Debt tax shield resurfaces in fiscal talks(2)

US firms are once again gearing up for a fight on the tax deductibility of interest paid on debt as Congress considers ways to afford a cut in the corporate tax rate.

The industry’s “life blood” is once again under threat as the US Congress considers limiting the deductibility of interest expenses.

Industry sources speaking to PE Manager have confirmed reports that Washington lawmakers are considering limiting the deductibility of interest on debt to produce a revenue neutral reduction in the corporate income tax rate. The interest write-off has been a key component of the private equity model, allowing dealmakers to supplement their capital firepower with tax advantageous leverage on target companies.   

Last year President Obama proposed a slash in the corporate tax rate from 35 percent to 28 percent in exchange for (undefined) limits to the deductibility of interest expenses. Subsequent legislation in Congress put a hard number on Obama’s proposal, lowering any interest deduction to 75 percent from the current 100 percent available offset on corporate taxes.

While that measure stalled in Congress, looming federal spending cuts forced by “sequestration” if Congress fails to act, a ballooning national debt and eagerness to cut the corporate tax rate to remain competitive on the world stage have kept the proposal alive. 

There is optimism, however, that the debt tax shield will remain fully intact. Questions surround the net economic benefit of a lower corporate tax rate brought by a reduction in the deductibility of interest expense. Assuming the above figures from the legislative proposal, a study conducted by Ernst & Young and backed by the Private Equity Growth Capital Council found that a company’s marginal effective tax rate (METR) would climb to 33.1 percent from 31 percent if the bill was passed.

The METR provides an estimate of the tax cost of a hypothetical marginal investment over its life. The METR can be viewed as measuring the additional economic income a marginal investment needs to earn to cover taxes over its lifetime, explained the study. 

“This significant increase in the METR indicates that business investment would decline in response to lower after-tax returns. The resulting lower level of investment would have the potential to impede rather than encourage economic growth,” the study said. 

The White House argues limiting interest deductibility would reduce the bias towards debt in businesses’ capital structures. The study countered that limiting the deductibility of interest to fund a lower corporate tax rate would increase the cost of capital for businesses.