The enactment of the Tax Cuts and Jobs Act (2017), also known as TCJA, introduced a number of changes to corporate income taxes, many of which are a net positive from a corporate perspective. In particular, the reduction in the statutory rate for (most) corporate businesses to a flat 21% will radically change reported earnings, especially in the short term, though some small businesses will actually experience a tax increase since the prior tiered brackets provided for a lower initial rate for small corporations.
However, one of the more pernicious aspects of the TCJA is the introduction of a limitation on the deduction of corporate interest expense. In our view, the details of the change and the potential impact on many businesses are underappreciated by many investors and have been largely lost due to the focus on the lower statutory tax rate. In this article, we discuss in broad terms some of the aspects of the new interest expense deduction limitation and the potential impact on a selection of companies which may face deductibility challenges – and therefore higher effective corporate income tax rates – in the near term as well as further out when the definition of adjusted taxable income against which the deductibility threshold if calculated changes in 2022.
Provisions Limiting Interest Expense Deductions
The TCJA, broadly speaking, introduced a limitation on the deductibility of corporate interest expense based on adjusted taxable income. Interest expense may be deducted from taxable income, provided the interest expense deduction does not exceed 30% of adjusted taxable income, which is initially defined as income before interest, taxes, depreciation, and amortization, or EBITDA, with a few additional adjustments. The additional adjustments will be relatively minor for most companies. The specific text is provided below:
Source: United States Congress
The specific definition of adjusted taxable income is provided below for reference, including the handful of additional inclusions and exclusions beyond a straight calculation of EBITDA:
Source: United States Congress
We refer to the maximum amount of interest expense which a company may deduct in any given taxable year as the deductibility threshold. In other words, for a company with EBITDA of $100 million, the deductibility threshold, ignoring any other small adjustments, would be $30 million.
However, note that the initial definition of adjusted taxable income changes beginning on January 1, 2022, after which the definition of adjusted taxable income becomes potentially significantly less beneficial by excluding depreciation and amortization expense. In effect, the limitation is calculated as 30% of earnings before interest and taxes (EBIT) beginning in 2022, further reducing the deduction threshold only a few years into the future. The change has the potential to significantly impact businesses with large depreciation and amortization expenses which, ironically, in many cases are the same companies which tend to rely disproportionately on debt to finance larger capital expenditures than less capital intense businesses. It’s possible this provision will be revised in the future as the full impact of this future adjustment (and the disproportionate impact on industries such as manufacturing) is felt in future years, but as the law currently stands, these provisions remain applicable.
Additional clarification was provided in the conference report on the reconciliation of the original tax proposals by Congress:
Source: United States Congress
Variable Effective Tax Rates
The introduction of the interest expense deduction limitation also introduces a new dynamic into corporate financial reporting by creating the possibility of highly volatile effective tax rates and, indeed, the possibility of effective tax rates exceeding 100% of reported net income.
Under the prior corporate tax structure, a company’s effective tax rate (barring unusual items) tended to be relatively consistent from period to period regardless of the company’s profitability. In other words, a domestic company with a relatively straightforward tax position could reasonably expect its effective income tax rate to approximate the statutory rate (adjusted for typical credits, etc.) from quarter to quarter even if profitability varied significantly between quarters. A company, such as Buckle (BKE), that reported an effective income tax rate of 37% in a quarter with $50 million of taxable income would likely report a similar effective tax rate of around 37% the following quarter even if taxable income fell to $15 million due to seasonality or other factors. The consistency added a level of predictability when projecting forward earnings.
The stability in period-to-period effective income tax rates will continue for many companies after the introduction of the limitation on corporate interest deductions. However, for a company subject to the deductibility limitation, the company’s effective tax rate can now vary dramatically from period to period (and year to year) as interest expense becomes non-deductible. In fact, a company’s effective income tax rate could exceed 100% of income after interest expense – and a company can even owe Federal income taxes despite being unprofitable after interest payments. This is a poorly understood aspect of the new structure for heavily indebted companies.
