The Tax Cuts and Jobs Act signed into law on December 22, 2017, amended the Internal Revenue Code of 1986 (IRC) and made significant changes to the treatment of individual and corporate taxpayers beginning January 1, 2018. While many understand that the overall corporate tax rate is going down, the specific effects of this tax reform on distressed companies, debtors, creditors, and lenders are still being uncovered. Practical Law asked Patrick M. Cox of Baker McKenzie LLP to discuss his views on the Tax Cuts and Jobs Act (TCJA) and its potential impact on the Chapter 11 process.

Patrick regularly advises corporations and consolidated groups on the tax consequences of debt offerings, exchanges, and reorganizations. He has considerable experience in advising companies, equity owners, and creditors regarding the tax aspects of financial restructurings.

How will the changes to the treatment of net operating losses effect distressed companies?

From a restructuring point of view, the headline change under the TCJA has to be to the rules regarding net operating losses (NOLs). Debtors traditionally use NOLs to fund the administration of the case when the debtor carries the NOLs back to generate a quick tax refund, especially when the debtor has quickly spiraled into bankruptcy. Further, the debtor’s plan of reorganization is often designed to maximize the utilization of NOLs on a go-forward basis to better ensure that the post-bankruptcy effective tax rate of the debtor is as low as possible, freeing up cash and making the reorganized company more competitive. NOLs are an important part of any restructuring because they are frequently utilized in these ways as a form of currency contributing to the rehabilitation of the restructured company.

The TCJA significantly changes things for NOLs arising in tax years beginning after December 31, 2017 (New NOLs), but does not apply to NOLs arising in tax years that began before January 1, 2018 (Grandfathered NOLs), so it is important to distinguish between Grandfathered NOLs and New NOLs. The crucial changes to the treatment of New NOLs and how they differ from the treatment of Grandfathered NOLs, include:

  • New NOLs are no longer eligible to be carried back and can only offset up to 80% of a company’s taxable income. In contrast, Grandfathered NOLs can be carried back two years and are not subject to the 20% haircut. New NOLs can be carried forward indefinitely, which is somewhat beneficial, but the overall impact of the TCJA is to decrease the value of New NOLs.
  • Going forward, identifying the amount of Grandfathered NOLs will be important, as will managing how they are utilized. To the extent possible Grandfathered NOLs should be used to offset 35% taxable income (i.e., pre-2018 corporate income), as opposed to corporate income after 2017 that is subject to the new 21% corporate tax rate. For distressed companies that generated positive taxable income in 2015 or 2016, any Grandfathered NOLs should be used to offset that income first.
  • The corporate taxpayer should make an election to avoid using Grandfathered NOLs against the repatriation tax which carries a low tax rate of 15.5% or 8%, thereby preserving Grandfathered NOLs to be used against income subject to a higher tax rate.

How may the TCJA's forced repatriation provisions for multinational corporations influence distressed companies? 

It is often the case that a company is forced into bankruptcy because of a cash crunch. The company may have a bright future, but it may be unable to meet its current operating obligations. Distressed multinationals, especially those with significant cash flow issues, could have a cash crunch problem with the tax resulting from the forced repatriation.

The TCJA imposes a tax on certain earnings of foreign companies held by a US taxpayer that are deemed to be repatriated to the US, whether or not cash or other property is actually distributed back into the US. The rate of tax is 15.5% on offshore cash (and other liquid assets) and 8% on non-cash (and illiquid) assets. If the foreign subsidiary does not have the cash to distribute, that does not mean that the tax is not owed. Rather, it could generate a phantom tax, which is a tax obligation that arises without a concomitant amount of cash (or other property) being distributed to pay the tax.

