November 13, 2017
The Tax Cuts and Jobs Act bill (HR 1 or the House Bill) approved November 9 by the House Ways and Means Committee could alter the course of mergers, acquisitions and other deals, based on our initial analysis. On the same day, the Senate released a version of the bill (the Senate Bill) that is still a work in progress and expected to change over the next week or so during the markup process. In its current form, the House Bill includes several proposals that would both present opportunities and pose potential challenges for dealmakers. While the impact of the Senate Bill is not as clear, it also should be considered. Among the areas of particular interest are (click the link to go directly to the topic):
- Business tax rates
- Interest expense
- Cost recovery and immediate expensing
- Net operating losses
- International provisions
- Industry-specific provisions that could affect valuations
- Employee compensation
Here’s a look at each of the areas under the House Bill and how changes could affect deals, if enacted. Where appropriate, a parenthetical is included outlining how the current Senate Bill differs from the House Bill.
The reduction of the top corporate tax rate to 20% (effective for tax years beginning after 2017) could significantly impact valuation and purchase price adjustments for deals now in the pipeline. (The Senate Bill would delay the rate reduction until tax years beginning after 2018.) The proposed repeal of certain special tax credits and deductions could partially offset the corporate tax rate reduction, with some companies being affected more than others. For example:
- Businesses and potential buyers will need to model projected after-tax cash flows with and without changes in law.
- Corporate blockers would be less expensive to use, and tax receivable agreements would be less lucrative.
- Targets with large tax attributes will require modeling the potential impact of the reduction of deferred tax assets (DTAs) on balance sheets.
- In deals with purchase price adjustments, tax rate reductions may lower the purchase price if the adjustment formula includes DTAs – a situation that sometimes arises in financial M&A.
In addition, a new 25% tax rate would apply to certain “pass-through” business income of US individuals from businesses operated as sole proprietorships, partnerships, LLCs and S corporations. (The Senate Bill proposes a 17.4% deduction to reduce taxes on such income, which would effectively yield a top 31.8% rate.) Eligible businesses may favor a pass-through structure for US individual owners. This would apply differently for capital- vs. labor-intensive businesses, and is only partially available for actively participating individual taxpayers.
The gap between individual tax rates and the 20% corporate rate may influence some buyers to incorporate pass-through targets, and some lenders may not allow for partnership tax distributions equal to the highest individual tax rates.
The House Bill generally caps net business interest expense deductions at 30% of adjusted taxable income, but that doesn’t apply to businesses with average gross receipts of $25 million or less ($15 million in the Senate Bill), certain regulated public utilities and real property businesses. US taxpayers that are part of a large multinational group would contend with additional limits on deductible net interest expense, and disallowed interest expense would be carried forward for up to five tax years. (Under the Senate Bill, the carryforward would be indefinite.)
The potential increase of the after-tax cost of debt will need to be modeled for deals in progress and existing structures, and US tax rate reductions would raise that cost. Private equity deals may not be affected much in the current environment, but firms may want to allow for the impact of future interest rate hikes on variable term debt and diminished EBITDA from potential market downturns.
Those doing global deals may be less inclined to leverage US entities with a disproportionate amount of third-party debt, while multinational groups should consider shifting debt to non-US jurisdictions. Borrowers should consider repaying existing debt, and the combination of new limits on interest deductibility and a low, flat corporate income tax rate may lead taxpayers to choose proportionately higher equity capitalization relative to debt. Also, in states that conform to the new rules, traditional debt pushdown planning for state tax purposes may become less effective.
Businesses would be able to immediately deduct the cost of certain property, other than structures, that is acquired and used between Sept. 27, 2017, and Jan. 1, 2023. Businesses will need to model the potential impact on present value of after-tax cash flows, and these deductions could generate significant tax shield in the first post-deal year, as they would apply to tangible assets acquired in a taxable asset acquisition or deemed asset acquisition under the House Bill. (The Senate Bill proposals are more narrow in scope.)
