Republican tax-reform proposal caps interest-payment deductions

Republicans in the House of Representatives unveiled their new proposal to reform the tax code, which would limit the ability of private equity firms to deduct the cost of interest payments from their portfolio companies’ tax bills.

Under the proposed reforms, businesses would only be able to deduct interest payments for up to 30 percent of their annual EBITDA.

Small businesses with average gross receipts of less than $25 million would be exempt from the limitation. Certain public utilities and real estate businesses are also exempted.

The Joint Committee on Taxation estimates the new rules would generate $172 billion of additional revenue over the next decade.

“Interest deductions may create a negative income tax rate for corporate income when combined with depreciation deductions, credits, preferential rates, or tax exemption of the earnings financed with debt,” according to a bill summary put out by the House Ways and Means Committee. “Many countries around the world, such as Germany, have similar rules on limitations on interest expense on third party debt and thin-capitalization rules.”

The deductibility of interest payments has long been touted as critical to the viability of leveraged buyouts, in which company’s assume liberal amounts of debt as they’re acquired by a private equity firm. Limiting the interest payment deduction affects the company’s cash flows, which in turn alters the company’s long-term value as an investment asset.

Private equity industry organizations like the American Investment Council have long opposed any changes to the deductibility of interest payments. The AIC, alongside trade groups representing industries ranging from gaming to agriculture, are part of a group known as BUILD Coalition that has led lobbying against the changes on Capitol Hill.

“Placing a limitation on the deduction of interest expense—a normal cost of doing business—amounts to a new tax on American job creators who borrow to invest and grow. This policy change would harm the global competitiveness of businesses across all sectors of the U.S. economy, from manufacturing, to agriculture, to telecommunications and broadband,” BUILD Coalition spokesman Mac O’Brien said in a statement.

Lower rates

Limiting interest deductibility isn’t happening in a vacuum. Republicans also want to reduce the corporate tax rate to 20 percent from 35 percent. If the proposal were to pass in its current form, companies would also be able to fully deduct the cost of new equipment or other capital expenditures.

As such, it’s difficult to gauge how an adjustment to the deductibility of interest would affect the private equity industry at large. Certain portfolio companies could benefit, others could falter.

“My own view at a very high general level is that, for example, if there was a limitation or elimination of interest deductibility and there was no grandfathering of existing companies, for those existing companies obviously that would have a significant and clear negative impact,” said Jay Wintrob, CEO of Oaktree Capital Group, during a third quarter earnings call.

“There are so many moving parts that to evaluate just the impact of interest deductibility on an existing portfolio, to me, isn’t a particularly meaningful exercise.”

Furthermore, interest rates on more recent deals remain at-or-near record lows, effectively minimizing payments on business interest. The average debt-to-EBITDA multiple on new deals through the first three quarters of 2017 stood at 4.7x, according to Pitchbook.

“Interest rates are so low today, so even if they go a little higher … it’s still a relatively modest interest charge to what it was many many years ago,” Carlyle Group Co-Founder David Rubenstein said during a recent earnings call, adding that Carlyle hasn’t been putting as much debt in its deals as it had, historically.

Next steps

The Republican proposal is a jumping-off point for what will likely be a contentious battle over specific deductions and rates. Republican Lee Zeldin from New York has already said he would oppose the bill in its current form, as it limits deductions for state and local taxes. Republicans from other high-tax states like New York, New Jersey and California may follow suit.

The proposal also has to go through the Senate, where Sen. Marco Rubio (R-Florida) has said the initial proposal doesn’t do enough to help working families. Few, if any, Democrats are expected to offer their support.

The bill will go through its first mark-up in the House on Monday. President Donald Trump hopes to have work on the bill completed by Christmas.

Action Item: To read a summary of the GOP proposal, visit http://bit.ly/2zqW3yu

Speaker of the House Paul Ryan talks to reporters in Washington, DC, about the GOP’s health-care bill on March 8, 2017. Reuters/Joshua Roberts