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In Senate bill, interest deduction cap could slow corporate loan market

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The Senate tax reform bill may be designed to benefit Corporate America, but there's little in it to cheer speculative-grade companies - or those who lend to them.

Risky companies with heavy debt loads typically pay little corporate tax, so they won't see as much benefit as more profitable companies of a 20% tax rate.

And, adding injury to insult, the bill passed after midnight on Friday would also cap the amount of interest expense they can deduct from their taxes to 30% of earnings.

Currently, many junk-rated firms are able to offset their corporate tax liability because all of the interest that they pay on their debt is deductible. Limiting the deduction to 30% could potentially offset any benefit of a lower tax rate, as well as some other goodies such as immediate expensing of capital costs.

In a letter to Senate leaders last week, a coalition of technology, health care and other other kinds of firms – including Dell Technologies, whose debt is the most widely held in U.S. CLOs – warned that the Senate’s version of the bill represented a $300 billion tax increase on corporate borrowers over the next decade.

Collateralized loan obligations, which are some of the biggest investors in the loans of speculative-grade companies, could also be impacted because of the likelihood that tax cuts could reduce the amounts of borrowing by speculative-grade rated companies as leveraged loans lose the tax advantage from uncapped deductibles.

On Saturday, Moody’s Investors Service said the Senate bill represented a potential negative credit even for CLOs, due to uncertainty of the impact on the loans pooled in their portfolios.

"Because speculative grade companies now pay relatively little taxes, the curbing of interest deductibility, as envisioned in the tax bills, could outweigh the benefits of the legislation for many obligors in the CLO market, a credit negative," said Jian Hu, a managing director, for Moody’s, in a statement issued Saturday.

In a Nov. 14 newsletter, the Loan Syndications & Trading Association cited Barclays research data showing that “lower tax rates tend to reduce corporate leverage, as debt becomes more expensive relative to equity.

“If one adds in a reduction in interest deductibility, debt may become still less attractive to many corporates,” the newsletter stated. “Thus, theoretically, the overall trend could be toward deleveraging.”

Barclays research has indicated that more than 32% of firms with corporate debt (including investment grade) have interest expenses that exceed the proposed cap of 30% of earnings.

Both the Senate bill and the House bill go easier on highly leveraged companies than the GOP's original 2016 plan to eliminate the deduction altogether, according to the LSTA. But in the Senate version, the 30% cap would go further than the House bill in expanding the amount of taxable income it uses to calculate the interest-rate deductible.

Rather than using earnings before interest, taxes, depreciation and amortization (EBITDA), as the House bill does, the Senate bill would require the use of a higher earnings figure in determining the interest deductible. The Senate bill's calculation would involve EBIT, or earnings without accounting for depreciation or amortization costs.

The Senate bill also delays lowering the corporate tax rate until 2019, which means companies would have their interest rate deduction lowered for an entire year before they would see any offset from a lower tax rate.

The LSTA also cited Barclays research showing more than 32% of highly leveraged companies have interest expense greater than 30% of EBITDA. Most of these are speculative-grade. “The question is,” the newsletter stated, “how big is that universe of companies and ... will their increase in taxable income be counterbalanced by lower corporate taxes and capex expensing?

Speculative-grade companies that were acquired by private equity companies may be among the hardest hit, according to the LSTA. That's because these companies tend to be among the most heavily indebted.

“LBO math – which was already difficult, considering high purchase price multiples, capped leverage and high equity contributions – might become more challenging,” the newsletter stated.

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Financial regulations Finance, investment and tax-related legislation CLOs CDOs Moody's Loan Syndications & Trading Association