Tax Reform: Impact on Lending

Introduction

On December 22, 2017, President Trump signed into law the bill formerly known as the Tax Cuts and Jobs Act (the “Act”). The Act includes substantial changes to the taxation of domestic and multinational businesses. Most significant for the leveraged finance markets is a broad limitation on the deductibility of business interest expense under newly amended Section 163(j) of the Internal Revenue Code of 1986, as amended (the “Code”). This new rule will limit the ability of many businesses to deduct interest expense paid or accrued to the extent net interest expense exceeds an adjusted earnings-based threshold. In addition, changes to tax rates, including a new deduction for non-corporate owners of pass-through entities (resulting in a lower effective tax rate), will be relevant for purposes of tax distribution provisions in credit agreements and the operating agreements of pass-through entities.

New Limitation on Deductibility of Interest

General Rules
Under pre-Act law, business interest generally is deductible in the taxable year in which it is paid or accrued, subject to a number of limitations. These limitations apply primarily to interest paid to related parties under the so-called earnings stripping rules of former Code Section 163(j) and to certain high-yield debt instruments (so-called AHYDOs). The Act repeals the earnings stripping rules and imposes a new limitation on the deductibility of net business interest expense under new Code Section 163(j). The new rules are effective for taxable years beginning after December 31, 2017. There is no grandfathering for debt instruments outstanding prior to such date.

Under new Code Section 163(j), the deduction for business interest expense in excess of business interest income is limited to thirty percent (30%) of the taxpayer’s adjusted taxable income (computed without regard to (i) any item of income, gain, deduction, or loss not properly allocable to a trade or business, (ii) business interest income or business interest expense, and (iii) net operating loss deductions). For taxable years beginning before January 1, 2022, the taxpayer’s adjusted taxable income is computed without regard to depreciation, amortization, and depletion, whereas for subsequent years, those items are taken into account. Thus, the interest deductions that businesses will be able to take under the Act essentially will be limited to 30% of EBITDA through 2021 and 30% of EBIT thereafter. Of course, this definition of EBITDA and EBIT is different from the definition that most banks use, as it starts from taxable income, not book income, and does not add back unusual or non-recurring cash charges, projected cost savings, or non-cash items other than depreciation and amortization (in the case of EBITDA).

Business interest does not include investment interest. There is an unlimited carryforward period for interest deductions that are disallowed under these rules.

For purposes of applying this test, all members of a consolidated group are treated as a single taxpayer.

Exceptions for Certain Businesses
The interest expense deduction limitation does not apply to taxpayers with average gross receipts of $25 million or less for the three-taxable-year period ending with the prior taxable year. The $25 million threshold applies in the aggregate to certain related taxpayers. Companies with little history or that experience rapid growth may be able to benefit from this exception, at least temporarily.

Floor plan financing interest is not subject to the new Code Section 163(j) limitation. Floor plan financing interest is interest on debt used to finance the acquisition of certain motor vehicles held for sale or lease. The new limitation also does not apply to certain regulated utility companies.

Taxpayers engaged in certain real property and farming trades or businesses are permitted to elect out of the interest expense deduction limitation with respect to such businesses. Eligible real estate businesses are defined broadly by reference to Code Section 469(c)(7)(C), which includes real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or businesses. However, any taxpayer electing out is required to use the alternative depreciation system with respect to such businesses (which is generally less favorable to the taxpayer than the general accelerated depreciation system).

Pass-Through Entities
In the case of a partnership or S corporation, the limitation under Code Section 163(j) applies at the entity level. After application of the limitation, any partnership or S corporation deduction for business interest will reduce the business income allocated by the partnership or S corporation to its partners or shareholders, respectively.

A special carryover rule applies to partnerships. Interest expense in excess of the limitation (“excess business interest”) is allocated by the partnership to its partners. Each partner carries over its excess business interest and may utilize it in a subsequent year to offset such partner’s distributive share of the partnership’s unused taxable income limitation for such year (“excess taxable income”). Excess business interest of a partner may not be offset by taxable income from other sources.

If a partnership has excess taxable income for a year, a partner generally is permitted to utilize its share of such excess in computing its business interest limitation for use against such partner’s income from other sources (after first utilizing any carried-over excess business interest against such excess under the carryover rule described above). The Act provides for similar rules to apply to S corporations.

Examples
The new Code Section 163(j) limitation is illustrated as follows:

Example 1: Corporate taxpayer has $10 of business interest income for 2018 and $90 of other taxable income for 2018, determined without regard to business interest expense. The taxpayer’s only expense is business interest of $40. The taxpayer’s business interest expense deduction will be limited to $37 ($10 + 30% x $90). Accordingly, the taxpayer may deduct $37 of business interest and will have an interest deduction disallowance of $3, which may be carried forward to future tax years.

Example 2: Corporate taxpayer has $60 of taxable income for 2018 (none of which is business interest), determined without regard to business interest expense but after taking into account $30 of depreciation. The taxpayer’s only expense (other than depreciation) is business interest of $40. The taxpayer’s business interest expense deduction will be limited to $27 (30% x ($60 + $30)). Accordingly, the taxpayer may deduct $27 of business interest and will have an interest deduction disallowance of $13, which may be carried forward to future tax years.

