The new law changes that calculus. Whereas there used to be no limit on the amount of interest that could be deducted, from now on, a company can only deduct interest expense equal to 30 percent of its Ebitda, or earnings before interest, taxes, depreciation and amortization. (In 2022, the limit on tax deductibility of interest tightens further to 30 percent of Ebit, after depreciation and amortization are deducted.) According to the Congressional Joint Committee on Taxation, the first phase of the limit will raise $171 billion over 10 years, while the limit that begins in 2022 is estimated to raise $307 billion over the next 10 years. (It’s worth noting that the real estate industry somehow got itself exempted from these changes.)
All things being equal, the change in interest deductibility could affect how much buyout practitioners are willing to pay for companies. The cost of capital will now be higher, which in turn will affect the value of the company or business for sale.
What’s more, with the corporate tax rate lowered to 21 percent from 35 percent, the present value of the tax savings provided by the interest deduction will be less, too.
This is not good news for sellers. By some measures, the prices paid by private equity firms to sellers were at a record high in 2017 as was the level of debt used to finance those deals, according to LeveragedLoan.com. Given that the changes to interest deductibility will, in effect, increase the cost of borrowing for leveraged buyouts, it’s almost inevitable that prices paid to sellers will come down. (Where Congress’s sudden aversion to debt came from is not clear, but it also extended to mortgage interest. Thanks to the new law, homeowners are now only able to deduct interest on mortgages up to $750,000; the marginal interest paid on a larger mortgage will no longer be deductible.)
There are other changes as well that will affect the buyout business. Whereas in previous years, private equity partnerships could get lower long-term capital gains tax treatment after owning a company for only one year, the new tax law requires that buyout firms hold their companies for three years before getting the lower capital gains tax treatment. That shouldn’t be too onerous. It’s fair to say that most buyout firms do end up owning their companies for at least three years. (It could hurt hedge funds, though, which generally prefer shorter holding periods.)
The good news for buyout moguls is that Congress left alone their cherished loophole on carried interest, the percentage of an investment’s gains that a private equity partner takes as compensation. The provision allows that income to be taxed at the lower capital gains rates rather than at ordinary income rates. It’s that tax that favors capital over labor and that allows, say, Warren Buffett to pay a lower tax rate than his executive assistant does. The only change to the “carried interest treatment” for buyout firms under the new tax law is that companies have to be owned for three years instead of one.
The private equity industry, especially the bigger firms that like to use lots of leverage to goose their equity returns, cannot be happy about these changes to the tax code. Some analysts have taken note. “This change to the tax code will take a bite out of the bottom line of heavily leveraged Main Street companies owned by private equity firms and will reduce the incentives of these firms to overload the companies in their portfolios with debt,” observed Eileen Appelbaum, a senior economist at the Center for Economic and Policy Research. “This is a curious development considering the lobbying effort to defeat this provision and the large number of PE big shots in positions of influence in the Trump administration.”
But the industry’s lobbying arm is doing its best to put a good spin on the unexpected changes. In a statement, Mike Sommers, the president and chief executive of the American Investment Council, wrote me that it “commends Congress for its pro-growth, comprehensive tax law. Tax reform is challenging, and this new law requires some trade-offs from all sectors of the business community, including private equity. While we advocated against changes to the tax treatment of carried interest capital gains, we feel the three-year holding period will continue to support long-term investment. The new limitations to interest deductibility will impact all industries that need debt to help finance growth, but we are encouraged that the provision remains a part of the tax code.”
There will be unintended consequences of the new tax, that’s for sure; only time will tell how severe they will be.
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