Why Debt Won’t Go Away…Even Under Proposed Tax Changes

By Geri Westphal

Tax changes under President Trump could lead to reduced tax deductibility on debt but Deutsche Bank believes it may only have a limited long-term impact on how most companies use debt in their capital structure.

The Trump Administration and Congress have been discussing tax reform that promotes the benefits of a lower marginal corporate tax rate—particularly in motivating companies to not only stay in the US but to also increase investments and employment.

The market impacts of this legislation are yet unclear, but there has been speculation that this proposed legislation could lead to reduced borrowings and greater reliance on equity financing.

iTreasurer recently spoke to Roger Heine, Managing Director, Head of Americas Liability Strategies within Debt Capital Markets at Deutsche Bank, about his contrasting view that the elimination of tax deductibility on debt may only have a limited long-term impact on how most companies use debt in their capital structures, and by implication limited impact on the structure of capital markets and financial institutions. He also reviewed several short-term tactics companies could consider to economically lock-in the 35% rate currently in effect.

Short- and Long-term Impacts

The core of the Republican tax plan is a reduction of the current federal corporate tax rate from 35% to 20% or even 15%. To offset the loss in revenue, lawmakers are considering disallowing or capping the interest deduction, imposing border taxes, repealing other deductions and credits and collecting a deemed repatriation tax. Full CapEx expensing, also under discussion, could possibly cost the government all the revenue gains from the lost interest deduction and border taxes combined. And if the controversial border taxes do not get passed, the tax rate cut might be limited to 25% or even higher to satisfy revenue neutrality requirements.

In the short-run, release of trapped cash resulting from the deemed repatriation tax will likely result in anywhere from $200bn to $400bn of debt reduction as companies repay the debt they incurred in the US to previously fund share repurchases and dividends backed by trapped cash abroad. This could temporarily depress bond issuance and reduce corporate credit spreads as was observed during the 2004 repatriation holiday.

Companies could also consider several tactical maneuvers now to lock in the current 35% ahead of tax reform:

• Accelerate contributions to traditional pension plans. Clearly this activity has picked up over the last year, also motivated by reducing escalating Pension Benefit Guaranty Corp. (PBGC) fees applied to pension deficits.
• Repurchase or exchange high coupon debt—several prominent telecom and media companies have done so in the last several months. Although the main drivers have been repurchasing debt cheap to their refinancing curves, extending maturities and accelerating tax losses, capturing a 35% tax deduction on the premium when future high coupon payments would only have been subject to a smaller tax rate would be “icing on the cake.”
• Replace shorter-term debt with longer-term debt that can be grandfathered for interest deductibility (highly uncertain but possible).
• Ready offshore borrowing structures that could continue to utilize deductibility of interest expense in foreign jurisdictions where available.

But in the long run, it would also seem that loss or limitation of the tax shield would make debt issuance less attractive relative to other sources of funding. But Mr. Heine disputes this, arguing that the existing tax shield is materially diluted by the high personal rate on interest and that other compelling motivations will continue to favor debt including pecking order theory, structural issues, some features of typical corporate governance and perhaps most importantly, inability of major classes of investors to lever themselves (all discussed further herein).

Impact on WACC Less Than Expected

Even before lower corporate tax rates or loss of interest deductibility are considered, marginal tax rates at the individual level increases a company’s weighted average cost of capital (WACC) and meaningfully diminishes the tax shield benefit from incremental leverage.

Academics would argue that the tax shield is the main driver behind the desire for higher leverage because of interest deductibility. Absent the tax shield, the higher expected shareholder returns from increasing leverage would be completely offset with a higher required return on equity and a corresponding lower PE ratio. But, the higher tax rate on interest income (39.6% in the US) compared with dividends and capital gains (20%) increases the cost of corporate debt as demonstrated by lower non-taxable yields in the tax-exempt muni bond market. Mr. Heine also estimates that trillions of fixed income investments are held by fully taxable investors who drive the marginal pricing of debt. According to Mr. Heine, the difference in marginal tax rates dilutes the benefit of the tax shield to just 36% of its nominal amount, dampening the impact from the potential elimination of the corporate interest deduction under possible tax reform.