This is a timing benefit of accelerated deductions that wouldn’t help all companies. Those with significant tax attributes likely would see little benefit, but PE buyers focused on after-tax cash flows in the early years may find it valuable. The provision also may increase demand for equipment and boost valuations of manufacturing companies. Keep in mind, however, that not all states may conform to this change.
Net operating loss (NOL) deductions utilized in tax years beginning after 2017 would be limited to 90% of taxable income. Most NOL carrybacks would be repealed, which could reduce the tax value of transaction expenses, such as investment banker fees, compensatory payments, and debt payoff costs. This is because they wouldn’t be recovered until there’s sufficient post-closing taxable income to monetize the taxable income benefit. NOLs generated in tax years beginning after 2017 would be carried forward indefinitely and increased by an interest factor.
The 90% limit would slow the ability to use the NOL carryforward in post-closing years. This limit, along with the interest limits noted above, also may lead highly leveraged companies that generate significant interest expense to become taxpayers more quickly after debt is paid off or revenues increase.
Starting next year, a 100% tax exemption for certain dividends received by US corporations from foreign subsidiaries would convert our worldwide tax system into a territorial system. There would be a one-time “deemed repatriation” tax on previously untaxed post-1986 earnings and profits (E&P) of foreign subsidiaries of US corporations. E&P held in cash and cash equivalents would be taxed at 14%, and any remaining E&P at 7%. (The Senate Bill proposes lower tax rates of 10% and 5%, respectively.) This tax essentially is a debt-like item that could be paid in installments over eight years.
To discourage shifting profits offshore, the House Bill requires taxing 50% of “foreign high returns” of US companies’ foreign subsidiaries. In some cases, the parent company may pay up to 10% in tax on foreign subsidiary income. In addition, certain payments for goods and services from US companies or US branches of foreign companies to related foreign corporations would be subject to a 20% excise tax. (The Senate Bill proposals are somewhat different in scope and tax rates, but broadly target a similar universe of transactions and income.)
These changes likely would eliminate the incentive for US multinationals to hold earnings offshore. Buyers will need to model the impact on potential targets and existing cross-border structures, and during due diligence will need to ensure they’re adequately measuring post-1986 offshore E&P and scrutinizing any planning that was done by sellers to reduce or eliminate such E&P.
Ultimately, the United States could become a more attractive tax jurisdiction while designing multinational structures. Also, US multinationals would be better able to offer a full collateral package to lenders; the parent wouldn’t be taxed on a deemed dividend when a foreign subsidiary guarantees its debt, or when more than two-thirds of the foreign subsidiary’s stock is pledged to secure the parent’s debt. Meanwhile, non-US buyers would be less inclined to strip earnings from the US target, e.g., use intercompany debt. Structures that depend on US earnings stripping, such as reinsurance to offshore affiliates, would be harder to implement.
While some investors may see tax benefits, multiple provisions could challenge real estate businesses. The bill limits the interest deduction for new home mortgages to mortgage amounts of $500,000, down from $1 million, and it caps the individual property tax deduction at $10,000. (The Senate Bill would not reduce the existing cap on mortgage interest, but would completely eliminate the property tax deduction.) Insurance companies would be adversely affected by some provisions in both bills.
The House Bill would expand restrictions on certain public companies’ ability to deduct compensation above $1 million paid to the CEO and four other top executives, adding stock options and other performance-based compensation. The restrictions also would cover more corporations and include issuers of public debt, even if company stock is privately held. (The Senate Bill also proposes to accelerate taxation of deferred compensation, so that stock option gains are taxed upon vesting, not exercise.) These proposed changes could lead dealmakers to alter their incentives for management and could increase the use of partnership profits interests instead of stock options.
Clearly this proposed legislation gives dealmakers plenty to digest. And as it makes its way through Congress in the coming weeks, some provisions could be added, and others may be changed or completely disappear. While practitioners across the deals spectrum watch the process and await the outcome, they should consider the above aspects of the bill and how they can adjust their strategy to succeed in a potentially new environment.