Two key changes to business tax provisions in the Tax Cuts and Job act that will interest private equity sponsors and their lenders are the new limitation on deductibility of business interest expense and the temporary increase in the amount of capital expenditures that may be currently expensed. This piece explores the implications of these changes for credit terms and deal structures.
President Trump signed the Tax Cuts and Jobs Act (the New Tax Law) into law on December 22, 2017. The key provision in the New Tax Law was the reduction of the maximum corporate tax rate from 35 percent to 21 percent. In addition, there are a few key changes to business tax provisions that will interest private equity sponsors and their lenders. Two important changes are (1) the new limitation on the deductibility of business interest expense and (2) an increase in the amount of capital expenditures that may be currently expensed.
Limit on Deductibility of Interest Expense
The New Tax Law limits the amount of interest expense that a business may deduct in a given year to 30 percent of its adjusted taxable income. Any interest expense disallowed as a deduction in a given year may be carried forward indefinitely.
For taxable years beginning before January 1, 2022, “adjusted taxable income” (ATI) is calculated based on a company’s EBITDA, resulting in the disregarding of certain line items that are not related to the ability of a business to generate income from operations (excluded line items include interest, taxes, depreciation and amortization, which is how “EBITDA” in most credit agreements is calculated). For taxable years beginning on or after January 1, 2022, ATI can no longer be calculated without giving effect to depreciation or amortization (i.e., EBIT).
Parties to credit agreements will want to know the types of borrowing terms that will be most tax-advantaged. With regard to determining how to maximize the interest expense deduction under the New Tax Law, there are four variables in play: (1) the amount of ATI, (2) the leverage of the borrower (the Leverage Factor), which is calculated by dividing a borrower’s indebtedness by its ATI, (3) the interest rate the taxpayer is paying on its indebtedness (the Interest Rate), and (4) the amount of any interest being carried forward. Assuming there is no interest being carried forward, a good rule of thumb for maximizing the benefit of the interest deduction is to ensure that the product of the Leverage Factor and the Interest Rate is as close to 0.3 as possible. The preferred result stated as an equation reads as follows:
Rule of Thumb:
Leverage Factor * Interest Rate = 0.3
This rule of thumb derives from the fact that to maximize the interest deduction under the New Tax Law, the taxpayer’s goal should be to minimize the daylight between (1) the cap on interest deductibility (i.e., 30 percent of ATI) and (2) the amount of interest expense (i.e., Leverage Factor *ATI*Interest Rate + Interest being carried forward). This equation stated differently reads as follows: Leverage Factor * Interest Rate – Interest being carried forward = 0.3.
For example, assuming there is no interest being carried forward, a borrower with a Leverage Factor of 5 and an Interest Rate of 6 percent would be maximizing its interest deduction as would a borrower with a Leverage Factor of 3 and an Interest Rate of 10 percent. In light of the foregoing, borrowers should start thinking about, and lenders should expect that borrowers soon will be, adjusting their behavior so as to maximize their interest deduction under the New Tax Law.
In order to reduce their interest exposure, some commentators are predicting that borrowers may consider issuing preferred equity as an alternative to indebtedness with a high interest rate; however, preferred equity issuances are likely to be more expensive and dilutive to the private equity sponsor, so they are unlikely to appeal to private equity sponsors and their portfolio companies. In addition, borrowers with many non-US investors will find preferred equity to present problems because the rules regarding withholding taxes remain unchanged. Dividends continue to be subject to withholding (even under relevant tax treaties) whereas interest payments tend to be exempt from withholding tax under the portfolio interest rules and many tax treaties.
Finally, to the extent that applicable foreign jurisdictions offer more cost-effective interest expense deductions, private equity sponsors owning US-parented foreign subsidiaries may consider shifting debt from their US companies to these foreign subsidiaries.
Temporary Increase in Permitted Expensing of CapEx
The existing tax law requires deductions for capital expenditures to be taken over the useful life of the asset being acquired. In contrast, the New Tax Law amends the current law by permitting 100 percent of qualifying capital expenditures to be expensed in the year that the applicable property is placed into service until 2023 (at which point the amount that may be expensed in the year the applicable property is placed in service falls to 80 percent and will continue to decline by an additional 20 percent per calendar year thereafter, with exceptions for longer production period property and certain aircraft).
Many credit agreements contain provisions limiting the amount of permissible capital expenditures. As a result of the New Tax Law, borrowers may want to revisit credit agreements containing capital expenditure limitations to implement amendments that allow them to take full advantage of the increased expensing allowance under the New Tax Law.
As we move into 2018 and companies react to these tax law changes, a clearer picture will begin to emerge as to whether the effect of the limits on interest deductibility are adequately counterbalanced by the reduction in the corporate tax rate and the temporary increase in permitted expensing of capital expenditures. Discerning private equity sponsors and their lenders will also be well-advised to plan for the further changes to the calculation of ATI in 2022 and the phase-downs of the increased expensing of capital expenditures beginning in 2023.