On December 22, 2017, President Trump signed into law H.R. 1, commonly referred to as The Tax Cuts and Jobs Act (the “Act”), effecting the most signifi cant U.S. tax changes in more than 30 years. Due to provisions in the new Act, highly leveraged companies with over $25 million in revenue and poor profit margins need to be aware they may not be able to deduct the full amount of their interest expense in 2018 and subsequent years. This has potentially significant impacts of concern to many business entities and their advisors, as well as parties in interest to potential restructurings and distressed transactions.
Under Section 13301 of the Act, the interest expense deductions of any business will be subject to a “Ceiling Test,” unless the business falls under the “Exemption for Certain Small Businesses.” The Ceiling Test limits the interest expense deduction of nonexempt businesses to the sum of the following items: 1) business interest income, 2) 30% of adjusted taxable income, which approximates earnings before interest, taxes, depreciation, and amortization (EBITDA), and 3) floor plan financing interest. For any taxable year beginning after December 31, 2021, adjusted taxable income will include any allowable deduction for depreciation, depletion, and amortization. Thus, in four years, adjusted taxable income will essentially be equal to earnings before interest and taxes (EBIT), making a business’ adjusted taxable income relatively lower for 2022 and later years, which would make a business’ limitation amount relatively lower, as well.
This new limitation, determined by the Ceiling Test, replaces Section 163(j) of the Tax Code prior to the 2018 changes. Section 163(j) similarly provided a limitation on interest expense deductions, but it mostly applied to interest paid on loans to relatives or controlled entities (more than 50%). Therefore, the impact of the old limitation was relatively insignificant and unsubstantial when compared with the new limitation’s impact on distressed businesses.
The Ceiling Test does not, however, apply to all companies. The Exemption for Certain Small Businesses provides that any business that qualifies under the “Gross Receipts Test” of Section 448(c) is exempt from the Ceiling Test. A business meets the requirements of the Gross Receipts Test (which is amended by Section 13101 of the Act) if the company’s average annual gross receipts during the last three taxable-year periods does not exceed $25 million. If the business has not existed for three or more years, the interest expense deduction would simply be the average annual gross receipts over the year(s) the business has existed. Thus, any business that does not earn more than $25 million (on average) can deduct all of its interest expense each year.
Nevertheless, the Exemption for Certain Small Businesses only applies to just that – certain small businesses – leaving those highly leveraged companies with over $25 million in revenue subject to the new Ceiling Test and unable to include full interest expenses on their tax returns. This is significant because before the Act, very few distressed companies paid income taxes. As the new tax provisions are implemented, it is important to examine potential tax impacts for certain distressed companies, particularly those with:
As companies start to experience distress, they often borrow more and at higher interest rates. These are the very companies that will see their interest expense climb above 30% of EBITDA. Such companies often end up asking lenders for relief and need lower tax burdens during turnaround and recovery, so they can continue providing jobs and supporting the U.S. economy. But instead, the Act’s changes to the corporate tax code could boost defaults and cause more struggling companies to end up in bankruptcy.
It is expected that over 25% of junk bond issuers will pay more in taxes under the new Act. Junk bonds are rated BB or lower by Standard & Poor’s and BBa or lower by Moody’s.
Figure 1 shows the total amount of U.S. bonds outstanding when Congress passed the Act, December 20, 2017. According to Moody’s ratings, over $1.3 billion are considered junk bonds. This suggests that issuers of more than $325 million ($1.3 billion x 0.25) in junk bonds may experience higher taxes and increased cash constraints starting in 2018.
Source: Bloomberg Finance, L.P. (2017).
U.S. corporate bonds outstanding as of December 20, 2017.
Junk bonds have the highest interest rates because the issuers are the riskiest borrowers; therefore, the combined effects of the new Act and other factors may help create the “perfect storm” of demands on troubled companies. Lower EBITDA, higher interest expense, and increased taxes will put these entities even more at risk of having to file for bankruptcy.
In fact, reduced interest deductions may lead to paying higher taxes even at the new lower 21% rate. Figure 2 illustrates the tax effect before and after the 2018 changes under two scenarios: where a company is at break-even EBITDA and where it has minimally positive EBITDA.
This simplified analysis shows that in this instance, the company will pay more in taxes under the new Act in 2018 under either scenario.
To a distressed company with low profit margins, paying increased income taxes or any income taxes may cause an immense burden. Thus, due to higher taxes under the Act, highly leveraged companies with poor profit margins will be under more pressure to find solutions, and will need to focus even more on generating and preserving cash if they are going to recover. Quite often such businesses do not have the ability to deleverage; however, they may be able to address the issue through the following approaches.
Many distressed companies have already generated net operating losses (NOLs) that may be able to offset increased taxes. It is unfortunate that NOLs may have to be used to shield taxes created by the Act’s tax code changes; however, disallowed interest deductions can be carried forward to future years when the company’s interest expense is below the ceiling.
The Act also provides major changes to utilization of NOLs: 1) effectively limits the amount of NOLs businesses can deduct to 80% of a business’ taxable income (gross income minus allowable deductions other than the NOL deduction), 2) removes the ability of businesses to carry back NOLs to prior years, and 3) allows businesses to carry forward NOLs into perpetuity instead of limiting carryforward to 20 years.
A complete review should be made of all assets, including subsidiaries, business units, and intangibles. Assets that are not core to the business could be sold or otherwise monetized to reduce debt levels, which in turn will reduce the amount of interest expense. This needs to be carefully evaluated, as selling a profitable subsidiary may allow for the paydown of the debt but can also reduce EBITDA. These are tough strategic and financial decisions that may require the help of outside advisors.
Look at the capital structure of the organization and determine if there is a tranche of debt that might be open to converting to equity. This will both strengthen the company’s balance sheet and reduce interest expense. With a stronger balance sheet, it may also be possible for the company to refinance the remaining debt at lower interest rates.
Most businesses quickly implement cost cutting and operational improvement when they start to see a decline. But it is worthwhile to take another look, get a second opinion from an outsider, and look “under every rock.” If a business can improve cash from operations, it will see higher EBITDA, which will allow for a higher deductibility cap.
Although each case is unique, all distressed situations have many moving parts, and finding and addressing problem areas require aggressive action and thoughtful consideration. The tax code changes wrought by Congress in the Tax Cuts and Jobs Act have created additional hurdles that troubled companies will have to anticipate and address.
Jamie Peebles, JD, MBA
McKinnon Patten & Associates, LLC