Changes to the Deductibility of Business Interest Expense—Grandfathering the Treatment of Old Debt Is Not a Given

By Stuart E. Leblang, Geoffrey K. Verhoff,  Amy S. Elliott, and Ryan Ellis

• In their September 27 unified framework for tax reform, tax writers announced that they plan to partially limit a C corporation’s ability to deduct net interest expense (while studying treatment for pass-throughs), but no specific details were provided.¹
• Many in the business community viewed the language as positive, given that they had been preparing for a more complete disallowance of the current deductibility of net interest expense as contemplated in the 2016 tax reform blueprint.²
• According to a September 27 Axios article, two of the options under consideration are either a 20 percent to 30 percent haircut on the deductibility of interest expense or a “debt-to-EBITDA” cap³ similar to the thin capitalization (thin cap) rules in countries such as Germany and the U.K., which allow their businesses to deduct the portion of their net interest expense that does not exceed 30 percent of their adjusted earnings.⁴ 
• Tax writers are considering allowing businesses to continue to deduct the interest expense on their existing debt, only applying the limitations to new debt. But whether the two options described above would actually provide for such grandfathering is an open question, especially since grandfathering could be administratively challenging.

Limitations on the deductibility of corporate interest expense may turn out to be the hot-button issue in business tax reform. While businesses large and small all claim to want a reduction in the top corporate income tax rate from 35 percent to 20 percent, they may not be so eager if it comes along with an increase in their cost of capital as a result of new restrictions on their ability to deduct the interest payments they make on their debt.

There are three primary reasons why tax writers are seeking to limit the deductibility of business interest expense. One, such a limitation has the potential to generate a significant amount of revenue to pay for a corporate rate cut. According to the Tax Foundation, a full disallowance of net interest expense as was contemplated in the 2016 House Republican tax reform blueprint would have generated an estimated $1.2 trillion in revenue over 10 years. ⁵ 

Two, many tax policy experts believe that providing full expensing (so that businesses can write-off or deduct 100 percent of the cost of certain capital investments as soon as they are acquired and placed in service) in addition to allowing a full deduction for business interest expense is inappropriately distortive (lets businesses “have their cake and eat it too” ⁶ ) and would only exacerbate the existing tax code’s bias in favor of debt financing over equity financing. According to American Enterprise Institute’s Alan Viard, giving businesses both expensing and interest deductibility would “spur companies to borrow for tax advantages, not investment.” ⁷ Granted, that belief is not universally held. ⁸ 

But the framework released September 27 only called for full expensing for five years (with a tease for additional enhancements) and merely limitations on the deductibility of interest expense. Businesses will still get to have and eat their cake—just a smaller piece.

Three, doing away with the deduction for business interest expense would also do away with the threat of base-erosion posed by earnings stripping—that is, setting up intercompany loans whereby a U.S. entity in a group borrows money from a foreign affiliate in a low-tax country, using the interest payments to reduce the amount of U.S. taxes it pays on its earnings.

As U.S. tax planners are acutely aware, payments of interest to a foreign shareholder are deductible whereas payments of dividends to a foreign shareholder are not. As The Wall Street Journal noted in a September 29 article listing the downsides to tax reform for Wall Street, this debt bias “enabled the rise of leveraged buyouts in which financiers borrowed heavily to buy companies, then wrote off the interest payments. More recently, it has underpinned stock buybacks. Apple Inc. [(NASDAQ: AAPL)], for example, has borrowed nearly $100 billion in recent years, much of it to repurchase shares. Just this week, investment bank Greenhill & Co. [Inc. (NYSE: GHL)] said it would borrow $300 million to buy back stock whose dividend payouts had become a burden.” ⁹ 

The Companies Fighting to Preserve the Deduction

Given the many policy reasons for such a limitation, what is the problem? Politics. Some businesses treasure the interest expense deduction, especially cash-strapped businesses that have to borrow a lot to fund capital-intensive investments necessary to stay competitive. Any limitation on that is so disturbing to certain firms that they have gathered together to form a coalition to push back against what they describe as “a new tax targeting interest.” ¹⁰ The firms come from a diverse range of industries including real estate, telecommunications, manufacturing, agriculture, healthcare and finance.

