The new tax reform bill made monumental changes to the way corporations pay tax. With lower tax rates for corporations across the board, and an especially low rate for those who repatriate money from overseas entities, there are a lot of positives for companies and the investors who own their shares. The bill was so business-friendly that many critics have centered their attacks on the idea that individuals didn't get enough of the benefits of the measure.
Yet those corporate tax breaks came at a price, and businesses had to give up some favorable provisions in order to get the tax-rate relief they wanted. In particular, the dramatic scaling down of one key provision made some businesses big losers from tax reform, with future consequences that have dramatic implications for the way companies sustain themselves financially.
Forcing debt discipline on corporate America
The provision in question is Section 163 of the Internal Revenue Code, which governs the deductibility of interest. Under previous law, the general rule for business interest was quite simple: "There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness."
For the most part, exceptions to that general rule were limited in scope. The tax law disallows deductions of interest for personal borrowing, and it places limits on the deductibility of investment income for non-corporate taxpayers. With the exception of some narrow instances, though, corporations generally got to deduct all of their interest owed on their debt.
The new tax law changes that scheme entirely. Now, corporations can deduct business interest up to the amount of interest income they receive, and then up to an additional 30% of their adjusted taxable income, which the measure generally defines as earnings before interest, taxes, depreciation, or amortization. Beyond that, most taxpayers won't be able to claim business interest deductions on their debt, and they'll have to carry forward any disallowed interest to future tax years.
The death of leverage?
Most well-established, successful corporations won't face a big problem meeting that standard. Especially with interest rates at extremely low levels, it's hard for most businesses to borrow enough money to owe 30% of their pre-tax operating earnings in interest each year.
However, one common method that private equity investors use involves leveraged buyouts of businesses. In order to maximize the potential returns on equity, private equity companies often borrow extensively against the assets of an acquired business in order to pay off its former owners, with the expectation that they'll be able to deduct the full cost of interest payments against the company's ordinary income. Under the new tax law, this will no longer be available.
Not all leveraged businesses will become impractical, even under the new law. For instance, real estate investment trusts that focus on mortgage securities often incur substantial interest expense in borrowing money to make leveraged bets on the bond market. Yet because they buy interest-paying securities with their borrowings, mortgage REITs will be able to offset the interest income from their investments against their interest expense before being subject to the 30% limitation.
A big hit for start-ups, largely averted
The hardest-hit businesses from the loss of debt financing would arguably have been start-ups in sectors that have traditionally relied on debt financing to raise capital. For instance, farming and ranching requires huge upfront expenditures for land and equipment, and eliminating interest deductions essentially raises the cost of capital for farmers and ranchers to a prohibitive extent.
That's one reason lawmakers added provisions that limit the loss of business interest deductions for certain small businesses. A gross receipts test applies to make some businesses exempt from the provision, and special treatment for electing real estate businesses and farming operations give specialists in those areas the flexibility to get the financing that meets their needs.
Watch for debt restructuring in the future
As interest rates increase, a 30% limitation on business interest deductions will become relevant for more companies. Initially, most of the behavioral changes will be confined to high-yield borrowers and leveraged financing plays. Over time, though, the new restrictions could lead more companies to limit their debt exposure, relying more on equity financing for the capital they need. That could become the unintended consequence of the business interest provision of tax reform.