Debate over a border-adjustment tax is consuming Washington, but another, less-discussed proposal in House Speaker Paul Ryan’s tax plan stands a better chance of being included in a GOP overhaul bill, reports Bloomberg.
The measure would force companies to include the interest they pay on loans in their taxable income. That could pit financial services firms such as banks and insurers that have been promised relief from the proposal against private equity firms, which rely on leverage and wouldn’t get special treatment.
As Ryan struggles to get support within his own party for border adjustments, the interest provision is more likely to be included in a House tax bill, according to Robert Willens, an independent tax and accounting expert. That’s because eliminating interest deductions may be politically easier for Congress to support since consumers wouldn’t be directly affected, as critics of border adjustability argue, Willens said.
More House Republicans are also supportive of making the tax treatment of debt equal to that of equity, which the GOP interest provision would effectively do, since companies can’t currently deduct dividend payments, according to Willens.
Companies are “just starting to get their minds around it and to think about how it will affect them,” said Robert Gordon, managing director at True Partners Consulting, a corporate tax consulting firm and a former senior tax executive at BP Plc.
Part of what complicates who wins and who loses is that related to the interest measure is a plan to allow companies to deduct the cost of capital expenses for plants, equipment and buildings immediately, instead of spreading those expenditures out over several years. That would free up tax dollars to reinvest in the business.
Still, Gordon said the trade-off wouldn’t be equal for companies that have spent their cash on dividends and stock buybacks in recent years rather than on plants and new equipment.
Proponents of the House plan say that ending the interest deduction would let market forces more efficiently allocate investment where it’s most productive and curb excessive borrowing by companies. “Special rules” would be developed for banks, insurers and leasing companies to take into account the important role interest income and expense play in their business models, according to the GOP blueprint. Some experts expect concessions for small businesses, which tend to rely on debt financing.
The tax-writing House Ways and Means Committee is still reviewing the special circumstances that arise for particular industries, according to a person familiar with the discussions who asked not to be named because the matter is private. If a grandfather clause were included that allowed companies to continue to take interest deductions on existing debt, it would apply to all industries, the person said.
The Ryan-backed plan calls for cutting the tax rate to 20 percent for traditional companies, and applying that rate to domestic sales and imported goods while exempting exports. That’s led to a face off between import-dependent industries such as retail against export-heavy ones like manufacturing. The House GOP proposal also calls for a 25 percent rate for partnerships and other "pass-through" entities that are a mainstay of private equity.
During the campaign, President Donald Trump proposed cutting the corporate tax rate to 15 percent and allowing certain manufacturers the choice between deducting their interest expenses or immediate expensing of equipment, rather than completely eliminating the interest deduction, as the House GOP plan does. Trump has said his tax plan is “nearly finalized,” but he hasn’t provided any details.
The ability to finance a buyout by saddling a company with debt is key to the private equity playbook. Under current tax law, buyout shops can knock the portfolio company’s cost of debt -- meaning interest expense -- off of its taxable income. Firms use this allowance to reduce the target company’s tax liability. It also makes leverage more attractive.
“Private equity gets stung” by the removal of the interest deduction since so many of those firms depend on it, said Evan Migdail, a tax lawyer at DLA Piper.
Blackstone Group LP said the interest expense change could make using leverage less attractive for new investments, which could force it to adjust its funds’ investment strategies and potentially lower returns for investors, according to the private equity firm’s annual report released last week. The tax measure could also hurt the profitability of portfolio companies, the report said.
Companies are scouring their business models to see if eliminating interest deductibility would squeeze profit margins or deter an acquiring company from "pushing down" debt onto a target company, said James Maloney, a spokesman for the American Investment Council, a trade group for the private equity industry.
Banks are among companies that dedicate the highest percentage of their earnings to paying interest costs, according to a Bloomberg analysis of Standard & Poor’s 500 Index companies. About 41 percent of Goldman Sachs Group Inc.’s operating profit went toward its interest costs last year; Citigroup Inc.’s ratio was almost 37 percent while Morgan Stanley’s was more than 27 percent.
“The doors are open for financial services and insurers to negotiate with policy makers in the House to ease into this, as they know that removing the net interest deduction is particularly onerous,” said Henrietta Treyz, a macroeconomic policy expert who recently left Height Securities LLC to start her own research firm.
Despite the promise of special treatment, banks may still be wary. JPMorgan Chase & Co. said it was "unclear" how the proposal would affect deductions for short-term obligations like commercial paper when they come due and get swapped, or "rolled," into new debt, according to a Jan. 1 note by Michael Cembalest, the chairman of market and investment strategy at J.P. Morgan Asset Management.
Real estate investment trusts such as Vornado Realty Trust and SL Green Realty Corp. have high interest costs, but they could make up for the loss of the interest deduction by fully deducting costs for any new buildings they acquire or build, said Alexander Goldfarb, a managing director of equity research at Sandler O’Neill and Partners.
“It’s like if you reach into the spice cabinet and remove the pepper, there are still other spices,” Goldfarb said.
But the trade-off could mean that REITs, which are required to distribute at least 90 percent of their profits to shareholders as dividends, have to pay out more to investors but retain less cash for investments, said Edward Mui, a real estate equity research analyst at Morningstar Inc.
Other S&P 500 firms that could be negatively affected since they don’t have high capital expenditures to offset the loss of the interest tax benefit would be energy companies -- Duke Energy Corp., Kinder Morgan Inc. and NextEra Energy Inc., Bloomberg data show.
A Jan. 31 report by S&P Global said the "net interest deduction removal also has the potential to discourage debt issuance in the long run."
While the interest deductibility measure isn’t under attack like the border-adjusted tax, it still faces some internal GOP opposition. House Ways and Means Committee member Vern Buchanan, a Florida Republican, said earlier this month that he sees the interest issue as a major obstacle to the tax rewrite, along with the border-adjusted tax.
One of the concessions House leaders may make is to allow existing debt to be grandfathered, so companies could continue to deduct the expenses associated with that debt. An exemption could be limited to 10 years after the proposal becomes law, making it more likely companies would load up on shorter term debt, according to Treyz.
The measure could also push U.S. multinationals to have their foreign subsidiaries located in countries like Ireland that allow the interest deduction to do more borrowing, said Gordon of True Partners Consulting. That’s because they would still be able to take foreign deductions on that debt and use it as a credit against their U.S. taxes.
"If you have a company with both U.S. and foreign operations, the game has always been to get the interest deduction into the U.S.,” Gordon said. “Now they’re thinking about moving debt offshore.”