One group that is seeking special treatment under a contemplated interest expense limitation is the utilities industry. According to a September 29 article in The Washington Post, the Edison Electric Institute (EEI), which represents electric companies, is educating “policymakers on the unique nature of our industry.” ¹¹ One of the companies that has been actively working with EEI, energy holding company PNM Resources Inc. (NYSE: PNM), said on a February 28 earnings call that it not only wants the deduction retained but that it is also interested in “securing normalization rules.” ¹² 

Another EEI member, Great Plains Energy Inc. (NYSE: GXP), said on a February 24 earnings call that an interest expense limitation “could create headwinds” for its EPS growth given the level of debt that it has in its holding company. Its CFO Kevin Bryant said, “We expect there will be extensive deliberation on the topic, resulting in significant change to tax policy before it is ultimately adopted.” Its CEO Terry Bassham added, “We are continuing to work on ensuring that impact is lessened from legislation and from the implementation if there was legislation.” ¹³ 

But educating tax writers is not the only way a business can protect itself from the possible limitations on interest expense. Defense contractor and weapons manufacturer Raytheon Co. (NYSE: RTN) has been working to accelerate debt pay downs in an effort to lower its interest expense in a way that allows it to maintain “financial flexibility, especially ahead of potential tax reform and what that could mean for us.” ¹⁴ 

Solid waste collection company Advanced Disposal Services Inc. (NYSE: ADSW) also said it plans to take various steps to reduce its leverage if it looks like the deductibility of its interest expense might be limited. On a February 24 earnings call, it said such steps might include “a combination of accretive tuck-in acquisitions and paying down debt.” ¹⁵ 

Some tax writers seem sensitive to their concerns. Treasury Secretary Steven Mnuchin has indicated that interest deductibility should be preserved for certain businesses. ¹⁶ And back in June, House Ways and Means Committee Chairman Kevin Brady (R-TX) said, “my current thinking is . . . that we grandfather existing debt in a generous way so that the financial arrangements that are currently in place stay there.” ¹⁷ On September 14, Brady said grandfathering was still on the table and added that lawmakers were also considering providing exemptions from the interest deduction limitation for small businesses and agriculture. ¹⁸ 

Option #1: A Haircut

As reported by Axios, one possible interest deduction limitation under consideration is a simple haircut, meaning instead of letting businesses deduct 100 percent of their interest expense, they will only get to deduct 70 percent (a 30 percent haircut). It remains to be seen whether such a haircut would sufficiently address lawmakers’ base-erosion concerns so as to cause them to repeal the rules under Section 163(j) and Section 385. Treasury recently decided to delay the effective date of parts of the latter rules, ¹⁹ which were extremely controversial, and is currently studying whether to recommend them for full withdrawal. ²⁰ 

Option #2: A Thin-Cap Rule

As reported by Axios, another option for limiting the deductibility of interest expense is adopting a far-reaching thin-cap rule. Whereas a haircut does not care about the debt-to-equity ratio of the company seeking to take an interest expense deduction, a thin-cap rule looks to the overall leverage of the company. Axios’ source said a “debt-to-EBITDA” cap of something like 30 percent was under consideration. EBITDA—earnings before interest, tax, depreciation and amortization—is a proxy for a company’s pre-tax cash flow. A highly leveraged company would have a high debt-to-EBITDA ratio.

Thin-cap rules are not new, and in fact the earnings stripping rule in Section 163(j) is essentially a thin-cap rule in that it only applies to limit the deductibility of a corporation’s net interest expense if the corporation has a debt-to-equity ratio of more than 1.5, and then only to the extent net interest expense exceeds 50 percent of cash flow. ²¹ But Section 163(j) is generally limited in its application to related party or guaranteed debt of foreign-parented groups. The thin-cap rule potentially under consideration by tax writers today would be expansive in that it would apply to all corporate debt, regardless of the lender.

