Tax Bill’s Limitation in Interest Expense Deductibility Greatly Impacts Highly Leveraged Firms

The impact of the limitation in the deductibility of interest expense in the reconciled U.S. tax bill will be more severe for highly leveraged firms, according to a new report by Fitch Ratings.

The change in net income under the reconciled bill, which will be voted on likely later this week, should be neutral to slightly positive for issuers with leverage 5.0 times or below, analysts said. The bill would limit the deduction of interest to 30% of EBITDA until 2021, after which the limitation of deduction would apply to 30% of EBIT. The non-deductible portion of interest expense can be carried forward for five years, and would reduce the effects for issuers with growing EBITDA or who are reducing debt, Fitch said.

Fitch estimates, based on a sample of 575 leveraged loan and high-yield issuers, that 37% of issuers will lose a portion of their interest deductions under the EBITDA definition. Also, 27% would be unable to deduct 20% or more of their interest and 10% would be unable to deduct 50% or more.

If EBIT is at 30%, there’s a bigger hit with the limitation of interest deduction, Fitch said. Without that depreciation buffer, 64% of the Fitch sample would lose a portion of their interest deduction, while more than half would be unable to deduct 20% or more of their interest and 40% would be unable to deduct half or more.

“We believe the limitation on interest expense deduction is unlikely to have a significant effect on debt issuance (speculative grade and investment grade), both from a supply and demand viewpoint,” Fitch analysts said. “Demand for corporate debt, including leveraged finance products, will likely remain robust as investors continue to seek yield on their investments. This will provide attractive markets for issuers. Even with the limitation, the cost of debt (before any tax benefit) is typically well below the cost of equity and the limited corporate tax deduction on interest expense will provide an offset.”

– Nicholas Stern, managing editor

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