Highly Leveraged Firms Face Headwinds From GOP Tax Bill

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By Lydia O'Neal (Bloomberg Tax)

The GOP’s new tax law is a mixed bag for corporations with high debt-to-equity ratios and large losses.

The measure ( Pub. L. No. 115-97), signed by President Donald Trump Dec. 22, would restrict net operating loss and interest-related deductions, while allowing companies to carry over those deductions indefinitely and replenish their coffers with offshore cash at a low repatriation rate. (For a road map of where to find key provisions in the new tax law, and comparisons with the previous tax code, read Bloomberg Tax’s analysis.)

The House-Senate conference committee chose to lower the cap on deductions for corporate interest payments to 30 percent of earnings before interest, taxes, depreciation and amortization (EBITDA)—as proposed in the House bill—until the start of 2022, after which the Senate bill’s definition of qualifying income, EBIT, which doesn’t add back amortization and depreciation, will kick in.

Put simply, the amount of income on which the 30 percent is computed will shrink after four years. The provision, which applies to companies with gross receipts of more than $25 million, is expected to raise $90.2 billion in revenue by 2022 and $253.4 billion in fiscal years 2018 through 2027, a fraction of the bill’s nearly $1.5 trillion shortfall over the next decade, according to the conference committee report.

The change may doom some highly leveraged firms, particularly those fresh off of an acquisition of another company or that have recently gone private, because the bill doesn’t grandfather already debt-saddled firms into prior full deduction allowances.

“There are companies whose effective tax rate because of heavy leverage is well below 20 percent. We can argue about whether that’s proper or not or whether they’re overleveraged, and that’s a problem, but the reality is their position is going to be far worse than it was before because they won’t be able to deduct that interest,” Jim Barry, a partner at Mayer Brown LLP, told Bloomberg Tax. “Companies, when trying to figure out the cost of their operations, take into consideration taxes, and when trying to figure out their costs of their acquisitions, they’ve taken into consideration the deductibility of the interest.”

Relief From Offshore Cash

In a new report based on a survey of 575 high-yield and leveraged loan issuers, Fitch Ratings suggested something along those lines. The credit ratings agency found that 37 percent of issuers would lose part of their interest deduction under the EBITDA definition of income used for the first four years, while one in 10 would be unable to deduct at least half of their interest. Under the more restricted EBIT definition of taxable income, leaving out depreciation and amortization deductions, 64 percent said they would lose part of their interest deduction, and four in 10 said they’d lose half.

The change could be dire for issuers with leverage of over 7.0x, or debt equal to seven times EBITDA, and interest rates of around 8 percent, while those with leverage of 5.0x or less and lower interest rates could see no change to net income or even a net gain, thanks to other business-friendly provisions in the bill, according to the Fitch report. In light of the Federal Reserve’s continual lifting of its policy interest rate, however, the ratings agency suggested issuing firms may be wary of floating-rate debt, as they may not be able to deduct the resulting growth in interest expense.

Still, corporations holding some of the $2 trillion in profits kept offshore, on which they’ve deferred taxes, may have a chance to buy back their bonds after bringing some of that cash back to the U.S. to be taxed at a lower 15.5 percent repatriation rate for liquid assets.

In a Dec. 20 interview with Bloomberg TV, Bruce Richards, chairman and chief executive officer of Marathon Asset Management LP, which focuses on distressed debt, expressed optimism in this regard, but cautioned that the overall bill would nonetheless be “good for stocks, but not so good for bonds.”

“This year alone, there’s been $1.3 trillion in investment-grade corporate issuance,” Richards said. “That’s a record, which I think will not be broken in the next decade.”

Indefinite Carryover

On top of the availability of offshore cash at a lower tax rate, the bill would allow interest deductions to be carried forward indefinitely. At the forefront of the lobbying campaign was the BUILD Coalition, which paid the lobbying firm Cypress Advocacy LLC $110,000 to lobby exclusively on the issue during the third quarter, the most recent available, federal lobbying forms show.

