March 16, 2017 - Washington and Wall Street have been pondering tax reform plans – and now borrowers are doing so as well. Both the Trump and House Republican plans significantly reduce companies’ ability to deduct interest. For the loan market, there are (at least) two important impacts to consider. First, the impact on the companies themselves – i.e., whether the reforms make the companies more creditworthy. Second, how potential tax reforms impact companies’ demand for debt. Below, we review recent analysis on the impact of Trump and House Republican tax plans on U.S. companies, as well as how one company is preempting the issue.
This week, Moody’s published “Debt and Taxes”, which analyzes the impact of the tax reform proposals on both investment grade and speculative grade companies. The research focuses on the impact of i) a reduction of corporate taxes from 35% to 15% (Trump) or 20% (House), ii) the reduction/elimination of interest deductibility, iii) the immediate deduction of capex, iv) the import border adjustment, and v) the elimination of income taxes on exports and repatriation of foreign profits.
The first takeaway is that the tax rate reduction, full investment deductibility and more favorable foreign profit treatment will boost cash flow. That said, investment grade companies – which are larger, more multinational and pay more tax– will fare better than speculative grade companies under the tax reform plans. In particular, the loss of interest deductibility for spec-grade companies is much more consequential – and may ultimately lead to higher overall tax burdens for a number of firms.
Why are leveraged companies hurt more by the loss of deductibility? First, leveraged companies have more debt relative to their income and pay higher interest rates, so they have relatively more interest to deduct – which they lose under the new plans. Second, the House plan permits companies to net interest payments against interest income. Investment grade companies generally have more interest income, thus still can use interest payments to reduce their taxable income.
Moody’s analyzed the trade-off between a reduction in corporate taxes to 15% or 20% and the loss of interest deductibility for leveraged companies. The more interest a company pays – or, conversely, the lower its EBIT/interest ratio – the more the loss of interest deductibility affects it. As the chart indicates, if a company has EBIT/interest coverage of less than 2.33x, it pays more tax under the House plan that reduces corporate income tax to 20% while removing interest deductibility. If a company has EBIT/interest coverage of less than 1.75x, it would pay more tax under the Trump plan that reduces corporate income tax to 15%. According to Moody’s statistics, 60% of the leveraged companies they measured had EBIT-to-interest coverage of less than 1.75; 67% had interest coverage of less than 2.33 times. This means most of their leveraged companies come out worse if they trade interest deductibility for lower corporate income tax. Moreover – and as the left side of the chart illustrates – the lower a company’s interest coverage ratio, the harder it is hit.
Considering the potential impact of the end of interest deductibility, it’s little surprise that companies may look to adapt their capital structures. For instance, ThomsonReuters LPC detailed how data center Cyxtera added protection against possible tax changes. The new $1.3 billion loan backing Cyxtera’s buyout includes an $815 million first lien loan and a $310 second lien loan. The second lien loan is callable at 102 in year one and 101 in year two. Cyxtera, however, is asking for the ability to call its second lien loan at 101 in year one if the government removes interest deductibility.