Distressed investors should consider the impact of the forced repatriation when analyzing companies and their debt issuances. Keep in mind that the TCJA does allow for the tax on the forced repatriation to be paid back over eight years, the bulk of which is paid in years six through eight. Specifically, the first five installments require that 8% of the total obligation be paid, and then installments are 15%, 20%, and 25% in years six through eight, respectively. Importantly, certain events can trigger immediate acceleration of the entire obligation, which include:

  • Filing for bankruptcy.
  • The sale of substantially all of the corporate taxpayer’s assets.
  • Ceasing business operations.
  • Failure to pay any installment on time.

The TCJA is drafted so as to attempt to give the IRS priority over later-in-time claims, so investors need to be aware of the forced repatriation liability.

With the new limitations on interest deductibility, what will the impact be on highly leveraged companies seeking debt financing? 

One of the most significant changes brought about by the TCJA is the new limitations on the deductibility of interest. As a general rule, prior to the TCJA, US companies were allowed to deduct 100% of their interest expense, unless one of the following specific exceptions applied, such as:

  • Where the interest was paid to a related foreign party (old IRC § 163(j)).
  • Where the interest arose from a so-called applicable high yield debt instrument (AHYDO).
  • Where the interest payment was successfully recharacterized by the IRS, as not being an interest payment on debt at all, but rather a dividend on equity (IRC § 385).

However, these instances were outliers, and most of the time interest paid on debt was fully deductible, especially as between domestic counterparties.

Now, the TCJA has abolished the old IRC Section 163(j) and reinvented it. The new IRC Section 163(j) generally provides that a taxpayer can deduct interest only to the extent of its business interest income, plus 30% of its adjusted taxable income for the taxable year. This change applies not only to newly issued debt instruments, but also to debt issued prior to enactment of the TCJA. For this purpose, currently, adjusted taxable income essentially equals earnings before interest, taxes, depreciation, and amortization (EBITDA) but changes to EBIT for tax years starting in 2022, so that the available interest deduction is reduced, because 30% is multiplied by a smaller integer.

For highly leveraged companies the value of their interest tax shelter is not only cut by the new IRC Section 163(j), but its effective benefit is diminished because the corporate tax rate has been reduced from 35% to 21%. This means that lenders may not see the same sort of demand for new issuances of debt, since the after-tax benefits are reduced. Whether this decrease in demand will decrease the price of new issuances, and thus also raise yields, will have to be monitored over the coming months and years.

Overall, does the tax cuts Act mean more or fewer chapter 11 trestructuring in the coming years?

This is hard to say. 2018 could catch some multinational companies off guard as they may see an immediate tax hit from the forced repatriation tax, and if this does not cause an immediate cash crisis, it may force companies to use NOLs to shelter lower tax rate income (such as the 15.5% and 8% repatriation tax), drastically decreasing the value of their deferred tax assets. As such, it might be the first turn in the spiral towards bankruptcy. The next turn might be the realization that it is no longer possible for the company to get the full tax benefit of interest deductions on debt obligations. For example, whereas before the TCJA a $100 interest payment would offset $100 of income at a 35% rate, resulting in zero tax owed, now a $100 interest payment reduces $30 of the same $100 of income, so that at a 21% rate, there is a tax of $14.70 on the remaining amount ($70 x 21% = $14.70). That is a whole lot worse than zero, especially when you change $100 in the example to $10,000,000.

That all said, there are still a number of factors that will buoy troubled companies, such as the amount of liquidity in the capital markets and the lower corporate tax rate of 21%. Moreover, for new and expanding companies, there is the benefit of 100% expensing for new capital investments that is provided by the TCJA.

Careful assessment of the impact of TCJA is necessary because the new law has broad application and renders existing tax planning obsolete in many instances, especially for multinational companies (e.g., the repeal of IRC Section 958(b)(4) and the resulting creation of new “controlled foreign corporations” out of thin air). However, well advised companies should, in most instances, be able to adjust their structures and capital to navigate the new law, and take advantage of the many new opportunities the TCJA has to offer. The companies that do not have a close look at the TCJA could soon find themselves in Chapter 11.