Private Equity Firms Get Clarity on Interest Deduction Limits

(Bloomberg) -- Highly-leveraged companies can start calculating just how much the Republican tax law limits their interest deductions for debt, thanks to 439 pages of regulations released by the Internal Revenue Service on Monday.

The proposed rules provide guidance for a key provision in the 2017 tax overhaul that restricts the deductions businesses can take from the interest they pay on loans. Previously, those interest expenses were fully deductible. The IRS said the new limits apply to interest on traditional loans, as well as debt instruments and transactions that don’t take the official form of a loan, but have the same “substance.”

The regulations also move to block certain creative financing transactions companies may use to avoid the deduction cap.

The law’s interest deduction change -- and how the IRS implements it -- is particularly critical for private equity deals, where the financing can involve large amounts of debt, said Eric Sloan, a partner at law firm Gibson, Dunn & Crutcher. Public corporations tend to be less leveraged than private equity portfolio companies.

The restriction on interest deductions was an attempt by Congress to equalize the treatment of debt and equity financing. The measure was included to offset large tax cuts in the law, including slashing the corporate rate to 21 percent from 35 percent.

Under the law, companies can deduct interest costs up to 30 percent of earnings before interest, tax, depreciation and amortization, or Ebitda, until 2022. After that the cap narrows to 30 percent of earnings before interest and taxes, or EBIT -- since that number includes depreciation and amortization, it’s lower, making more companies subject to the limitation.

The change comes as businesses are increasingly leaning on leverage as a financing tool. Corporate debt levels have increased more than 82 percent to $6.2 trillion from $3.4 trillion in the past decade. There have been 451 leveraged buyouts so far this year, up from 340 five years ago, according to data compiled by Bloomberg.

The tax law is causing private equity funds to re-think how they finance deals. If earnings are low enough that the cap is triggered, funds may consider ditching debt in exchange for equity, even though that can dilute the value of the existing stake in the company.

Tax Law’s Intent

The IRS is casting a wide net as in terms of which interest expenses fall under the deduction cap. There are certain cases where something that was previously considered a business expense -- and eligible for a full deduction -- is now considered an interest expense and subject to a narrower tax break, according to the agency’s regulations.

The approach is likely to restrict companies from striking deals with their lenders to increase costs that are deductible and lessen those that aren’t, said Joe Kristan, a partner at accounting firm Eide Bailly. For example, without the IRS rule, a borrower and a lender could negotiate a lower interest rate, where the deduction is limited, in exchange for a higher loan commitment fee, that was -- until these regulations -- able to be written-off as a business cost.

The rules break from a system of allocating interest that has been used for decades over concerns that taxpayers could find ways to circumvent the law’s intent, the regulations said. That could complicate calculating the deduction for companies that have units that aren’t subject to a cap and some that are -- such as farm with a manufacturing business, Kristan said.

Leveraged Loan Market

The deduction change is expected to raise about $253.4 billion over a decade, according to estimates from the non-partisan congressional Joint Committee on Taxation.

The law provides exceptions for certain industries, including real estate, farms, car dealerships and businesses with less than $25 million in revenue.

So far, the deduction change hasn’t triggered a big decline in corporate lending. High-yield bond sales are down significantly from a year ago, but a lot of that activity has just moved to the leveraged loan markets.

That may be because the tax law overall -- with provisions such as the corporate rate cut -- is seen as a boon for business.

“I think companies are making decisions based off the whole gambit of tax law changes,” said John Puchalla, a senior vice president at Moody’s Investors Service. “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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