As seen in the graph below, under traditional WACC, increasing leverage will continue to reduce the cost of capital (i.e., increase firm value) equal to the higher full 35% tax rate, absent consideration of distress costs. With personal taxes incorporated the impact on cost of capital is much flatter due to the 36% effectiveness of the tax shield.

If the corporate tax rate is lowered but net interest expense remains tax deductible and personal tax rates on interest income and equity income are equalized, there is actually a net improvement of the tax shield compared to the current tax regime. However, if net interest expense is no longer deductible, WACC increases to the unlevered return on assets and will be a constant regardless of leverage indicating that companies should be theoretically indifferent between levels of debt.

Other Motivations to Retain Leverage

The “pecking order” theory postulates that companies will take the course of least resistance to obtain financing from sources that are readily available and then steadily move on to sources that may be more difficult to utilize. Cash flow is usually first, then debt, and finally, when no other options are available, the business may choose to make use of the equity. Mr. Heine believes that the modest impact on the cost of debt from tax reform will not displace debt as the second place go-to financing vehicle after internally held cash. Debt has lower fees, avoids dilution of ownership and control, and avoids the signaling issues of equity issuance.

Structural issues can also cause borrowing rates to be unusually low: demand for long-duration debt to match pension and insurance liabilities, periods of frothy credit market pricing, and lower debt costs during periods of heavy cash repatriation. Corporate governance issues can motivate debt such as executive comp linked to EPS, which can be increased from leveraged share repurchases, and higher value of executive stock options with the volatility that results from more leverage.

But perhaps most importantly are institutional constraints on investor borrowing. If investor borrowing is unconstrained, as assumed by CAPM, and the deductibility of interest is eliminated, investors should be indifferent between borrowing on their own to buy stock to create desired risk/return profiles or having the company add leverage to its balance sheet.

However, many investor categories are debt constrained (i.e., IRAs, 401ks, 529s and many mutual funds and ETFs) and companies can provide leverage more cost effectively than individuals can themselves. Individuals also benefit from the limited liability shield that corporate borrowing provides. So the CAPM assumptions likely don’t hold because investors seem to place a value on the leverage provided by companies. This is demonstrated by the seemingly persistent undervaluation of low-beta (low-risk) firms compared to the CAPM model.

Evidence Supports Unimportance of Tax Shield

The most direct evidence that the tax shield doesn’t matter much is that corporate leverage has increased over time despite having a constant 35% corporate tax rate.

Since the economic downturn of 2008, corporate issuance volumes have grown significantly from approximately $375B to $900B in 2016. Corporate leverage has, in turn, risen beyond pre-crisis levels and credit ratings have declined—particularly among double- and single-A companies. Intensity of share repurchases and stretching leverage to fund acquisitions have been drivers.

Other incidental evidence that leverage doesn’t matter:

• REITs and MLPs, with no tax shield, have substantial amounts of debt.
• A study conducted by Mr. Heine’s team showed that from 2010-2017 excess returns of stocks were not correlated to rating across the single-A to triple-B spectrum whereas the expectation would have been higher returns for higher risk.
• Another study conducted by Mr. Heine’s team showed that P/E ratios did not decline as expected to reflect higher leverage following Accelerated Share Repurchase (ASR) announcements since 2012.
• Finally, one might ask if cash flow constraints could force companies to de-lever. Mr. Heine’s team conducted another study that showed that for most investment grade and near-IG companies the reduction of the corporate tax rate down to 25% or lower generates more incremental cash flow than cash lost to the eliminated deductibility of interest expense, and if up-front CapEx expensing is also layered in almost all companies will experience substantially higher cash flows.

With all this in mind companies should look to current strategies to lock in today’s 35% tax rate on top of other benefits and not worry about economic or other pressures to de-lever if tax reform is enacted.