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INSIGHT: Private Equity and Corporate Debt Binge—Impact of Disallowed Interest on Deal-Making

March 23, 2020, 8:01 AM

Give a man a fish and he will eat for a day. Offer a private-equity professional access to cheap debt, and he will orchestrate the leveraged buy-out of the fish farm, processing plant, and grocery store.

No matter where you look these days articles abound concerning the unprecedented $253 trillion in global debt. In the U.S., amidst a historic decade-long economic expansion driven by accommodative central bank policies, the leaders of the private equity and corporate worlds have taken every opportunity to leverage-up. Up until this past week when the Covid-19 outbreak began to ravage global and domestic capital markets, this access to capital had fueled an aggressive M&A marketplace in which competition was high and valuation multiples showed no signs of plateauing.

As businesses large and small are now forced to assess their leverage position given the market shocks emanating from the COVID-19 pandemic; a date beyond the immediate panic looms large on the horizon for any business employing leverage in its capital stack: Jan. 1, 2022. While the immediacy of such a seemingly far-off date may be easy to dismiss given the current state of the economy, it should not be ignored. That date will usher in a change stemming from the 2017 Tax Cuts and Jobs Act (TCJA), which is related to the deductibility of business interest will come into full effect. Previously deductible in full, the TCJA altered tax code Section 163(j) and implemented a limitation based on 30% of a calculation roughly equivalent to a business’s EBITDA. The initial limitation, however, becomes far more punitive to leveraged businesses beginning in 2022 when the 30% calculation is computed using the EBIT of the business—losing valuable addbacks for depreciation and amortization.

Regardless, the practical consequences of a disallowance remain the same: the amount of the disallowance in the current year is carried forward to the next taxable year. Thereafter, the disallowed amount may be limited again in the next taxable year, thus resulting in an indefinite carryforward of disallowances until the business is sold or there is excess taxable income in a particular taxable year, which utilizes some or all of the disallowed interest carryforward. There are differences in how the disallowance is accounted for depending on the type of entity for which the interest is limited.

While the impacts above may seem straightforward, as with many areas of tax, the interplay with other provisions of the tax code as well as non-tax business items can significantly obscure the results. A simple example of such complications concerns the results of an interest disallowance for a partnership. If interest is disallowed at the partnership level, that means that the partnership likely will be recognizing more income. With increased income comes a corresponding increase in tax distributions required to be made to partners—now a common provision in most partnership operating agreements. Accordingly, a partnership facing an interest disallowance might see this issue ripple across its balance sheet in unanticipated ways; potentially causing larger issues should the business not have the cash flow to support the increased distribution burden.

Assessing the Impact—Partnerships

Many in private equity may dismiss this issue as trivial. After all, the private equity industry is built on finite hold periods and the creation of value through acquisition. But, if the ultimate aim is to sell, why be concerned with a few years of disallowed interest that will be recognized on the backend of the deal?

This position is understandable, but it does not fully consider the ramifications of the dynamics at work. As previously mentioned, with valuations still remaining at record levels, many industry experts anticipate some funds shifting toward a longer-term hold period in order to meet lofty investment return expectations. While this move can provide LPs with greater certainty regarding an investment return, it does not account for the accumulation of significant disallowed interest deductions that may not be recognized by an LP for 7-10 years. Accordingly, while funds may be incentivized to lengthen investment time frames, their LPs may feel differently, as the longer an asset is held the longer such deductions remain trapped and unutilized.

Assessing the Impact—Corporations

The consequences at the corporate level are even less palatable, but for completely different reasons. Unlike in the partnership context where disallowed deductions flow out to individual LPs only to be frozen at the investor level, any disallowed interest deductions for corporations remain at the entity level. What makes things more difficult in the corporate framework is that any disallowed interest deduction carried forward into a subsequent taxable year is further limited according to Section 382—the provision that imposes a limit on the utility of net operating losses.

Adding insult to injury for many highly-leveraged corporations, the TCJA additionally introduced a limitation on the utility of a net operating loss through a change to Section 382, such that a corporation can no longer carry a loss backward and any loss carried forward—indefinitely—may only offset 80% of taxable income. Examining both changes in the aggregate means that any corporation that carries a disallowed interest deduction forward will likely be limited year-after-year unless they actively engage in limitation planning. For the corporate world, gone are the days of net operating losses and interest deductions completely eliminating federal tax liabilities.

Mitigation and Solutions

The intention of this article is not to cover the wide array of exceptions, exemptions, and caveats associated with the limitation. It is important to note, however, that the real estate industry received a beneficial exception from having to comply with this deduction limitation. For businesses that find they exist beyond any specific exemption, there still are planning techniques and strategies to implement that can lessen any potential impacts.

First, business owners should be mindful of balancing the competing considerations associated with the full expensing of new and used fixed assets. Businesses should engage in financial modeling to determine the optimal strategy with an eye toward the looming change in 2022. Secondly, with the phased implementation provided by Congress, business owners have enough time to contemplate current capital structures to determine the future impact and whether a recapitalization or other financial planning for the business might be a prudent long-term decision.

Finally, for businesses engaging in frequent acquisitions, alternative entity structuring for asset or entity purchases might provide a blend of investment and business interest, which could resolve or at least mitigate any potential disallowances.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Christopher Hanewald is a member of Wyatt, Tarrant & Combs LLP’s corporate and securities team in Memphis, Tenn.

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