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Treasury & Taxation

Highly Leveraged Will See Tax Reform Pain

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December 20, 2017

Tax reform’s interest deduction should harm only the most leveraged

IRS and dollarUnder tax reform passed by Congress today, saddling companies with significant leverage may no longer be a viable strategy for buyout firms, and already highly leveraged companies may want to explore how to reduce their debt.

In a recent note sent to investors, Fitch Ratings calculates that corporate issuers with leverage of five times EBITDA and a debt cost of 6% should realize tax savings due to the corporate tax rate dropping to 21% from 35%.

“However, the impact turns negative at higher leveraged levels. Assuming an issuer with leverage of 7 times and an 8% cost of debt, tax payments would increase and could result in tighter liquidity for smaller companies,” Fitch says, noting the calculations are based on simplistic assumptions that do not incorporate the current issuer-effective tax rate or the impact from other amendments.

Fitch says that the bill, reconciled between the Senate and the House of Representatives, would limit the deduction of interest to 30% of EBITDA until 2021, and after that to EBIT, which would result in a bigger impact. The non-deductible portion of interest expense can be carried forward for five years, potentially lessening the impact for issuers that are increasing EBITDA while reducing debt.

Analyzing 575 leveraged loan and high-yield issuers, Fitch estimates that 37% of them would lose a portion of their interest deduction under the EBITDA definition, while 27% would be unable to deduct 20% or more of their interest, and 10% unable to deduct 50% or more.

Fitch goes on to note that there is a bigger impact when the limitation of the interest deduction is based on EBIT at 30%.

“Without the depreciation shield, 64% of the sample would lose a portion of their interest deduction,” Fitch says. “Furthermore, 56% would be unable to deduct 20% or more of their interest and 40% would be unable to deduct 50% or more of their interest.”

Fitch notes several considerations behind the new law. For example, EBITDA defined under the tax code could vary materially from what is reported as adjusted EBITDA, such that one-time restructuring costs “properly allocable to a trade or business” could be included in EBITDA, limiting the interest-rate deduction. In addition, as earnings fall in a slowing economy, Fitch says, issuers will lose a greater portion of the interest deduction as EBIT and EBITDA decline.

The rating agency also points out that the reconciled bill will repeal the tax carryback provision and restrict tax carry forward to 80% of taxable income. As a result, tax refunds would be materially limited as issuers recover from an economic recession.

“During the last financial crisis many firms, such as homebuilders and casinos, benefited greatly from tax refunds from utilizing the tax carryback provision from 2009-2011,” Fitch says.

Nevertheless, the limitation on the interest-expense deduction is unlikely to have a significant effect on speculative-grade or investment-grade debt issuance, either from supply or demand viewpoints, Fitch says. Demand for corporate debt, including leveraged financial products, will likely remain strong as investors continue to seek higher yields, providing an attractive market for issuers, although the interest-deduction limit could reduce the amount of leverage on loans, due to the reduced benefit of the interest tax shield.

The last point Fitch makes is that the Fed’s anticipated shorter-term rate increases should prompt issuers to considering financing through high-yield bonds rather than leveraged loans to lock in interest rates, “since rising interest expense on floating-rate debt may not be deductible.”

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