Private equity firms get clarity on interest deduction limits

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Highly-leveraged companies can start calculating just how much the Republican tax law limits their interest deductions for debt, thanks to 439 pages of regulations released by the Internal Revenue Service on Monday.

The proposed rules provide guidance for a key provision in the 2017 tax overhaul that restricts the deductions businesses can take from the interest they pay on loans. Previously, those interest expenses were fully deductible. The IRS said the new limits apply to interest on traditional loans, as well as debt instruments and transactions that don’t take the official form of a loan, but have the same “substance.”

The regulations also move to block certain creative financing transactions companies may use to avoid the deduction limitation.

The law’s interest deduction change — and how the IRS implements it — is particularly critical for private equity deals, where the financing can involve large amounts of debt, said Eric Sloan, a partner at law firm Gibson, Dunn & Crutcher. Public corporations tend to be less leveraged than private equity portfolio companies.

The restriction on interest deductions was an attempt by Congress to equalize the treatment of debt and equity financing. The measure was included to offset large tax cuts in the law, including slashing the corporate rate to 21 percent from 35 percent.

Under the law, companies can deduct interest costs up to 30 percent of earnings before interest, tax, depreciation and amortization, or EBITDA, until 2022. After that the cap narrows to 30 percent of earnings before interest and taxes, or EBIT — since that number includes depreciation and amortization, it’s lower, making more companies subject to the limitation.

The change comes as businesses are increasingly leaning on leverage as a financing tool. Corporate debt levels have increased more than 82 percent to $6.2 trillion from $3.4 trillion in the past decade. There have been 451 leveraged buyouts so far this year, up from 340 five years ago, according to data compiled by Bloomberg.

The tax law is causing private equity funds to re-think how they finance deals. If earnings are low enough that the new limitation is triggered, funds may consider ditching debt in exchange for equity, even though that can dilute the value of the existing stake in the company.

The deduction change is expected to raise about $253.4 billion over a decade, according to estimates from the non-partisan congressional Joint Committee on Taxation.

The law provides exceptions for certain industries, including real estate, farms, car dealerships and businesses with less than $25 million in revenue.

Bloomberg News
Tax deductions Tax regulations Tax reform Private equity IRS