A 30 percent debt interest-to-EBITDA cap is very different from a 30 percent haircut. The cap would only allow businesses to deduct the portion of their net interest expense that does not exceed 30 percent of their earnings before tax. An outstanding question is whether the cap would apply to the EBITDA on a worldwide-group basis or only to U.S. EBITDA.

This is somewhat harsher than the thin-cap rule proposed by former House Ways and Means Chair Dave Camp as part of the Tax Reform Act of 2014. Under Camp’s plan, if the debt-level of a U.S. parent company was more than 110 percent that of its worldwide affiliated group or the parent’s net interest expense was more than 40 percent of its adjusted taxable income, then interest expense would be disallowed.

The Option #2 Thin-Cap Rule is consistent with the kinds of rules many of our trading partners are adopting. In fact, the base erosion and profit shifting guidance on interest deductions (Action 4) released by the Organisation for Economic Co-operation and Development (OECD) recommended that all countries adopt a rule whereby a business is only allowed to deduct interest expense up to between 10 percent and 30 percent of its EBITDA. ²² Effective April 2017, the United Kingdom adopted what amounts to a 30 percent interest-to-EBITDA cap, calculated on a group-wide basis to allow higher leverage for certain entities. ²³ 

Transition: Will Congress Grandfather Existing Debt?

When the U.K. adopted its worldwide debt cap regime, it only provided grandfathering for special cases (namely some existing U.K. infrastructure projects). ²⁴ But U.S. lawmakers have already indicated that they are open to the idea of allowing interest payments on existing debt to continue to benefit from full deductibility. Speaking at the U.S. Chamber of Commerce September 28, Brady said that he understands how important transition rules are in tax reform and promised to reach out to industry representatives to give them the chance to “test-drive some of these provisions and the transition rules . . . to get the policy right.” ²⁵ 

If grandfathering is provided either for Option #1 or Option #2, it could be tricky to identify what debt benefits from transition relief and what does not. Short-term or revolving debt and debt that is either refinanced or has had some of its terms modified could present sympathetic cases for exceptions. In addition, many companies have accumulated deferred tax assets over the years that are tied to interest expense. Will those carryforwards be preserved?

However, grandfathering could also present some competitiveness challenges. As Goldman Sachs’ Daniel Shefter pointed out, grandfathering could give an advantage to companies that either implemented capital structures or significantly increased their leverage with longer-dated debt prior to the effective date of the limitation. ²⁶ 

What might be the effective date of a limitation? The most likely dates include the date a more detailed provision is announced, the date the actual legislative language is released or the date the bill is first marked up (likely by the Ways and Means Committee). As for the timeline, the first thing that needs to happen is both chambers need to pass an FY 2018 budget resolution with tax reform instructions. The Senate Budget Committee plans to mark up its budget resolution, which is different from the one passed by the House Budget Committee in July, the first week of October, with a Senate floor vote expected in the third week of October. Now that the House Freedom Caucus has agreed to get behind the House’s budget resolution, a floor vote on it could come as soon as the first week of October.

Once the House has passed a budget resolution (and even before it agrees to a conference version that resolves expected differences with the Senate), it can proceed to mark up tax reform legislation in the Ways and Means Committee. That means a detailed announcement or the release of legislative language could be just around the corner. The wait is almost over.

^{[1] https://www.speaker.gov/sites/speaker.house.gov/files/Tax%20Framework.pdf}

^{[2] According to the 2016 “A Better Way” tax reform blueprint (http://abetterway.speaker.gov/_assets/pdf/ABetterWay-Tax-PolicyPaper.pdf), “job creators will be allowed to deduct interest expense against any interest income, but no current deduction will be allowed for net interest expense. Any net interest expense may be carried forward indefinitely and allowed as a deduction against net interest income in future years.”}

^{[3] Primack, Dan, Sept. 27, 2017, “GOP tax plan cuts corporate interest deductibility,” Axios (https://www.axios.com/gop-tax-plan-cuts-corporate-interest-deductibility-2490152019.html).}

