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Fitch: US Tax Plan Reform Tougher for Highly Leveraged Firms.

New York: The impact of the limitation in the deductibility of interest expense in the U.S. tax bill will have a limited effect on the overall Leveraged Finance market and issuers after considering the effects of a lower corporate tax rate, expensing of capital expenditures and other amendments, according to Fitch Ratings. The impact of the deduction will be more severe on highly leveraged firms. The change in net income under the reconciled bill to be voted on later this week should be neutral to slightly positive for issuers with leverage 5.0x or below.

The reconciled bill calls for limiting the deduction of interest to 30% of EBITDA until 2021. After that, the limitation of the deduction would apply to 30% of EBIT, although we could expect pressure to continue using EBITDA over EBIT. The non-deductible portion of interest expense can be carried forward indefinitely, which could lessen the impact for issuers with growing EBITDA or who are reducing debt.

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

There is a bigger impact when the limitation of interest deduction is based on EBIT at 30%. Without the depreciation shield, 64% of the sample would lose a portion of their interest deduction. Furthermore, 56% would be unable to deduct 20% or more of their interest and 40% would be unable to deduct 50% or more of their interest.

A simplified analysis shows that a 5.0x levered issuer with a cost of debt of 6% would realize tax savings due to the corporate tax rate dropping to 21% from 35%. However, the impact turns negative at higher leveraged levels. Assuming a 7.0x levered issuer with a cost of debt of 8%, tax payments would increase and could result in tighter liquidity for smaller companies. These are simplistic assumptions that do not incorporate the current issuer effective tax rate or the impact from other amendments.

There are several considerations behind the new law: For example, EBITDA as defined under the tax code could be materially different than what is reported as adjusted EBITDA. For example, one-time restructuring costs that are "properly allocable to a trade or business" could be included in EBITDA, which may limit the interest deduction. Note the analysis above is not based on the tax code definition. Additionally, issuers that capitalize a substantial portion of interest may realize more favorable treatment. Also, as earnings fall in a slowing economy, issuers will lose a greater portion of the interest deduction as EBIT/EBITDA declines.

The change in tax carryback and carry forward provisions could exacerbate the impact of an economic slowdown for weaker credits. The reconciled bill will repeal the tax carryback provision and restrict tax carry forwards to 80% of taxable income. Therefore, tax refunds would be materially limited as issuers recover from an economic recession. During the last financial crisis, many firms, such as homebuilders and casinos, benefited greatly from tax refunds from utilizing the tax carryback provision from 2009-2011.

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. 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.

The limitation of interest deduction could also lessen the amount of leverage on loan issuance due to the reduced benefit of the interest tax shield. Finally, as the Fed hikes short-term rates, issuers may consider financing in the high-yield bond market over the leveraged loan market to lock in interest rates since rising interest expense on floating-rate debt may not be deductible.
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Publication:Daily the Pak Banker (Lahore, Pakistan)
Date:Mar 7, 2018
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