This is part of a series of articles discussing restructuring and insolvency related provisions of the Tax Cuts and Jobs Act, which is now expected to become law this week (the “Act”).
Previously we discussed net operating losses (“NOLs”) and cancellation of the debt (“COD”). The provisions on NOLs have generally remained the same (adopting the Senate version of the revisions, but immediately capping the use of NOLs to 80% of taxable income). However, the changes to COD rules we discussed are not part of the current version of the Act.
Here we will discuss the fundamental change to the landscape relating to the deductibility of interest that is part of the Act. Debt financing is the life blood of a majority of US companies and has an advantage over equity financing because debt financing can generally reduce US federal income by the amount of interest paid on the debt, while in contrast dividends paid on equity are not tax deductible.
Congress has a dilemma. Congress wants US companies to have the greatest access to capital, so it is generally willing to forego taxing non-US lenders on the interest income they earn from US taxpayers (as is reflected in income tax treaties it has entered into with foreign countries and the portfolio debt exception). At the same time, Congress does not want to allow US taxpayers to inappropriately strip, shift or delay US taxable income. Generally, Congress believes the inappropriate behaviour occurs when the non-US lender is related to the US taxpayer-borrower, as it is thought that otherwise market conditions between arm’s-length parties would adequately prevent excessive borrowing.
The deductibility of interest has historically been limited in two ways: (1) limits placed on the deductibility of interest from “valid” debt (e.g., Section 163(j)) and (2) recharacterizing “invalid” debt as equity (Section 385 and decades of case law). The first category reflects policy judgments regarding whether borrowing is excessive, (e.g., Section 163(j)), inappropriate (e.g., Section 163(h)), or distortive to the proper timing of income inclusion (e.g., Section 263A). The second category simply reflects the policy judgments regarding what arrangements should qualify as “debt” under the Internal Revenue Code (the “Code”).
The Act represents a significant shift to the present limitations on interest deductibility. Presently the Code mainly relies on Section 163(j) to deny interest deductibility to US corporations. This rule, generally, disallows interest when a US corporation’s debt-to-equity ratio exceeds 1.5 to 1, its interest expense exceeds an adjusted taxable income figure and the interest is paid to a related party that does not pay tax on the interest (or is paid to an unrelated party, but guaranteed by a related party).
The Act modifies Section 163(j) to impose a cap on the deductibility of interest. While the Act fully allows interest deductions to the extent of interest income, to the extent interest expense exceeds interest income (referred to as “net interest”), the Act limits the deductibility of such excess. The limitation would be 30% of earnings before interest, taxes, depreciation and amortization (“EBITDA”), starting on January 1, 2018 and ending before 2022, then the limit would be more restrictive (following the Senate language) by being 30% of EBIT (reduced by depreciation, amortization and depletion).
Importantly, this new Section 163(j) would not only apply to deny interest paid to related-party foreign affiliates, but would apply to interest paid to anyone. Further, it does not matter whether the borrower’s debt-to-equity ratio is 1.5:1 or 1:1, if the borrower does not have sufficient EBITDA or EBIT, as the case may be, it will be denied the deduction. The Act allows for a degree of carryforward for denied interest deductions, but simply treats such amount as business interest paid or accrued in the succeeding taxable year, needing to run through the gauntlet of limitations. The carryforward is unlimited.
These changes are significant to the struggling US corporation that has declining earnings. Indeed, the path to bankruptcy for a highly-leveraged company could be accelerated as a result of an increase in its effective tax rate caused by these rules. Moreover, the reduced allowance for deductions would mean fewer NOLs would be available for use should the company attempt a bankruptcy reorganization.
The Act provides that these new rules would apply to interest payments made after December 31, 2017, and therefore the new rules would not only apply to new loans entered into after December 31, 2017, but also to outstanding loans with maturity dates beyond the end of 2017. There is no grandfathering of old debt!