In a Dec. 8 letter to Senate Majority Leader Mitch McConnell (R-Ky.) and House Speaker Paul D. Ryan (R-Wis.), the coalition urged the conferees to shield old debt from the new interest deductions through grandfathering, based on the notion that “companies should have a reasonable period to reposition their debt without incurring significant economic penalties.”

“We also applaud both chambers for signaling the importance of providing a carryforward for disallowed interest,” the BUILD Coalition wrote. “In this regard, we support the Senate’s indefinite carryforward of disallowed net interest expense deductions. This feature is critical to mitigate the impact on start-ups and companies during a short-term down cycle.”

Dell Technologies Inc., one of the more prominent members of the BUILD Coalition, was also active on the lobbying front during the three months that ended Sept. 30, and continued to press congressional leaders during the more recent developments of each chamber’s tax bill as well. Its chairman and chief executive, Michael Dell, wrote in a Dec. 11 op-ed in the Hill that lowering the deduction “without regard for depreciation, pre-existing debt or transition periods will punish businesses that made investments in good faith, forcing them to accept a steep financial burden and unforeseen risks.”

Offsetting Temporary Expensing

Although carryover may come as a form of relief, the decreasing value of money with time makes repeated carryover less attractive, and no company wants to operate indefinitely without the income gains generally used to offset the carryover, according to Duke University School of Law professor Lawrence Zelenak. But, he noted, “certainly a company sitting on carryover could lobby for an easing of deduction limitations so that it could use the carryover faster than if the limitations were not eased.”

Lawmakers likely inserted the provision to offset the revenue losses—and windfall to corporations—stemming from the allowance of immediate temporary expensing of non-structure capital, Zelenak said. If they hadn’t, he added, the combination of an interest deduction and expense deduction would essentially amount to a subsidy, allowing companies to write off both the expenses they make and the cost of debt used to finance those expenses.

“If you are allowed to purchase business assets with borrowed money on one side of the transaction and immediately deduct these expenses and then deduct those interest expenses, it’s sort of a way of tax sheltering,” he said.

Others, like Stephen Entin of the conservative-leaning Tax Foundation, dispute this idea, arguing that lenders are already taxed, rendering an additional levy on borrowers a form of double taxation.

Lower NOL Deductions

Another deduction limit likely hurting companies deep in the red is the bill’s limit on deductions for net operating losses, a provision exacerbated by the legislation’s centerpiece—the steep cut to the corporate tax rate.

Under current law, corporations can use a net operating loss—taken when tax deductions are greater than taxable income—by deducting the amount of the loss in later years. The bill allows companies to use only 80 percent of the NOL—a slightly less generous ceiling than the House’s proposed 90 percent and the Senate’s proposal to start with 90 percent for four years after which the 80 percent deduction would kick in at the start of 2023. The restriction would bring in $68.5 billion in revenue by 2022 and $201.1 billion by 2027, according to the conference committee report.

That limitation, both Entin and Zelenak said, is less of an issue in itself than the effect of the lower corporate tax rate on how much businesses can reap from deferring an NOL. If the tax rate is 35 percent, the company is essentially carrying forward an asset equal to 35 percent of its loss amount. Dropping the rate to 21 percent would likewise shrink the deferred tax asset.

Like the new limits on interest expense deductions, the change in NOL deductions would allow companies to carry the NOL deduction forward indefinitely, with exceptions for property and casualty insurers. Those industries would be permitted to carry their NOLs over two decades, in line with broadly applicable current law, after which the deferred tax assets would essentially be lost.

With assistance from Nico Grant, Katia Porzecanski, Erik Schatzker, Katherine Tam (Bloomberg)

To contact the reporter on this story: Lydia O'Neal in Washington at loneal@bloombergtax.com (Bloomberg Tax)

To contact the editor responsible for this story: Meg Shreve at mshreve@bloombergtax.com (Bloomberg Tax)

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