^{[4] http://taxsummaries.pwc.com/ID/Germany-Corporate-Deductions and https://www.gov.uk/government/publications/corporation-tax-tax-deductibility-of-corporate-interest-expense/corporation-tax-tax-deductibility-of-corporate-interest-expense}

^{[5] https://taxfoundation.org/details-and-analysis-2016-house-republican-tax-reform-plan/}

^{[6] https://www.forbes.com/forbes/welcome/?toURL=https://www.forbes.com/sites/anthonynitti/2017/09/15/fun-with-math-one-mans-attempt-to-craft-revenue-neutral-tax-reform/}

^{[7] https://www.bloomberg.com/news/articles/2017-05-12/trump-preference-for-interest-deduction-may-snarl-gop-tax-plan}

^{[8] Cole, Rebel A., May 9, 2016, “100 Percent Expensing Is No Alternative for Interest Deductibility,” Tax Notes (http://condor.depaul.edu/rcole/pdfs/Cole.Tax.Notes.Op-Ed.2016-05-09.pdf).}

^{[9] https://www.wsj.com/articles/what-awaits-wall-street-in-trump-tax-plan-1506596402}

^{[10] http://buildcoalition.org/the-issue/}

^{[11] https://www.washingtonpost.com/news/powerpost/paloma/the-finance-202/2017/09/29/the-finance-202-the-lobbying-war-on-tax-overhaul-has-commenced/59cdb3e530fb0468cea81c98/?utm_term=.4feceba9bfbc}

^{[12] https://seekingalpha.com/article/4050683-pnm-resources-pnm-ceo-pat-vincent-collawn-q4-2016-results-earnings-call-transcript}

^{[13] https://seekingalpha.com/article/4049540-great-plains-energys-gxp-ceo-terry-bassham-q4-2016-results-earnings-call-transcript}

^{[14] https://seekingalpha.com/article/4066147-raytheon-rtn-q1-2017-results-earnings-call-transcript}

^{[15] https://seekingalpha.com/article/4049577-advanced-disposal-services-adsw-ceo-richard-burke-q4-2016-results-earnings-call-transcript}

^{[16] Jagoda, Naomi, May 24, 2017, “Mnuchin wants to keep deduction for businesses' interest expenses,” The Hill (http://thehill.com/policy/finance/335008-mnuchin-wants-to-keep-deduction-for-businesses-interest-expenses).}

^{[17] https://www.wsj.com/articles/for-cfos-tax-overhaul-is-a-leap-into-the-unknown-1497605408}

^{[18] Basu, Kaustuv, Sept. 18, 2017, “Hatch: Big-Six Tax Framework Won't Dictate Finance Bill,” Bloomberg BNA Tax Management Weekly Report.}

^{[19] Section 385 gives the IRS authority to treat some related-party debt as equity under T.D. 9790.}

^{[20] Foster, Emily L., Sept. 18, 2017, “Debt-Equity Regs: Withdraw, Modify, or Leave to Legislation?” Tax Notes (Doc 2017-69014).}

^{[21] https://www.irs.gov/pub/int_practice_units/IBF9423_05_04.pdf}

^{[22] http://www.oecd.org/tax/beps/limiting-base-erosion-involving-interest-deductions-and-other-financial-payments-action-4-2016-update-9789264268333-en.htm}

^{[23] http://www.ey.com/Publication/vwLUAssets/EY-tax-news-2016-05-17-02/$FILE/EY-tax-news-2016-05-17-02.pdf}

^{[24] http://www.ey.com/Publication/vwLUAssets/EY-tax-news-2016-05-17-02/$FILE/EY-tax-news-2016-05-17-02.pdf}

^{[25] https://www.uschamber.com/event/chairman-kevin-brady-addresses-us-chamber-tax-reform}

^{[26] Shefter, Daniel, June 7, 2017, “Interest Disallowance Proposals: Flow-Through Entities, Non-Interest Expenses, and Transition Rules,” Bloomberg BNA Real Estate Journal.}