Unintended Consequences Of Slashing The Interest Deduction
Article, Law360 – June 2016
Corporate / Corporate consulting
In an often unpredictable world, any discussion of change that alters fundamental business practices can (or should) raise warning flags for business owners and their legal counsel.
As published in Law360, June 6, 2016.
In an often unpredictable world, any discussion of change that alters fundamental business practices can (or should) raise warning flags for business owners and their legal counsel. That is precisely where we find ourselves as we approach significant changes in Washington this fall.
As candidates engage in the political process, campaign promises are continuing to be made. Among those promises squarely sits the issue of tax reform, specifically revisions to the tax code as it relates to corporate interest expense. There is broad acceptance of the need for corporate tax reform. Though, while the current debate broadly focuses on symmetry and revenue neutrality, little attention is being given to the implications of specific tax features.
A full elimination of the corporate interest tax (CIT) deduction with no offsetting benefits has the potential to result in trillions of dollars of value destruction for middle-market companies — the very heart of American business. For this reason, the discussion must be tempered with a careful examination of the far-reaching impacts of a change to the CIT deduction and the implications on corporate valuation, growth and jobs. Business and legal advisers should begin to understand what this means for transactions and the stability for middle-market companies.
Why the Middle Market
The middle market, which includes all American businesses between $10 million and $1 billion in annual revenue, sustains more than 47.9 million jobs — one-third of all private sector jobs — and generates $10 trillion in aggregate revenue annually. Middle-market companies also tend to generate revenue growth that outpaces their larger counterparts.
As a driver of the U.S. economy, mid-sized businesses in all 50 states are the foundation for the U.S. economy. They are also the businesses that must often rely on debt financing and are therefore most vulnerable to changes in the ability to deduct CIT.
The issue of corporate interest deductibility in the tax code has been debated for decades. Yet this is not an issue limited to a single candidate or party, but rather a wide-reaching debate that crosses party lines. The outcome of this debate could have a significant impact on the future of many American companies.
We’re Talking Apples and Oranges, Not Symmetry
Proponents of eliminating the CIT deduction often point to the need to treat payments made to debt and equity investors equally under the tax code. However, the need to equally treat the taxation of equity and debt investments is a fallacy.
In a recent conversation with Robert Kibby from Munsch Hardt Kopf & Harr, he summed up the issue to me perfectly. Debt and equity are the apples and oranges of capital formation — they can’t and shouldn’t be treated the same, as they factor into company operations differently.
Debt and equity are fundamentally different; just ask your lender. As such, there is nothing inherently improper about treating interest expense differently than dividends for tax purposes. Moreover, interest is a return on capital while dividends can also be a return of capital. Understanding this important distinction highlights why “symmetry” in the tax code is not relevant to the conversation.
In the middle market, the first line of financing is often bank debt as equity financing can be expensive or hard to access. The ability to deduct interest expense on this debt makes it an obvious option for businesses to finance operations and capital investments.
Proponents claim that the deductibility of interest promotes the sustainability of corporate growth by making funding options attractive to companies. Detractors assert that interest deductibility provides a perverse tax incentive to incur debt to fund growth, which could lead to companies becoming overleveraged and risking bankruptcy.
Kibby also aptly noted in our conversation that a balance in the middle is perhaps what will best serve middle-market companies. A judicious use of debt is good, and it is much less expensive than equity. Eliminating the CIT deduction could encourage an overutilization of equity and actually reduce economic incentives to owners to produce successful middle-market businesses.
The Illusion of Neutrality
Most discussions about changing the CIT deduction are also coupled with the notion of being “revenue-neutral,” whereby other taxes would be adjusted so that total taxes paid would be roughly the same as under the current system. What is missing in this thinking is a recognition of the greater impact that eliminating the CIT deduction will have on corporate valuations.
“Revenue-neutral” is not the same as “impact-neutral” in terms of equity valuation or the impact it would have on economic growth in the middle market.
The Impact on Valuation
Beyond a “revenue-neutral” change, the reduction or elimination of interest expense deductibility will affect more than just a company’s cash flow. More importantly, it is likely to impact the value of a company.
Value is a function of three elements: cash flow, growth rate and the cost of capital. Let’s bring it back to basic financial principles.
This foundational equation should be a touchstone in educating the debate over the corporate tax deductibility of interest expense. Corporate interest deductibility impacts not only the available cash flow for a company (CF), but it also affects the cost of capital (k), and quite possibly growth rates (g). Eliminating the CIT deduction decreases valuation multiples by increasing the cost of capital, decreasing growth, or both. This will ultimately destroy equity value for companies even if eliminating the CIT deduction is “revenue-neutral.”
Dollars and Sense
Imagine if you woke up tomorrow morning and your portfolio was off by 6, 10, 12 or even 15 percent? That is the type of impact potential that could result from eliminating the CIT deduction. RGL Forensics, working in cooperation with the Association for Corporate Growth, recently completed a research study on valuation implications for the middle market assuming an elimination of the CIT deduction.
If the CIT deduction were eliminated with no offsetting benefits:
- This would lead to a 6.3 percent drop in equity value for middle-market enterprises (MMEs), destroying equity value of approximately $1.1 trillion.
- If even a 0.5 percent decrease in growth resulted, MMEs would lose equity value of 15.3 percent, translating to equity destruction of approximately $2.5 trillion.
This is not an issue that affects only the wealthy or major metropolitan centers. This issue is not limited by geography or by industry. The effect of eliminating the CIT deduction will be felt from Wall Street to Main Street, and everywhere in between.
A further aspect to consider is that a company’s valuation plays a critical role in determining its access to (and terms available) in the capital markets. An increased cost of capital, or reduced access to debt, could likely result in fewer growth projects or acquisitions being pursued. This not only impacts companies themselves but also the private equity investors and advisers who rely on deal flow.
By any measure, middle-market companies represent a vital core of the U.S. economy. Policy changes, such as eliminating the CIT deduction, that adversely impact this core segment should be evaluated closely and with full information. The warning flags have been raised. As the conversation in Washington continues, the bar needs to be set appropriately high in terms of devising changes to the tax system that provide substantial benefits to offset the negative impact that eliminating the CIT deduction would have on corporate valuations, growth and jobs in the important middle market.
There are behaviors embedded in the market based on the ability to deduct corporate interest expenses, which has been in practice since 1894. It is unlikely we can fully predict all of the ways that eliminating the CIT deduction would affect companies. Changes to the CIT deduction should not result in unintended consequence for American companies.
Matthew Morris is a partner in the Dallas office of RGL Forensics, and Managing Director of the firm’s broker-dealer, RGL Advisors LLC. He is a veteran investment banker with more than 15 years of experience advising corporate clients and shareholders in transactions. He specializes in the practical application of financial, economic and valuation principles to solve a variety of challenges for clients.
Analysis and findings presented here are results from a research study on the corporate interest tax (CIT) deductibility conducted by RGL Forensics, in cooperation with the Association for Corporate Growth. A copy of the study can be downloaded here.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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