Part 2: Impact on Corporate Funding Decisions
One of the major headlines of the 2017 Tax Cuts and Jobs Act (TCJA) passed in the United States 22 December 2017, was the reduction in the corporate tax rate from 35 per cent to 21 per cent. But, as highlighted in the previous edition of the newsletter, the law also introduced a number of new provisions which may impact corporate decision making on investment, capital structure and risk management beyond just a reduction in tax rate.
In the previous edition of the newsletter, we focused on the movement and use of cash by corporates. This edition will focus on the provisions in the TCJA which can have an impact on a company's liability profile and funding decisions.
One of the drivers for changes in funding strategies is TCJA's limitation on the amount of net interest expense that is tax deductible. The new provision limits the deductibility of interest expense to 30 per cent of a US entity's adjusted taxable income (ATI) plus interest income. ATI is initially similar to EBITDA, then moves to EBIT in 2022. Upon first being passed, it was widely anticipated that this limitation would principally impact highly leveraged companies, however, other companies with significant earnings outside the US have also found themselves constrained by this limit.
One response to companies finding themselves in the latter situation has been to raise debt in foreign subsidiaries and reduce debt at the US entity level. As with any funding decision in response to taxation, the sizing of the debt requires an evaluation of other domestic and foreign tax provisions, including limitations from similar rules in foreign jurisdictions on interest and capitalisation. While moving debt out of the US entity, reduces the amount of US interest expense; US entities could still issue directly in foreign currencies and realise a reduction in overall interest expense, should the debt be issued in a lower yielding currency.
Should the lower rates in foreign currencies be attractive to US entities, companies can look to take advantage of these rates either directly or synthetically. Changes to hedge accounting under US GAAP help facilitate the recognition of the benefit of a lower foreign currency interest rate in earnings. The balance of debt between fixed and floating rates may also be evaluated in the context of the limitation.
As with any funding decision in response to taxation, the sizing of the debt requires an evaluation of other domestic and foreign tax provisions, including limitations from similar rules in foreign jurisdictions on interest and capitalisation.
While many companies remain unconstrained by this provision, it is worth planning ahead for when the calculation of the limitation changes to an EBIT basis from the 2022 tax year. The change in the measure will impact more companies. Assessing this limit under potential stress scenarios or simulations for earnings and interest in advance, can enable a company to take advantage of the time until the transition with making any incremental capital structure changes as funding or refinancing requirements arise.
There is another new provision of TCJA that has given companies some headroom under this interest limitation, but has also been a driver for raising debt in subsidiaries outside the US. Global Intangible Low-Taxed Income (GILTI) increases the tax base on which some companies will be liable for US taxes and is derived from certain earnings from foreign entities; subject to a number of specifications and structural considerations. The added headroom under the interest deductibility limitation comes from the inclusion of GILTI in the income base on which the interest limitation is calculated. For companies with other tax objectives and not benefiting from the additional headroom, some have explored placing debt in the foreign subsidiary generating the GILTI obligation, as the calculation of the tax considers debt at the foreign entity level.
Conversely, many non-US parented companies are looking at making the opposite shift in the location of funding compared to the US headquartered companies noted above and raising debt at the US subsidiary. To date, US subsidiaries of foreign companies are often funded through intercompany loans with the US entity paying interest to a funding entity outside of the US. The onshoring of debt to the US is driven by the Base Erosion Anti-Abuse Tax (BEAT) provision of TCJA. Under BEAT, the payment of interest on an intercompany loan can increase the tax liability of the company. A number of foreign companies have issued debt out of US subsidiaries this year, and for the first time in some cases. Syndicated loans and bilateral arrangements may also be used to onshore debt at the US subsidiary level.
BEAT is one of the provisions where incremental guidance and definitions was recently released by the Internal Revenue Service. Companies are actively analysing these rules to help determine their impact. The decision to onshore debt may wait until this analysis is completed, however, as with the other decisions discussed, sizing the proper amount of indebtedness for the US entity is likely to be circular with the interest deductibility limitation and capital structuring objectives serving as constraints.
In conclusion, adjusting capital structure and funding plans in response to the new US corporate tax regime can be a significant exercise for a company with many elements and corporate specifics to be balanced. Scenario and simulation analysis can be helpful in stress testing alternative structures. In addition, risk management strategies may need to be adjusted or can even support achieving the financial objectives of the targeted post-tax reform debt profile.
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