The deductibility of net interest payments has been a central part of the U.S. corporate tax system, and one that would disappear under the outlines of the Republican plan for reform.
Since there's a long road between proposals and actual legislation, it may be that elimination of deductibility for net interest payments may not make it to the finish line intact. Instead, it’s possible that a final corporate tax reform package could follow the suggestion made by the OECD to allow deductibility of a certain amount of net interest payments up to a cap that is based on a percentage of a company’s EBITDA or its revenue.
In an OECD report from 2014, the organization said interest deductions, if used a certain way, can "contribute to base erosion and profit shifting." The detailed report raised several scenarios for limitation of interest payment deduction. In a classic economist “on the other hand approach,” the OECD notes that having what it calls a “fixed ratio” cap is “relatively simple for groups to apply and tax administrations to administer.” But it doesn’t take into account that different sectors may have significantly different needs for leverage, and finding that one number that applies to all groups can be difficult. And then a year later, the OECD more specifically recommended a range of limiting deductions to 10%-30% of EBITDA.
In a recent report, S&P Global's Global Fixed Income Research team described the elimination of net interest deductions as "potentially the greatest headwind" in discussing whether the DBCFT has the potential to impact corporate debt markets. Despite the OECD recommendations, the reality is that elimination of net interest deductibility would put the U.S. in a category all its own. No other major country completely disallows a net interest deduction. (See editor’s note below). Projecting out what a loss of deductibility means to activity in bond issuance therefore is difficult, as there is little past data to indicate how markets react to such a change.
Still, the conclusion from the January 31 report of the Global Fixed Income Research team is if net interest deductibility is put in place, it "has the potential to discourage debt issuance in the long run." But there are many caveats in the team's findings.
The most intriguing data in the report is the average interest expense as a percentage of EBITDA broken down by ratings. For example, U.S. nonfinancial firms in the AAA or AA rating category have on average 5.01% and 5.71%, respectively, of interest expenses as a percentage of EBITDA. Single A is 15.56%; BBB is 12.68%; and then it climbs through to 15.23%, 34.44% and 101.91% for BB, B and CCC/C, respectively.
A cap on interest rate deductibility that permits, for example, 20% of interest expenses to be deducted would leave, on average, the universe of BB and higher companies with full deductibility (stressing that some individual companies in those categories will exceed 20%). But single B and below would see a significant amount of their interest deductibility disappear. "Some 'B" category rated firms would avoid a higher tax bill, but the CCC/C category would likely be completely open to a much higher effective tax rate," the team's report said of a 20% threshold.
Another step back from the elimination of full deductibility would see companies with revenue up to $1 billion still allowed to deduct interest payments. Such a step would leave a majority of the CCC/C companies permitted to deduct interest payments, and about half of the B companies. What if both were pursued? Such a step would be "highly unlikely," the report said, but if it was enacted simultaneously, "relief would be felt across the majority of the speculative-grade investment," the team said.
Another potential option for deductibility: a grandfathering of existing debt but with limitations on the deductibility of future debt obligations.
Among the Global Fixed Income Research team's other observations, it looked back on the "tax holiday" of 2004, which also was designed to bring cash repatriations from overseas holdings, parked there to avoid the unique U.S. provision to tax foreign earnings. A repatriation is part of the Republicans' DBCFT.
Data analyzed by the team showed that there was a 2-year decline in investment-grade issuance for nonfinancial companies after the 2004 tax holiday, with little impact to companies in the speculative grade category. What might be different this time would be, as the team calls it, "strings," in particular a possible requirement that some repatriated cash is used to help fund infrastructure investment.
There are other factors that could impact debt markets at a time of significant repatriation. Cash holdings are more concentrated in a smaller numbers of firms than in 2004; borrowing costs are less than in that period. Repatriation this time around would be into a significantly different market.
Editor’s note: An earlier version of this piece suggested that Germany and the U.K. disallow net interest deduction. They allow deductions subject to numerous restrictions.