The possibility can be illustrated through a hypothetical example, but let’s consider an actual company facing this problem in the near future – highly leveraged vitamin and supplement retailer GNC (GNC). The company has struggled with declining revenues and profitability in the last two years in the face of a looming debt refinancing (most of which was spent on share repurchases during better times) that promised to significantly increase the company’s interest expense. The company’s prior average interest rate of around 4% was set to increase dramatically towards 10% in a refinancing, pushing interest expense over the company’s deductibility threshold. The following table uses the company’s projected EBITDA for the current year to estimate potential effective income tax rates under various refinancing interest rate scenarios:
Source: Proprietary Calculations
Clearly, the interest expense deduction limitation has the potential to severely impact the company’s effective income tax rate and, thus, its profitability and free cash flows. A refinancing rate over 9% eliminates essentially all of the benefit associated with a lower statutory corporate income tax rate as the effective income tax rate rises dramatically due to non-deductible interest expense. The effective rate accelerates as interest expense rises, and at 13%, the company will actually owe more in income taxes than reported net income after interest expense – an effective income tax rate over 100%. The company, in fact, recently refinanced the majority of its debt at a weighted average rate close to 10% such that we may soon find out how much of an impact the interest expense deduction limitation will have in the real world.
The issue becomes even more unfavorable in 2022, as mentioned before, when the definition of adjusted taxable income used in the calculation of the deduction limitation changes to exclude amortization and depreciation. The change will reduce GNC’s deductibility threshold by around an additional $18 million.
The secondary effect is that the limitation on deductibility of interest expense has the potential to negatively impact a company’s free cash flows, thus reducing a heavily indebted company’s ability to reduce debt and better manage interest expense. The original tax structure essentially subsidized interest expense by providing – so long as a company was profitable – a deduction of the full amount of interest expense against taxable income regardless of the level of operating income and other factors. However, since interest expense may now be limited, companies impacted by this provision are obligated to continue paying the interest but simultaneously lose the free cash flow benefit associated with the deduction against taxable income for interest expense which is no longer deductible. The additional cash expenditures may be converted into deferred tax assets to the extent a company believes that any interest expense not deductible in the current period will be deductible in future periods due to the carryforward provisions, but others will effectively lose the difference through valuation allowances against any such deferred tax assets. The decline in free cash flows – critical to any heavily indebted company – ironically accelerates as a percentage of free cash flows as more and more interest becomes non-deductible.
The alternate, as just referenced, is that companies may maintain a relative stable reported effective tax rate from period to period but will make up the difference by adding to deferred tax assets as the potential carryforward of currently non-deductible interest represents a potential actual deduction in the future. We address this aspect later in the article.
Penn National Gaming (PENN) is another company facing interest expense deductibility issues although, unlike GNC, Penn National’s situation is an original sin without any need for detrimental effects from variable interest rates or refinancing necessities. Instead, Penn National is impacted by a combination of debt load, rising interest rates, and marginal operating results which make it difficult for the company to achieve full interest deductibility. Indeed, the company’s results over the last few years have been, at best, choppy, and declined into the most recent year which aggravated the situation. Penn National’s challenge is compounded by the company’s high capital expenditure requirements for ongoing growth which limit (or eliminate) cash flows which may otherwise be available for debt reduction to mitigate the impact. In some sense, it’s debatable whether Penn National would reasonably be in a position to utilize any deferred tax assets associated with nondeductible interest expense carryforwards in the future, thus creating some doubt about the actual value of any associated deferred tax assets and possibly requiring valuation allowances. A summary of Penn National’s situation is provided below:
Source: Penn National Financial Reports and Proprietary Calculations
The statutory tax rate may fall to 21%, but the effective tax rate can quickly accelerate far beyond the statutory tax rate as interest becomes non-deductible.
The Shifting Threshold
In other cases, though, companies that may not be subject to the interest expense deductibility limitations in the initial four year period from 2018 to 2021 could find themselves in a less desirable position when the calculation of the deductibility threshold changes in 2022. Caterpillar (CAT), for example, will have a significant deductibility margin in the initial years although the company’s high depreciation and amortization expense will cause this to reverse in 2022. Of course, much will depend on the company’s actions and results of operations in the next several years, and the four-year “grace” period using the EBITDA figure (instead of EBIT) for calculating the deductibility threshold provides an opportunity for companies with sufficient cash flows and flexibility to adjust their capital structures and operating results to avoid non-deductible interest expense down the line. A summary of Caterpillar’s deductibility threshold is presented below:
Source: Caterpillar Financial Reports and Proprietary Calculations
AECOM (ACM), another company with significant depreciation and amortization expense relative to earnings before taxes and interest, will find itself in a similar situation to Caterpillar, as reflected in the following table:
Source: AECOM Financial Reports and Proprietary Calculations
AECOM’s $500 million in annual free cash flows, on the hand, compares rather favorably to the company’s $3.7 billion in long-term debt.
