As more of the dust settles after the December 2017 passage of the Tax Cuts and Jobs Act, P.L. 115-97, borrowers and lenders alike are reconsidering their future financing strategies. One of the more significant changes in the tax law is the new limit imposed on interest expense deductions.
Prior to the passage of the tax reform bill, corporations could usually deduct the full amount of their business debt interest payments. The tax reform bill changed this for many taxpayers, including corporations, by imposing a limitation of the amount of the deduction based upon a formula. The new formula generally caps the business interest deduction at the sum of “(A) the business interest income of such taxpayer for such taxable year, (B) 30 percent of the adjusted taxable income of such taxpayer for such taxable year, plus (C) the floor plan financing interest of such taxpayer for such taxable year.” For most corporations, the practical result of the new tax provisions is that they can no longer deduct net interest expenses exceeding 30 percent of their earnings before interest, taxes, depreciation and amortization (EBITDA). This new challenge for heavily leveraged businesses will only increase in 2022, when the deduction must be calculated after computing depreciation and amortization expenses.
Under the old tax code, corporate debt swelled. Dividends, mergers and acquisitions, and leveraged buyouts were frequently funded at least in part with borrowed funds. As a result of the new limit on the deduction, many companies could have lower cash flow projections. Corporations may have less incentive to obtain financing and may instead raise cash through equity offerings, such as preferred stock. Corporations may look to increased use of leasing as another alternative to borrowing. Companies may also look for alternative ways to free up cash, such as streamlining operations and outsourcing.
Certain sectors are more likely to be negatively impacted by the change in the tax law. For instance, leveraged buyouts and mergers and acquisitions are often concentrated in the healthcare and technology industries.
Although multinational companies are beginning to consider moving debt to foreign subsidiaries now, the pressure may increase after 2021, at least until income earned outside the United States is addressed in a tax-efficient manner. There are questions about whether the Section 163(j) rules apply to foreign subsidiaries for purposes of the new “minimum tax,” which could affect the U.S. tax benefit or the cost of shifting debt to foreign subsidiaries. Guidance from the Internal Revenue Service is expected on this issue in the relatively near term.
In addition to causing a shift in financing strategies, the new deduction cap may result in an increase in the default rate for borrowers. Lenders could find themselves as creditors in bankruptcy proceedings and, depending on factors such as the priority of their liens and value of their collateral, recover pennies on the dollar. In addition to the exposure to existing loan portfolios, the increased risk of default may impact the factors used by lenders in issuing new debt.
While it is too early to predict the full impact of the change to the business interest deduction, it is clear that the factors that impact borrowing decisions are changing. There may be fewer leveraged buyouts, increased use of leasing as a means of equipping businesses and more equity offerings. Companies should continue to review their existing financing structures for tax inefficiencies created by the tax reform and adjust their strategies to meet the new challenges created by the changes.