The End of an Era for Interest Deductibility

Without deductibility of interest, as has been proposed, businesses will be forced to re-evaluate the structure of their capital and operations. There may be planning opportunities in advance of tax reform, however these opportunities will largely depend on the effect of transition rules. April 18, 2017
Eliminating the deductibility of net interest expense has a few advantages, such as eliminating a current distortion in favor of debt over equity financing. However, because deductibility of net interest expense has been a tenet of U.S. corporate taxation almost since its inception, eliminating net interest deductibility could cause serious real world consequences. For example, highly leveraged firms (especially private equity-backed companies) would need to reassess the modeling of their investments (limiting the traditional LBO model). In addition, the ability for multi-national enterprises to “earnings strip” would be eliminated. Businesses would be required to re-evaluate their capital structures because the debt on a company’s balance sheet would potentially become at least 35 percent more expensive. So debt capital markets and financings would likely be less active with issuers’ lower capacity to issue debt, notwithstanding the Blueprint’s proposal that interest would be subject to tax at the same rate as capital gains and dividends.

Both the Blueprint's and President Trump’s proposals are silent regarding transition rules for eliminating net interest deductibility. This presents a number of questions, including whether interest deductibility for outstanding debt will be “grandfathered” or whether there will be a transition period during which the interest in respect of outstanding debt will continue to be deductible. In addition, to the extent debt is grandfathered or pre-existing, it is unclear whether modifications or workouts in distressed situations will cause debt to no longer be grandfathered or deductible during a transition.

Notwithstanding the uncertainty, firms could be tempted to start issuing more long-term debt, just in case such instruments are grandfathered, and possibly to issue debt that includes rights for the issuer to redeem the debt before maturity if, as a result of tax reform, the interest accruing on the debt is no longer deductible. It is of course also uncertain, if grandfathering is available, whether such grandfathering could be subject to limitations.

Note that a “tax reform call option” in debt would not be unprecedented. In the 1990s, a number of corporations issued “100 year” debt that included a tax reform call option because, at the time the debt was issued, there were pending rule changes (never published or enacted) that would have eliminated the deductibility of interest accrued on such debt.