However, other companies, such as Owens Illinois (OI), a manufacturer of glass products, are not only much closer to the initial deductibility threshold but also in a much weaker position to address the impending change in the calculation of the interest expense deductibility limitation:
Source: Company Annual Report and Proprietary Calculations
Owens Illinois’s annual free cash flow of around $300 million is a small proportion of the company’s $5 billion in long-term debt, limiting the company’s ability to materially shift its capital structure before the definition of adjusted taxable income changes in 2022.
Owens Illinois also introduces an additional complication concerning the application and ultimate impact of the interest expense deduction limitations as the new corporate tax code also moves towards a more traditional territorial (versus global) tax structure. Owens Illinois is actually rather unprofitable from a domestic tax standpoint, as reflected in the disclosures in the company’s annual report:
Source: Owens Illinois Annual Report
The breakdown of operating profit by jurisdiction suggests that, among other things, a significant proportion of the company’s interest expense is allocated to U.S. operations in the calculation of taxable income:
A potential result is that, while the company could continue to report little or no taxable income in the United States, cash tax expenditures could rise significantly from their currently low level in the near future due to the interest expense deductibility limitation, further impacting cash flows:
Clearly, the calculations presented here are simplified and don’t account for several of the specific modifications provided for in the tax code or, in the case of companies with large international operations, the exact interplay between domestic and foreign operations from a tax perspective. The analysis of the impact of limitations on the deductibility of interest expense is, of course, subject to the particularities of individual companies and the interaction with other provisions in the revised tax code regarding tax deductibility of capital expenditures, etc. In some instances, the tax impacts are relatively easy to estimate, particularly for primarily domestic companies with relatively few specialized tax considerations. In other cases, particularly for companies with significant overseas income (especially relative to domestic income), companies with significant overseas debt, and/or unusual tax factors, the estimation of ultimate impact is somewhat harder determine with reasonable accuracy.
However, the examples nonetheless illustrate a new consideration for both companies and investors going forward – that earnings may be more significantly impacted in the future by effective income tax rates, capital structure, capital expenditure, and depreciation and amortization ratios relative to revenues and net income than has been the case in the past.
Rates and Refinancing
The impact of interest expense deduction limitations is not just applicable to those companies with an imminent exposure to non-deductible interest expense. Investors must also consider the impact on companies that may currently appear in a decent position under either definition of adjusted taxable income but face either rising variable interest rates on debt or impending refinancing of debt at what will likely be higher future interest rates.
Indeed, the potential for rising rates – whether due to variable rate debt or refinancing options in the future – may materially impact companies that would otherwise not have deductibility issues if only by limiting future financing options.
Sally Beauty Holdings (SBH) is a case in point for this scenario. The company will have no issues with interest expense deduction limitations in the initial years. The company’s $479 million in EBITDA (for 2017) would result in a deductibility threshold of $143.7 million, while interest expense for the coming year is expected to be closer to $93.1 million. The wide difference provides a significant amount of leeway for the company in the immediate future. However, once the definition of adjusted taxable income changes at the end of 2021, the company’s financial position shifts closer to the deductibility threshold. Sally Beauty will still be able to deduct all of its projected interest expense, but the margin between the deductibility threshold and interest expense will be much narrower and allow a far smaller margin for error.
Moreover, while the company’s debt is primarily fixed, a small portion is variable and all of the company’s debt matures shortly after the redefinition of adjusted taxable income in 2022 when applicable interest rates will be anyone’s guess (though likely higher than the present). Indeed, the interest margin between current year interest expense and the forward projection of the deductibility threshold would only require a 300 basis point increase in three-month LIBOR over the next three years to push the company’s interest expense over the deductibility threshold. A 300 basis point increase may appear on the upper end of reasonable outcomes, but it is not impossible.
