The first quarter of 2018 was marked by some of America’s largest corporations recording multibillion-dollar write-downs. Write-downs of such magnitude ordinarily might signal concern, but these write-downs were the result of a simple number change in the tax code—a reduction in the federal corporate income tax rate from 35% to 21%. Multinationals, particularly financial institutions, had billions of dollars in deferred tax assets on their books stemming from the financial crisis. The new corporate tax rate reduced the expected tax savings from deferred tax assets, resulting in the need to report a one-time charge.
This change and others in the Tax Cuts and Jobs Act (TCJA) have gripped the attention of companies from Main Street to Wall Street, who quickly found themselves navigating a new and uncharted body of tax law. In this article, we take a look at a couple of the corporate tax changes that are expected to have a significant impact on the private equity industry.
Corporate Tax Rate
As noted above, perhaps the most important change in the TCJA is the permanent reduction of the corporate tax rate from 35% to 21% and the elimination of the corporate alternative minimum tax (AMT). At its core, this means that US corporations will pay less tax on their profits, leaving them with more money to reinvest in the business, pay employees or return to shareholders. However, the lower tax rate also reduces the value of a corporation’s tax assets, such as net operating loss (NOL) carryovers, capital loss carryovers and basis in depreciable or amortizable property and increases the after-tax cost of purchasing new property. At the prior 35% tax rate, each dollar of investment in new depreciable or amortizable property resulted in 35 cents of federal tax savings over time. At the new 21% tax rate, this savings decreases to 21 cents on the dollar.
From an M&A perspective, the lower corporate tax rate is likely to result in increased portfolio company valuations. This increase is somewhat tempered by the decrease in the value of so-called “transaction tax benefits.” A seller is often able to deliver valuable tax assets to a buyer in connection with the sale of a corporate portfolio company. These tax assets include not only tax assets existing at the time of the M&A transaction, but also new tax assets generated from the transaction itself, such as deductions on account of change-of-control payments, repayment of indebtedness and fees paid for financial and legal advisors. The reduction of the corporate tax rate decreases the value of these assets to the portfolio company and thus the amount of money a buyer may be willing to pay for the assets. In an exit transaction structured as an IPO, sponsors are increasingly entering into tax receivable agreements, under which they are typically entitled to receive around 85% of the tax savings of the company from specified tax assets, calculated on a hypothetical with-or-without basis. The reduction of the corporate tax rate likewise has the effect of decreasing the expected payouts under such tax receivable agreements.
Depreciation of Tangible Property
Bonus depreciation has been in the tax code for nearly 20 years, but historically it has been of limited relevance to the private equity industry because it only applied to the acquisition of property that was newly placed in service. The TCJA made a fundamental change to the bonus depreciation regime by allowing a business to expense 100% of the cost of qualifying property in the first year and by extending the provision to apply to used property that is acquired from an unrelated party by purchase (in addition to new property).
With the new rules come new planning opportunities for private equity sponsors. Under prior law, the sale of assets comprising a trade or business was generally undesirable because of double taxation. The TCJA reduced the tax impact significantly by reducing the corporate-level tax to the seller and providing immediate expensing of certain tangible property to the buyer. In appropriate cases (e.g., the corporation has NOLs or significant basis in tangible property that has not been depreciated), asset sales may result in an overall tax savings to buyers and sellers. A sponsor selling a portfolio company in flow-through form, such as an operating partnership, should be able to deliver immediate expensing to a buyer with respect to the portion of its tax basis step-up in the partnership interest that is attributable to the portfolio company’s qualifying tangible property. In either case, a buyer that can benefit from the depreciation deductions may be willing to share part of the benefit with the sponsor through an increase in the purchase price. The new bonus depreciation regime also impacts the importance of purchase price allocations in asset deals, with an increased focus on allocating consideration to tangible assets eligible for immediate expensing, as opposed to intangible assets that generally continue to be amortized ratably over 15 years.
Net Operating Losses
Before the TCJA, a corporation could carry back NOLs for two years and carry forward NOLs for 20 years. The new rules, applicable to NOLs arising in 2018 or later, eliminate the carryback and permit NOLs to be carried forward indefinitely. In addition, NOLs may now only offset up to a maximum of 80% of taxable income, thereby creating a “semi-AMT.” NOLs in excess of the 80% limitation continue to be carried forward.
As discussed above, the reduction in the corporate tax rate reduces the value of a company’s tax assets including NOLs. The elimination of the carryback may also make it more difficult for a sponsor selling a portfolio company or blocker corporation with NOL carryovers to receive value because buyers often take the position that NOL carryovers (and other tax asset carryovers) are hard to value since their ability to be used following the transaction is speculative.
Because NOL carryovers can only reduce 80% of taxable income, a portfolio company with losses may actually find it more advantageous to delay deductions to a future year in which it expects to be profitable, because deductions incurred in the profitable year can reduce taxable income on a dollar-for-dollar basis (as opposed to 80 cents on each dollar for deductions incurred in an earlier year that result in a NOL carryover to the profitable year). Alternatively, the company may be able to offer another party tax benefits in an appropriately structured transaction. For example, a company that is considering a capital expenditure for new property may instead choose to enter into a long-term lease with a profitable lessor for the same property. The lessor may be willing to share part of the tax benefits of ownership of the property with the portfolio company through a reduction in the lease amounts, resulting in a situation where both parties benefit.
Limitations on Business Interest Deductions
Debt generally has a lower cost of capital than equity due to its ability to act as a “tax shield” for a company. Interest payments on debt (unlike distributions on stock or redemptions of stock) are generally deductible for tax purposes, subject to limitations. The TCJA replaced existing earnings stripping rules with a new limitation on interest expense deductions that is not tied to excessive debt-to-equity ratios or related party payments. Interest expense, including from related-party and third-party debt, generally may now be deducted to the extent of interest income plus 30% of adjusted taxable income. Any interest expense in excess of the limitation is carried forward indefinitely.
This new limitation on interest expense deductions may impact the desired mix of debt and equity in the capital structure of a portfolio company or the ideal amount of leverage for a blocker corporation. Importantly, leverage remains a valuable tool for both tax and commercial reasons, but the ideal amount of leverage needs to be carefully modeled in light of the new limitation. There is some incentive to use leverage in excess of the limitation: the nondeductible portion can be carried forward as a tax asset and can also reduce the corporation’s earnings and profits for tax purposes, which may cause an otherwise taxable dividend to be treated as a tax-free return of capital. Moreover, repayment of principal provides a means to repatriate cash from the corporation tax-free and without any withholding taxes. Excess interest expense carryovers are subject to the same usage limitations following a change of control transaction as NOL carryovers and capital loss carryovers.
In modeling the ideal leverage for a portfolio company or blocker corporation, one important detail to take into account is the change in the calculation of adjusted taxable income from an EBITDA proxy to an EBIT proxy beginning in 2022. A company with significant amounts of depreciation or amortization will have a significantly smaller limitation beginning in 2022 and thus may notice a significant decrease in the amount of interest expense it is able to deduct each year. Accordingly, the new limitation may also raise timing considerations with respect to a company’s leverage. A company that expects to have a significantly smaller limitation in 2022 may choose to prepay a portion of its debt at the end of 2021 or may structure a portion of its debt to mature at the end of 2021.
The IRS has stated that implementation of the new tax law is their “highest priority” in their five-year strategic plan that was released on May 23, 2018, and any forthcoming guidance has the potential to significantly shape the impact of the new law on sponsors and on their portfolio companies. Although many areas of uncertainty remain, sponsors should model the impact of the new law on their existing businesses and consider any planning opportunities the new law may offer for future deals.