In general, the effects of the new tax law should be very favorable to most corporate borrowers. Nevertheless, there may be situations where a corporate borrower benefits economically from a lower tax rate and other favorable tax changes, but has an issue with its financial covenants, particularly in 2018.
The devil is in the details, of course; the new tax law is complicated and its effects will vary from company to company, so we limit this article to a view from 30,000 feet.
Leverage Ratio. The reduction in tax rates and immediate expensing of CAPEX in the U.S. will be a significant benefit to many companies because it will increase their cash flow by the amount that they are no longer paying the government in taxes. Unfortunately, this benefit may not be captured in a traditional leverage ratio which measures the ratio of outstanding debt to EBITDA. The borrower’s cash flow and financial strength will be increased substantially by these changes, but that change will not be reflected by an increase in EBITDA because the EBITDA calculation adds back taxes only to the extent that they have been deducted from earnings. Earnings are increased only to the extent that taxes are reduced, so there is no increase in EBITDA. The benefits to the company will not be reflected in the calculation of the covenant unless (and until) cash is used to reduce debt.
Some borrowers have negotiated a “net debt” concept in the leverage ratio, which permits the borrower to net the amount of cash on its balance sheet (typically subject to limitations) against its outstanding debt for purposes of calculating the leverage ratio. This would permit borrowers to benefit from the cash flow improvements resulting from the tax reform even though their EBITDA would not change. It should also be noted that credit agreements with a “net debt” concept typically apply a “haircut” to the amount of cash in foreign countries that a U.S. borrower may net, with the purpose of approximating the repatriation costs that would be associated with bringing such cash into the U.S. Borrowers and banks may now desire to revisit what kind of “haircut” the calculation applies to such cash.
Some credit agreements measure leverage as total debt-to-equity or total debt-to-total capital, in which case a write-down of a deferred tax asset or liability (as discussed below) also could skew measurement of the leverage ratio in the near term. Depending on the materiality of the write-down, an amendment or waiver may become necessary.
Fixed Charge Coverage Ratio. The reduction in tax rates should have a positive impact on a company’s fixed charge coverage ratio in years after 2018, if it is calculated as the ratio of earnings plus fixed charges to fixed charges. The reduction in tax rates will increase earnings, and so increase the numerator in that fraction, while also reducing taxes, and so decreasing the denominator in that fraction. The result may be different for 2018, however, if the company takes an earnings hit for write down of a significant deferred tax asset or payment of the repatriation tax. In contrast, borrowers with a fixed charge coverage ratio based on EBITDA, instead of earnings, will not benefit from an increased numerator in the calculation, since EBITDA is calculated before taxes, but will still benefit from a reduced denominator in the future as a result of lower fixed charges (e.g., taxes). If the definition of EBITDA in the credit agreement also adds back non-cash charges (relatively typical) and/or items that are non-recurring and/or unusual (less typical, but present in some credit agreements), this may mitigate the adverse impact to the borrower under its fixed charge coverage ratio associated with a write-down of any deferred tax asset and/or payment of a repatriation tax.
Borrowers may request a couple of mitigating changes in connection with their fixed charge coverage ratios: (i) give pro forma effect to the tax reform (this would be particularly beneficial for trailing four-quarter periods that cover periods prior to implementation of the tax reform), and/or (ii) eliminate the effect of the one-time charges and/or payments associated with the tax reform, based on the argument that this ratio should measure the borrower’s continuing operations without regard to such unusual and/or non-recurring items.
Distortions in 2018. Deferred tax assets. The enactment of the new statute may require a significant write down of deferred tax assets on a company’s balance sheet. Such a write down would have an adverse effect on financial covenants based on EBITDA (unless the credit agreement’s definition of EBITDA excludes write downs of assets or non-cash items generally), including both the leverage ratio and the fixed charge coverage ratio, because the write down would reduce earnings for purposes of the calculation of EBITDA.
Banks may see a lot of waiver requests to address this issue. Borrowers will argue that the deferred tax asset had little value because it could not be sold separately, that the write down does not affect their cash flow, and that they should not be penalized for a reduction in tax rates which will have the net effect of increasing their earnings and cash flow for years to come.
Deferred tax liabilities. reduction in deferred tax liabilities may be more substantive than a write down of deferred tax assets, because there is arguably more certainty to future tax liabilities than to future tax benefits.
Repatriation tax. Payment of the repatriation tax on earnings held abroad will reduce both earnings and cash flow.
Repatriation of cash. The repatriation of large amounts of cash currently held abroad will increase the domestic cash flow of many companies, but will not increase earnings or EBITDA. But it may be used in part to reduce debt for purposes of the leverage ratio. Some large banks have expressed concern that they will lose foreign deposits because the cash of their corporate customers will no longer be trapped overseas, and will lose outstandings under domestic credit facilities because the repatriated cash can be used to pay down debt.
The Cap on the Interest Deduction
The Act caps the business interest deduction to approximately 30% of EBITDA from 2018 to 2021, and approximately 30% of EBIT thereafter. There is no grandfathering of existing debt, but there are exemptions for companies with average annual gross receipts of $25 million or less for the three preceding taxable years, and certain other businesses.
The calculations are based on the tax concept of “adjusted taxable income” which may not be the same as EBIT or EBITDA under GAAP. The differences may be significant if there are large differences between book and tax. The difference may complicate financial modeling by banks and private equity investors who are contemplating leveraged acquisitions.
This issue is clearly more important for highly leveraged borrowers. It may encourage some companies to reduce their leverage, to increase their use of leasing and other non-debt financing, to finance through foreign subsidiaries, or to favor convertible bonds or other funding sources with lower interest rates.
Pledging Stock of Foreign Subsidiaries
Surprisingly, the Act did not repeal section 956 of the Internal Revenue Code, so it will sometimes still be necessary to limit the pledge of stock of foreign subsidiaries to 65% of the outstanding voting stock.
The Act eliminates the carry back of net operating losses. This eliminates what has in the past been a significant source of cash for troubled companies, which have sometimes been able to obtain large refunds of taxes paid in previous years by carrying back current losses.
Loan agreements entered into with borrowers which are limited liability companies, Subchapter S corporations, or other pass-through entities often permit the borrower to pay tax distributions computed at the highest individual tax rates imposed by the federal government and the relevant states. The result under the new law may be to permit distributions far in excess of the individual’s actual tax liability, given the new 20% deduction for income from qualified pass-through entities. Query whether these clauses will be revised in the future to reflect the 20% deduction.