Source: Company Financial Reports and Proprietary Calculations
Of course, reliably projecting a company’s EBITDA, EBIT, or capital structure four years into the future is something of a fool’s game. The same can be said for the applicable interest rates available at the time or, for that matter, the tax code. However, the company’s recent operating result trends haven’t been moving in a favorable direction. Sally Beauty presently has the time and financial resources available to begin addressing these issues, but it only serves to emphasize that forward risks remain well hidden for many companies.
A further open question is exactly how the interest expense deduction limitation will be accounted for in quarterly results, given the limitation in the tax code is based on an annual reporting period, especially for companies with highly seasonable or variable operations where quarterly results in one period can vary significantly from quarterly results in a subsequent period. A retailer or tax preparation business, for example, such as Macy’s (M) or Liberty Tax Service (TAX) which generate the majority of revenues and earnings in one quarter but losses (or very thin margins) in other periods will experience highly variable EBITDA measures from period to period.
Observers will also note, however, that non-deductible interest expense may be carried forward and used against future taxable income with certain limitations. The carry-forward provisions provide an opportunity for heavily indebted business to realize the tax deduction benefits eventually, but in some cases, especially with the change in the definition of adjusted income in 2022.
The answer to the issue of quarterly impacts therefore probably lies, at least in part, in the opportunity to carry forward non-deductible interest expense. However, this attribute introduces yet another risk for both companies and investors, the likely accrual of far more deferred tax assets on the books of far more companies and the resulting challenges associated with determining the value of these deferred tax assets.
Adjustments and Carryforwards
Indeed, it rather begs the question – what will the deferred tax assets ultimately be worth and, for heavily indebted companies, are we on the cusp of an explosion in these types of rather ethereal assets on corporate balance sheets?
The answer will inevitably vary from company to company, but regardless of the particularities, it nonetheless introduces an additional source of risk for investors. A retail company with significant seasonality may well be able to take advantage of deferred tax assets for nondeductible interest expense from prior quarters in the final quarter, but consider the event in which revenues and profits missed by a wide margin in the critical period. In other cases, such as Owens Illinois or Penn National Gaming, the deferred tax assets may be deferred for more than a decade, thus reducing their present value and resulting, as mentioned earlier, in valuation allowances. In a sense, the temporary differences may well become more permanent differences between book and tax accounting.
Our sense is that the probable increase in deferred tax assets on the books of companies subject to the interest expense deductibility limitations will require a fundamental adjustment to the analysis of balance sheets, income statements, cash flow statements, and the resulting ratios commonly used for determining the financial health of companies. In some cases, this adjustment may be insignificant, but it has the potential to be material for companies constantly dealing with deductibility limitations.
The introduction of limitations on the deduction of corporate interest expenses has the potential to materially impact a wide range of companies – not just those heavily indebted and facing imminent deductibility issues but also those companies with significant amounts of variable rate debt and/or maturity schedules that may place them at risk in the foreseeable future. In addition, companies with high levels of depreciation and amortization expense as a proportion of net income may be at risk once these income statement expenses are excluded from the limitation calculation.
Ultimately, the impact will, in part, be determined by the free cash flows of the respective companies and the degree to which – and speed at which – companies may be able to reduce debt and associated interest expense below the deductibility thresholds to mitigate higher effective income tax rates or the accumulation of deferred tax assets. A company such as Sally Beauty, which presently has significant free cash flows (especially as a percentage of outstanding debt), has the opportunity to materially reduce debt and interest expense to preserve full deductibility going forward, provided there are no significant changes in the underlying business. In other cases, such as Penn National, the ability of the company to generate significant free cash flows for debt reduction while maintaining current commitments and expansion plans is somewhat in doubt.
In addition, tying deductibility to an operating metric also amplifies the impact of changes in operating results on the bottom line. The change may ultimately make it more difficult for struggling companies to turn their operations around by draining critical cash from the business at the least opportune time.
The result is that the new interest expense deductibility limitations introduce a variety of new considerations for investors that either didn’t exist or were approached differently under the prior tax code. Our sense is that many investors are ill-prepared for the impact of interest expense deduction limitations and the ramifications this will have for heavily indebted companies on both an annual and quarterly basis. The period of adjustment, which may occasionally be painful, presents its own risks and opportunities.
Disclosure: I am/we are long SBH, M. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.