Tax reform raises big questions about interest deductibility

The framework for tax reform put forward on Sept. 27 by President Donald Trump and Republican congressional leaders would limit the deductibility of interest payments on corporate debt.

The interest-payment deduction has been vital to the success of the LBO investment model, giving incentives to financial sponsors to use debt rather than equity to finance acquisitions or other expansions at portfolio companies. Limiting the deduction increases the tax burden of debt-loaded portfolio companies, which in turn affects cash flows and private equity fund valuations.

The Republican tax framework, which would cut corporate rates to 20 percent, specifies that “the deduction for net interest expense incurred by C corporations will be partially limited.” How the deduction would be capped is unclear.

The framework gives significant leeway to members of the Senate Finance and House Ways and Means committees, which are tasked with hammering out the specifics of the Republican tax proposal. The deduction could be limited at 20 percent to 30 percent of each payment, according to one lobbyist. Another rumored proposal would limit the deduction depending on a company’s EBITDA.

“Our understanding is that the amount is still under consideration,” said American Investment Council spokesman James Maloney, whose organization lobbies on behalf of around three dozen major PE firms. “It is too early to speculate on possible percentages or limitations; our plan is to work with the administration and the Congress to maintain full interest deductibility.”

PE firms and their portfolio companies could benefit from other elements of the Republicans’ framework, which calls for reducing the corporate tax rate to 20 percent and would allow companies to fully expense investments in depreciable assets for at least the next five years.

But without clarity around the interest-payment deduction, assessing the framework’s impact becomes impossible.

The White House declined to elaborate on the framework. “That’s as specific as we will be getting today,” White House spokeswoman Natalie Strom told Buyouts in an email.

Several PE-industry groups, along with the AIC, released statements signaling their opposition to the partial elimination of the interest-payment deduction. One group, the BUILD Coalition, was formed to specifically lobby on this issue on behalf of the PE industry and other sectors that could be hurt, including real estate and agriculture businesses.

“This action would effectively create a new tax on business investment, which runs counter to pro-growth tax reform,” BUILD spokesman Mac O’Brien said in a statement. “We will continue engaging with the administration and Congress as we educate stakeholders on full interest deductibility and its role as a necessary ingredient for future job creation and economic growth.”

Room for movement

While the framework offers the most specific tax blueprint the White House has offered to date, it’s a far cry from a final product. The framework offers, at best, a rough outline of topics where the White House and congressional Republicans reached consensus, CohnReznick Principal Jeremy Swan told Buyouts.

“Based on the very little they’ve said, their proposal is for a partial limitation for the deductibility of interest. Specifically calling out C corps,” he said. “Does this mean there will be loopholes for other types of corporate structures? It may end up being a non-issue, but that’s something to keep an eye on.”

“It’s tough to predict what it’s ultimately going to look like.”

The lack of specifics indicates private equity lobbyists still have runway to persuade congressional leaders to keep much of the deduction intact. In addition to PE, BUILD Coalition’s membership includes powerful lobbying groups like Real Estate Roundtable and the American Farm Bureau Association.

Politico reported Trump, a real estate magnate who’s been known to oscillate on major legislative proposals, is said to be lukewarm on the interest-deductibility component of the proposal.

But limiting the deductibility of interest payments “has been [Ways and Means Chairman Kevin] Brady’s baby from the get-go,” and Brady remains an incredibly important voice in shaping the final proposal, one lobbyist told Buyouts.

The GOP’s failure to repeal and replace Obamacare further complicates matters. Republicans who previously expressed support for keeping the interest-payment deduction in place are unlikely to let their opposition derail tax reform, particularly after disagreements between conservatives and Republican moderates in the Senate crushed repeated efforts to repeal and replace the Affordable Care Act.

“They’re not going to be the stick in the mud, or skunk in the garden party, for what a lot of Republicans consider their last shot at a big win,” said one lobbyist.

Action Item: For more on tax reform, visit the White House’s website at https://www.whitehouse.gov/

President Donald Trump delivers remarks on proposed changes to the U.S. tax code at the state fairgrounds in Indianapolis on Sept. 27, 2017. REUTERS/Jonathan Ernst