By Richard Rubin
Republicans looking to rewrite the U.S. tax code are taking aim
at one of the foundations of modern finance -- the deduction that
companies get for interest they pay on debt.
That deduction affects everyone from titans of Wall Street who
load up on junk bonds to pay for multibillion-dollar corporate
takeovers to wheat farmers in the Midwest looking to make ends meet
before harvest. Yet a House Republican proposal to eliminate the
deduction has gotten relatively little sustained public attention
or lobbying pressure.
Thanks in part to the deduction, the U.S. financial system is
heavily oriented toward debt, which is cheaper than equity
financing and widely accessible. In 2015, U.S. businesses paid in
all $1.3 trillion in gross interest, according to Commerce
Department data, equal in magnitude to the total economic output of
Australia.
Getting rid of the deduction for net interest expense, as House
Republicans propose, would alter finance. It also would generate
about $1.5 trillion in revenue for the government over a decade,
according to the Tax Foundation, allowing for investment breaks and
rate cuts elsewhere in the tax code.
The dollars at stake are even more than another controversial
proposal being pushed by House Republicans known as border
adjustment, which would tax imports and exempt exports. The border
adjustment plan has been under attack from retailers and Republican
senators, whose resistance has put it on the brink of failure. But
the idea of eliminating or limiting the interest deduction has
generated less vocal opposition, giving it a real chance of
passage, perhaps in a scaled-back form.
"The overall goal is to be pro-growth. What we're proposing is
to take the tax preference from the source of funds, borrowing, and
take that preference to the use of funds, business investment and
buildings, equipment, software, technology," Rep. Kevin Brady (R.,
Texas), the author of the plan, said at The Wall Street Journal CFO
network this month.
In a world with no interest deduction, debt-fueled leveraged
buyouts by private-equity titans could become more expensive to
finance and junk bonds less appealing. "That's not necessarily bad
for society," said David Beim, a retired finance professor at
Columbia University. "We have too much systemic financial risk in
our economy."
But for some debt-reliant businesses the interest deduction's
demise could be a significant blow. Crop growers who depend on
bridge loans to work through seasonal business fluctuations could
face higher tax bills for little benefit.
Andy Hill, who farms corn and soybeans on about 600 acres in
north-central Iowa, said he pays less than $10,000 a year in
interest on a line of credit between $100,000 and $200,000. That
loan helps him bridge gaps between his expenses and his income,
between when he needs to buy seed and fertilizer and when he sells
his crops.
"[Losing the ability to deduct interest] wouldn't put me in the
red by any stretch of the imagination, but it makes it very
debilitating as far as household income," said Mr. Hill, who added
that he has spoken to both of his senators and his House member
about the issue.
Midsize businesses may also get squeezed.
"The people that utilize debt, they utilize it because they
don't have the cash and they don't have the access to equity," said
Robert Moskovitz, chief financial officer of Leaf Commercial
Capital, which finances businesses' purchases of items like copiers
and telephone systems. "A dry cleaner in Des Moines, Iowa? Where is
he going to get equity? He can't do an IPO."
The idea behind the Republican plan is to pair the elimination
of this deduction together with immediate deductions for
investments in equipment and other long-lived assets. Party leaders
expect the capital write-offs would encourage more investment and
growth and greater worker productivity, but not the debt often
associated with it.
From an accounting standpoint, the tradeoff could hurt
companies' reported earnings because immediate expensing would just
shift the timing of deductions and the loss of the interest
deduction would be a permanent change.
Dennis Kelleher, chief financial officer of CF Industries
Holdings Inc., a fertilizer manufacturer, said at a conference in
May that the most important thing for the company would be a lower
corporate tax rate.
"I don't think that's a good thing," he said of repealing the
interest deduction. "I suspect that won't happen because it would
be rather destabilizing, just to the capital markets
generally."
Unlike border adjustment, the idea of accelerating investment
write-offs has broad support from conservative groups, such as the
National Taxpayers Union, and some support from Democrats,
including Jason Furman, who was President Barack Obama's chief
economist. It was a move in the opposite direction, toward longer
depreciation schedules, that helped doom a Republican tax plan in
2014.
The tax code treats equity financing more harshly than debt.
While interest is deductible, dividend payments typically aren't.
Corporate profits can thus be subject to two layers of tax -- once
at the business level and then when it goes to shareholders in the
form of a dividend.
That means the effective marginal tax rate on equity-financed
corporate investments is 34.5%, according to a report released by
the Treasury Department this year in the waning days of the Obama
administration. The corresponding rate for debt-financed investment
is negative 5%. That subsidy for corporate debt "potentially
creates a large tax-induced distortion in business decision
making," the report says.
But borrowing and deducting interest are deeply ingrained in
American corporate finance as a normal cost of doing business.
Dislodging the traditional practice will be challenging. Some firms
might look to borrow offshore instead to reap tax benefits
elsewhere.
"I don't even think people think about it much," said Robert
Pozen, a senior lecturer at MIT's Sloan School of Management. "It's
clear that they're going to finance it by debt if they have a big
acquisition or a big project."
Because so much is at stake for so many sectors, writing the law
could get messy. Mr. Brady said small businesses and utilities
could get exceptions or specialized rules, as would debt-financed
purchases of land, which wouldn't be eligible for immediate
investment write-offs.
The administration, including a president who proclaimed himself
the "king of debt," has been wary of repealing the interest
deduction but hasn't drawn a hard line. Treasury secretary Steven
Mnuchin has said his preference is to keep it. Resistance could
build among Republicans in Congress and among real-estate firms and
the agriculture industry, which have formed a coalition to fight
the proposal. Yet financial markets so far have registered little
reaction to the prospect of the interest deduction going away. One
reason: The tax change most likely would apply to new loans
only.
Junk-rated bonds, issued by companies that typically carry a
large amount of debt, have returned 4.6% this year -- better than
the 4.3% returns of investment-grade bonds, according to Bloomberg
Barclays data.
Without repealing the interest deduction, Republicans' hopes of
providing full and immediate deductions for capital investment are
dim. They probably wouldn't have enough money to offset the upfront
fiscal cost of accelerating all those deductions.
The plus for the GOP is that this issue is more familiar and
less black-and-white than the complex border adjustment plan.
Limits on interest and accelerated write-offs could be dialed to a
politically comfortable spot. If Republicans can't stomach full
repeal of the interest deduction and immediate write-offs, they
could try something short of that with, say, half of capital
expenses being deductible and half of interest being
deductible.
Andrea , head of global private investment research at Cambridge
Associates, which advises institutions that invest in private
equity, said the industry would survive a tax overhaul that removes
the interest deduction.
"The effects will reverberate for sure," especially among larger
firms that rely more on debt, she said. "But debt is still going to
be cheaper than equity, so I don't think it's going away."
--Sam Goldfarb contributed to this article.
(END) Dow Jones Newswires
June 25, 2017 07:14 ET (11:14 GMT)
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