lack tax treaties with the U.S., including Singapore and Saudi Arabia, would face the full 30 percent rate.

Borrowing costs

Corporate bond sales in the U.S. are poised to eclipse last year’s record as issuers take advantage of borrowing costs at about record lows to offer deals of unprecedented size.

With almost a month left in 2013, sales of notes from the riskiest to the most-creditworthy corporate borrowers are $18.4 billion shy of the unprecedented $1.48 trillion sold in all of last year, according to data compiled by Bloomberg.

Yields of 3.96 percent as of Dec. 3 on the Bank of America Merrill Lynch U.S. Corporate & High Yield Index are within 0.61 percentage point of the record low of 3.35 percent reached on May 2.

An eight-part $49 billion bond sale from Verizon Communications Inc. in September and Apple Inc.’s $17 billion issue in April were the two largest offerings on record, according to data compiled by Bloomberg.

Treasury Secretary Jack Lew spoke favorably about Baucus's broader plans on business taxation last month. He hasn't said anything specifically on the portfolio interest exemption. Victoria Esser, a Treasury Department spokeswoman, declined to comment on the issue.

Public comments

The Finance Committee is seeking comments from the public by Jan. 17. Camp’s 2011 international tax draft doesn’t call for repealing the portfolio interest exemption.

The Baucus proposal would make little sense if done unilaterally because it would drive borrowing out of the U.S., said Reuven Avi-Yonah, a tax law professor at the University of Michigan. It would be sensible, he said, as part of a coordinated effort with other governments.

Because treaties require information sharing between countries, the proposal would help non-U.S. governments get data they wouldn’t otherwise have about their citizens’ income from U.S. corporate debt, Avi-Yonah said.

“These are people who are cheating their governments out of taxes that are clearly legally due,” he said.

If tax evasion is the concern, there are narrower approaches the government could take besides removing the portfolio interest exemption, which was designed to broaden the market for U.S. corporate debt, said Michael Hirschfeld, a tax partner at Dechert LLP in New York.

“I’m just totally baffled as to why in this economy do they want to cut off this funding source,” he said. “If there’s something that’s bothering them, why don’t they focus on what the bother is?”