Clarifying Tax Reform: The Definition of Interest

IRS proposals could affect costs of debt and relationships with lenders

Friday, March 22, 2019

By John Hintze

Regulations typically aim to clarify vaguely written laws and ultimately reduce risk for those affected. Several regulatory proposals stemming from recent tax reform seek to provide companies with more certainty ahead of tax-filing season, but they also introduce new risks while clarifying the law's original ones.

Financial and nonfinancial companies frequently view the language in tax regulatory proposals as highly likely to remain in the final regulations, noted Joseph Calianno, partner and international technical tax practice leader at BDO, and formerly special counsel to the deputy associate chief counsel at the Internal Revenue Service (IRS). However, he added, the Treasury Department considers comments from taxpayers and practitioners, and a wave of strong arguments can persuade regulators to make changes.

Regulators likely received such a wave from taxpayers and practitioners expressing concerns about the new and controversial definition of interest in the proposed regulations under Section 163(j) of the tax law passed in December 2017.

“It is very noteworthy that in defining interest for purposes of this provision in the proposed regulations, the IRS took a very broad reading of what constitutes interest,” Calianno said.

In fact, the proposal - comments were due at the beginning of March - includes several payment types that, while similar to interest, are not treated as such for tax purposes. According to a December 31 report from Sullivan & Cromwell, those payments include substitute interest under a securities loan, gains and losses from hedges of debt instruments, commitment fees and debt issuance costs.

Companies deciding it is safer to comply with the proposed language and search their books for such transactions may, if regulators are swayed, end up having to make a last-minute reversal. If the broader definition prevails, on the other hand, there will be winners and losers.

New Deduction Limit

Taxpayers with deductions for interest payments falling well below the new limit of 30% of EBITDA (earnings before interest, taxes, depreciation and amortization) may see the broader definition as a boon, increasing their deduction. But for those with interest deductions already exceeding that limit, their debt will effectively become costlier.

Joseph Calianno Headshot
“The IRS took a very broad reading of what constitutes interest,” says BDO's Joseph Calianno.

David Gonzales, senior accounting analyst at Moody's Investors Service, noted companies will find it riskier to leverage up significantly to support a growth phase. Even more so after 2021, he added, when existing debt loses grandfathered status, and the 30% cap shifts from EBITDA to the much smaller EBIT.

“Debt running over that cap will become more expensive,” Gonzales said, adding that economic cycles will magnify the dynamics, since lower corporate income during downturns will shrink the available deduction, and vice versa during periods of growth. “So when companies need the deduction during downturns, they'll have to take less, and in good times they'll have a bigger deduction.”

Corporates already appear to be adapting their capital structures to 163(j), likely prompting lenders to re-examine their relationships with borrowers. Moody's reported in late 2018 that a sample of the top 100 corporate nonfinancial companies selected by cash holdings changed from net borrowers before the tax overall to net payers after.

“Prior to the tax overhaul, companies were adding a total annual average of $123 billion in additional debt. Since the overhaul, they have paid down $64 billion in total debt,” Moody's said.

Limitations in the Data

Gonzales explained, however, that the study looked at companies with large cash holdings overseas that typically are investment-grade and whose interest deductions are unlikely to approach the 30% limit. By definition, highly leveraged companies are likely to exceed that limit, although so far there's been little indication of corporate concern about the impact of 163(j).

“We're currently going through public company disclosures at year-end to look for any evidence that this 30% cap is a concern, but income-tax disclosures are so bad that almost nothing can be gathered from them,” Gonzales said.

Investment-grade companies could also be impacted, he said, if they are running enough income through a low-tax jurisdiction outside the U.S. to trigger tax reform's anti-deferral provisions, such as global intangible low-taxed income (GILTI) and base erosion anti-abuse tax (BEAT).

“A company with domestic debt, but running a lot of taxable income through a low-tax jurisdiction, may not have the domestic income that otherwise would show up in its financial statements to deduct all the interest,” he said.

Capital Strategies and Private Equity

The interest-deduction limit will clearly prompt companies to reconsider their capital strategies.

The deduction is a major factor in many private-equity firms' business strategies as well. Jason Mulvihill, COO and general council at the American Investment Council, which represents the private equity industry, noted that the U.K., Germany and other countries also set interest-deduction limits, and the 30%-of-EBITDA limit maintains U.S. competitiveness. Not so, however, after the shift to EBIT.

“The EBITDA vs. EBIT issue is particularly important,” Mulvihill said, adding that for policymakers seeking to strengthen high-tech and other manufacturing in the U.S., the tighter EBIT may discourage companies from using debt to fuel growth.

He added that politicians on both sides of the aisle may prefer a less restrictive limit, above 30% of EBITDA.

“When the economy is going well, having a limit based on EBITDA may seem less impactful, Mulvihill said. “But when there's an economic downturn and EBITDA shrinks, periods where companies are more reliant on debt to survive and grow, the 30% limit would sting more.”

Cost of Borrowing

Highly leveraged companies that have issued debt maturing over the next several years will no longer be able to deduct interest expense above 163(j)'s 30% limit when that debt is renewed or refinanced. That becomes more problematic after 2021 and the switch to EBIT.

“Whether that debt gets renegotiated or just replaced, the borrower is going to get a set of debt instruments that will be subject to the 163(j) limit, and the economic cost to the borrower [for debt whose interest expense exceeds that limit] could be significantly more,” said Marc Lim, a managing director in Andersen Tax's commercial practice.

Lim added that from a risk standpoint, organizations should monitor existing loans to understand at what point these rules come into play, as they are rolled over or refinanced. An important factor in M&A transactions, for example, is making sure the debt-financing model will provide the targeted return on investment.

“The tax calculations and deductibility of interest is often a critical factor in putting together the finance model, and that will have to be re-looked at,” Lim said. “Loans getting renewed or refinanced or otherwise may lose their grandfathered status.”

Overseas Earnings

Section 951A's global intangible low-taxed income (GILTI) provision, an anti-deferral measure that for the first time will annually tax the income of some U.S. companies' controlled foreign corporations (CFCs), could increase the tax liability for companies that generate significant earnings overseas. Offsetting deductions prescribed in the law are more restrictive and to some degree unresolved.

Calianno of BDO said that some corporations may in certain instances receive a deduction of up to 50% of their GILTI income. And if the foreign subsidiaries pay foreign taxes related to GILTI income to a foreign country, U.S. corporations may be eligible to claim a scaled back “deemed paid foreign-tax credit” related to GILTI.

“However, the deemed paid foreign-tax credit related to GILTI must be used in the current year,” Calianno said, and can't be carried forward for use in a later year.

Such limitations may exacerbate issues arising when U.S. companies are returning cash from foreign jurisdictions that impose significant withholding taxes. Under previous law, Lim of Andersen Tax said, companies were generally taxed at the point of repatriation and could offset those taxes with credits for foreign jurisdiction withholding and other taxes generated over several years.

Guidance on Credits

Guidelines on how foreign tax credits work in the GILTI regime have yet to be released, presenting the risk of double taxation, Lim said. He added that Treasury has acknowledged the issue but in the proposal refrained from providing answers, saying further study was required and guidance would follow.

Lim noted that companies' effective tax rate is often an important metric by which the market judges them. Hence managing that rate has been a major focus for tax departments, and uncertainty in this area could inhibit cash repatriation.

“If you ask a lot of corporate America whether there are still enough open questions to persuade companies not to repatriate cash, because they're not yet totally sure what their effective tax rate will be, I would say, 'yes,'” Lim said.

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