How the Trump Tax Reform Is Changing U.S. Private Equity Firms Interest Deduction
Private Equity Firms Get Clarity on Interest Deduction Limits
According to bloomberg.com, companies that are highly leveraged can start calculating how much the Republican tax law limits their interest deductions for debt. This knowledge came about due to 439 pages of regulations released by the IRS on November 26, 2018.
The proposed rules in this release provide guidance related to a key provision in the 2017 tax overhaul that places restrictions on deductions businesses can take from the interest they pay on loans. In past years, those interest expenses were completely deductible. The IRS stated that these new limits apply to interest paid on traditional loans and other debt instruments that are not officially loans but have the same purpose and substance.
The regulations also strive to block certain creative financing transactions businesses may employ to avoid deduction caps.
Private equity deals that could involve large amounts of debt are particularly susceptible to the interest deduction change and how the IRS implements that change. This change will not be as critical to public corporations as they tend to be less leveraged.
The restriction on the interest deductions is an attempt by Congress to level the treatment of debt and equity financing. The measure was also included to offset tax cuts such as the reduction of the corporate tax rate from 35 percent to 21 percent.
The law allows companies to deduct costs up to 30 percent of EBITDA (earnings before interest, tax, depreciation, and amortization) until 2022. Following 2022, the cap narrows to 30 percent of EBIT (earnings before interest and taxes). EBIT includes depreciation and amortization which make it lower than EBITDA and will make more companies subject to the limitation.
This change comes at a time where businesses are increasing their leverage and using it as a financing tool. In the past decade, corporate debt levels have risen more than 82 percent from $3.4 trillion to $6.2 trillion. Leverage buyouts have also increased from 340 five years ago to 451 this year alone.
These changes in the tax law are forcing private equity funds to re-consider how deals are financed. Low earnings that trigger the cap may lead funds to consider eliminating debt in exchange for equity, regardless of the fact that this could dilute the value of the existing stake in the company.
Tax Law’s Intent
The IRS is allowing a broad range in terms of which interest expenses are included in the deduction cap. Expenditures previously considered a business expense, and eligible for a full deduction, are now considered interest expenses and lead to a narrower tax break according to the IRS regulations.
The regulations say that the rules break from a system of allocating interest used for decades over concerns that taxpayers could likely find ways to circumvent the intent of the law. Calculating the deduction could be more complicated for companies that have units that are not subject to a cap, and other that are such as a farm with a manufacturing business.
Leveraged Loan Market
The non-partisan congressional Joint Committee on Taxation has estimated that the deduction change is expected to raise $253.4 billion over a decade.
Certain industries are provided exceptions under the new tax law. These industries include real estate, farms, car dealerships and businesses with under $25 million in revenue.
At this point, the deduction change has not led to declines in corporate lending. High-yield bond sales are down from a year ago, but the majority of that activity has simply moved to the leveraged loan markets.
That could be due to the tax law overhaul being seen as a boost for business due to provisions such as the corporate tax cut.
John Puchalla, a senior vice president at Moody’s Investors Service stated, “I think companies are making decisions based off the whole gambit of tax law changes. In isolation this is a negative because it’s a limit on a deduction. In the context of everything else for most companies the tax law changes are a net positive.”
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