Example 3: Partnership AB is owned 50% by Partner A and 50% by Partner B. Partnership has $10 of business interest income for 2018 and $90 of other taxable income for 2018, determined without regard to business interest expense. Partnership has business interest of $30. In addition, Partner A has business interest of $10, but Partner B has no additional business interest. All $30 of Partnership AB’s business interest is deductible ($10 + 30% x $90 = $37), and Partnership AB has $7 of excess limitation, which is allocated 50% to each of Partner A and Partner B. Partner A may deduct $3.50 of its partner-level business interest (50% x $7) and will have an interest deduction disallowance of $6.50 ($10 - $3.50), which may be carried forward to future tax years.¹

Tax Distributions

Where a borrower is a pass-through entity, credit agreements typically permit distributions to be made to equityholders to enable them to pay the U.S. federal, state, and local tax due with respect to their allocable share of the entity’s income. Various changes in the Act may affect the amount of actual cash that it is necessary to distribute to such equityholders. For example, the Act provides for a maximum 20% deduction for non-corporate owners of pass-through entities on the qualified business income allocated to them from the entity (the “pass-through deduction”). The pass-through deduction will lower the effective tax rate for direct or indirect individual equity holders of many pass-through entities (including, e.g., income earned through most private equity portfolio companies that operate in pass-through form). The pass-through deduction applies at the partner level. The extent to which the pass-through deduction will be taken into account in determining permitted tax distributions under the applicable credit agreements and under the operating agreements of the pass-through entities is not yet clear. Conversely, non-corporate taxpayers will no longer be able to deduct state and local taxes above a threshold, so those not eligible for the pass-through deduction may request larger tax distributions if they currently are required to assume the deductibility of state and local taxes.

Cross-Border Considerations

The Act contains wholesale changes to the taxation of multinational corporations, changing the system from one of worldwide taxation with deferral for most income of foreign subsidiaries to a modified territorial system in which, subject to rules that ensure a minimum level of tax is being paid on offshore income (the so-called GILTI tax), most income of foreign subsidiaries will not be subject to U.S. federal income tax. To transition to the new rules, a one-time repatriation tax is imposed on U.S. shareholders of foreign corporations (payable, at the election of the taxpayer, in eight back-loaded installments). The end result of these reforms is that offshore earnings that have been “trapped” in non-U.S. subsidiaries now can be repatriated without further U.S. federal income tax.

For unknown reasons, however, unlike both the House and Senate tax bills that were the basis for the Act, the Act does not change the rules relating to potential “deemed dividend” inclusions that may occur where stock of a controlled foreign corporation (“CFC”) is pledged as security on a loan of a U.S. borrower or a CFC guarantees the loan of its U.S. parent (i.e., Code Section 956). The Act, therefore, establishes a curious system where an actual dividend paid by a foreign subsidiary to its U.S. parent corporation is not subject to U.S. federal income tax, whereas a “deemed dividend” is fully taxable. Therefore, we expect the current industry practice of not pledging more than 65% of the voting stock of a CFC (and CFCs not being guarantors) to continue.

What is unclear at this time is how industry practice will adjust to the Act’s modified territorial system. For example, some CFCs may in effect pay U.S. federal income tax on most of their earnings under the GILTI rules, thereby reducing the negative impact of Code Section 956 on CFC stock pledges or guarantees. U.S. borrowers with such CFCs may agree to 100% stock pledges or guarantees to improve credit pricing. As another example, although a requirement by a CFC to distribute excess cash may run afoul of Code Section 956, other structures may be developed that have the effect of requiring or incentivizing foreign subsidiaries to distribute excess cash.

Practical Implications

• Historically, because the United States had among the highest effective corporate tax rates in the world, it was most tax-efficient for corporations to borrow in the United States and utilize interest deductions to offset U.S. taxable income. Because of the reduction in the U.S. corporate tax rate to 21%, borrowers may be looking to shift a portion of their borrowing to foreign subsidiaries.
• The new interest deductibility limitation may impact the mix of debt and equity used in leveraged buyouts and the capitalization of businesses in general. For example, subordinated debt currently used in leveraged acquisitions may be replaced by preferred equity in some cases. Our experience in the limited time that the Act has been effective is that in the current low interest rate environment, most financial models for a typical leveraged acquisition indicate that borrowers’ interest deductions will not be limited by new Code Section 163(j).
• As described above, the lower tax rate for pass-through entities may impact the tax distribution provisions of credit agreements and operating agreements in the case of loans to such entities.
• We expect the current industry practice of not pledging more than 65% of the voting stock of a CFC to continue. Other credit agreement terms may develop, however, to incentivize repatriation of excess offshore cash now that there is no longer any U.S. federal income tax cost to doing so. (This may not be costless, however, as there may still be dividend withholding in the jurisdiction in which the CFC is a tax resident.)
• For credit agreements that have fixed-charge coverage ratios that take into account taxes and tax distributions, lenders will need to pay close attention to existing and proposed covenant levels and related models and inputs in light of the changes to U.S. federal income tax rates (and other changes that could affect borrower tax liabilities and tax distributions).

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¹ _{The Act sets forth a complicated formula for arriving at this result.}