Taxing Questions (and the Loan Market)

February 1, 2018 - Since the tax reform was signed into law last December, LSTA members have wondered what it means for the loan market (and for themselves). We have begun to answer at least part of the first question. On Thursday, January 30, 2018, Jiyeon Lee-Lim, Elena Romanova and Jane Summers, partners at Latham & Watkins, laid bare the new tax rules generated by the Tax Cuts and Jobs Act. While the Act includes important changes impacting businesses and individuals, the panelists highlighted those new tax rules particularly relevant for financings. (We will summarize briefly three points here, but encourage readers to refer to the webcast replay and additional materials for a full explanation.) 1) The tax rates for corporations and certain business in pass-through entities have been reduced to 21% (permanently) and 29.6% on “qualified business income” (through 2025), respectively.  2) Net business interest expense is capped at 30% of “adjusted taxable income” (ATI). This calculation warrants careful attention. Before 2022, ATI approximates EBITDA on a consolidated group basis, but after 2022 that becomes EBIT, which may be of significant impact to leveraged and IG borrowers. A company’s straight EBITDA may be a good proxy for this determination, but not if there are large book/tax differences. Because financial tests in credit agreements are based on adjusted EBITDA, these EBITDA numbers will not align. Market participants will need to pay close attention to their financial modeling of transactions.  3) The US international tax system has moved to a “partial territorial system” which is complicated by the unexpected retention of Section 956 (relating to foreign subsidiary credit support for US parent debt).

With those changes in mind, what are the prime considerations for leveraged finance transactions? 1) Group structure is more important now for purposes of credit modeling and the approach to modeling will need to be revised for the interest expense cap and better access to offshore assets. 2) The advantages of being non-US parented are reduced in both operations and in M&A with inversions being more difficult than ever. 3) The one time transition tax and partial territorial system unlocks US access to offshore cashand assets and cash flows will be revalued under new tax rates which may encourage M&A activity. 4) US issuers of debt may want to move debt outside the US because of the new cap on interest expense and anti-base erosion. CLOs, which have limits on non-US debt, should track this space closely. 5) While there is more flexibility in non-US affiliates providing credit support to US borrowers and sweeping cash to the US, the retention of Section 956 is a complicated – and little understood – factor. Market participants should watch that space for further clarification.  6) Credit agreement drafting will be impacted. Parties should pay careful attention to how baskets, such as restricted payment baskets, are structured. It will be important to ensure these baskets are structured to account for the actual projected expenses of sponsors. Also, while there are greater opportunities now to require that cash sweeps actually do capture non-US cash, parties should not expect greater credit support outside the US, except in limited circumstances. In conclusion, we are still in early days of the new tax regime with much left to be understood (and clarified). The LSTA will monitor this space to update our membership on its impacts on leveraged finance.

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