Tax Reform Part 4: Restructuring & Insolvency Related Provisions - Deductibility of Interest
This is the fourth and final part in a series of articles discussing restructuring and insolvency related provisions of the Tax Reform currently working its way through Congress. Previously we discussed net operating losses (“NOLs”), cancellation of the debt (“COD”) and pledges and guarantees. Here we will discuss the fundamental change to the landscape relating to the deductibility of interest that is proposed by the House (“House Plan”) and Senate (“Senate Plan” and together with the House Plan, herein collectively referred to as the “Tax Reform”). While this is the last installment, look for updates to the four-part series and additional shorter posts, as the process in Washington, D.C. unfolds.
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 Tax Reform 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).
Both the House Plan and the Senate Plan modify Section 163(j) to impose a cap on the deductibility of interest. There are only slight differences between the House and Senate proposals. The House Plan and the Senate Plan fully allow interest deductions to the extent of interest income. To the extent interest expense exceeds interest income (referred to as “net interest”), both the House Plan and the Senate Plan limit the deductibility of such excess. The House Plan limits net interest to 30% of earnings before interest, taxes, depreciation and amortization (“EBITDA”), while the Senate Plan limits new interest to 30% of EBIT. Thus, the Senate plan is more restrictive as the 30% applies to a smaller base of earnings (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. Both the House Plan and the Senate Plan allow for a degree of carryforward for denied interest deductions. The House Plan treats the amount denied as an interest expense in subsequent years, for up to five years. The Senate Plan is the same, but 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 Tax Reform 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.
Further, the Tax Reform addresses base erosion by dealing with interest payments to foreign entities. From the US perspective, base erosion is the use of tax planning by a multinational corporation to reduce its US taxable income. The Tax Reform deals with base erosion in several ways, but as it relates to interest deductions, essentially the House Plan and the Senate Plan both limit the ability of a US payor to deduct interest by proposing complicated formulae. The House Plan limits the interest deduction of a US member of an “international financial reporting group” based on the US member’s share of the group’s EBITDA. The Senate Plan limits the net interest expense of a US member of a “worldwide affiliated group” using a “debt-to-equity differential percentage.” Detailing these rules is beyond the scope of this article, but it is clear that they present additional reasons why a leveraged company facing declining revenues could lose valuable tax deductions and concomitant tax attributes, such as NOLs, as it heads towards a restructuring.
As this series of articles shows, the Tax Reform could add stress to struggling companies, especially overleveraged ones relying on NOLs. The question now is whether the Tax reform will become law.