One of the big distortions in corporate finance, with increasing relevance in recent years, has been the tax deduction allowed on interest expenses. This has allowed companies in developed economies to lower their tax liabilities (and thereby boost profits) by leveraging the low interest rate regime and load up debt, even to the extent of using them to finance share buy-backs.
Fundamentally, the favourable treatment give to debt has not only led to erosion of the corporate tax base but has also encouraged corporate indebtedness. Most worryingly, it has encouraged resource misallocation towards speculative financial market activities that have in turn furthered the trend towards excessive financialization.
In this context, the G-20 and OECD's Base Erosion and Profit Shifting (BEPS) project to modernise international tax rules had in 2015 recommended that interest expense deductions be capped at a net interest/EBITDA ratio in the range of 10-30%, at the discretion of national governments. However, it allows for actual deductions in cases where the entire group’s ratio is higher than the fixed ratio, thereby acknowledging the supremacy of the principle of tax deduction on interest expenses.
Accordingly, the UK Government led the way by promulgating a Fixed Ratio Rule as part of its tax rules.
The Fixed Ratio Rule will limit the amount of net interest expense that a worldwide group can deduct against its taxable profits to 30% of its taxable earnings before interest, taxes, depreciation, and amortisation (EBITDA). A modified debt cap within the new rules will ensure the net interest deduction does not exceed the total net interest expense of the worldwide group. The Group Ratio Rule allows a ‘group ratio’ to be substituted for the 30% figure. The group ratio is based on the net interest expense to EBITDA ratio for the worldwide group based on its consolidated accounts.
One of the less discussed, maybe even partially redeeming, feature of the Trump administration's tax reform plan is the introduction of limit on the tax deduction on interest expense. The rules state that the deduction shall not exceed the sum of the tax payer's business interest income and 30% of the adjusted EBITDA. The provision becomes tighter by 2021 by making it 30% of EBIT. However, it allows for "carry forward of disallowed interest" which allows corporates to deduct the remaining interest expense in the following years, upto the fifth year after the expense is incurred.
Whatever the qualifications, these are undoubtedly positive developments to correct a serious distortion to corporate financing.
It is expected to hurt private equity firms which have specialised on leveraged buyouts to generate returns. It is estimated that in the US, nearly 70% of companies with debt more than five times EBITDA would be negatively affected.