Tax Bill's New Math Could Be Toxic for More Junk-Rated CompaniesBy and
Senate uses different method for capping interest deduction
Switch could mean 38% of junk companies don’t benefit from law
When U.S. Senate lawmakers changed just two letters used for a calculation in their proposed tax bill, they may have increased the number of junk-rated companies that would be hurt by tax overhaul.
Legislators for both the House of Representatives and the Senate are looking to cap a commonly used corporate deduction, to help limit the cost to taxpayers of the tax cuts they plan. Under current rules, companies can deduct 100 percent of their interest payments from their taxable earnings, while under new proposals, borrowers would only be able to deduct interest equal to less than 30 percent of a measure of their income.
The devil is in how earnings are measured. For the House bill, it’s essentially earnings before interest, taxes, depreciation, and amortization, a commonly used metric of a company’s performance known as Ebitda. The Senate bill uses a gauge closer to Ebit, which includes depreciation and amortization expenses and therefore is a lower number for most companies. By using a form of earnings just two letters different from the House measure, the Senate bill would allow borrowers to deduct less interest and potentially pay more taxes.
For companies with high debt levels, the difference between these can be stark. Almost 40 percent of junk debt would be affected by the House proposal interest deduction cap, while 67 percent would be for the Senate version, according to strategists at Barclays Plc. With the Senate version of the law, about 38 percent of junk-rated companies would not benefit at all from the tax rate cut, and a chunk of the market would see a sizeable increase in their overall burden, according to strategists at Morgan Stanley.
"People are doing this math all over Wall Street," said Rich Farley, a lawyer that works on debt transactions at Kramer Levin Naftalis & Frankel LLP in New York.
A collection of companies and trade groups, including Dell Technologies Inc., First Data Corp., and the Mortgage Bankers Association, wrote a letter to key Senate leaders dated Tuesday calling for lawmakers to revise the limitations. Other countries restrict interest deductibility to 30 percent of Ebitda, and basing the limits on Ebit instead would put "U.S. businesses at a competitive disadvantage around the world," the letter said.
The switch between the House method for calculating limits on interest deductions and the Senate method underscores how a tax overhaul that is designed to cut taxes for companies will not help all corporations, and may leave some worse off on balance.
It’s unclear how tax law will ultimately change, if it gets altered at all. The proposed Senate bill is due to get a vote on the floor as early as Thursday, and even if it’s passed, it still has to be reconciled with its House counterpart. But the risk of higher taxes for companies with heavy debt levels is worth looking at when evaluating individual bonds, said Gershon Distenfeld, director of credit at AllianceBernstein LP, which manages more than $500 billion of assets.
"If we’re looking at a company, and the Senate bill would impair their ability to generate cash flow for servicing debt, that’s absolutely a consideration," Distenfeld said.
When the dust settles, a number of companies could look to cut their borrowings, especially issuers that were bought buy private equity firms, said Chris Padgett, an analyst at Moody’s Investors Service. A good number of these companies were paying relatively low taxes to begin with, she added.
Restricting interest rate deductions for companies is a key part of the math for the tax bill. Republican lawmakers want to avoid adding more than $1.5 trillion to the deficit over the next 10 years, a hurdle that if cleared would make the bills filibuster-proof. Both bills are estimated to increase federal deficits by about $1.4 trillion over 10 years, before accounting for any macroeconomic effects the changes may spur.
The House version of the limits on interest deduction for companies would raise around $172 billion for the government over a decade, compared with around $308 billion under the Senate version, according to Congress’ Joint Committee on Taxation.