Making capital allocation decisions in light of US tax reform.
The Tax Cuts and Jobs Act (the Act) will have immediate and long-term implications on capital structure, capital allocation and performance measurement and forecasting. These implications are primarily driven by a much lower nominal corporate tax rate, changes to credits and deductions for businesses and individuals, and a modified territorial system for overseas earnings.
The following are answers to some of the top questions that finance executives should be considering.
How will the decrease in the corporate tax rate and limitation on the deductibility of interest expense affect our capital structure?
The decrease in the US corporate tax rate increases the effective cost of debt due to the lower tax benefit. Therefore, these provisions effectively make high levels of leverage less attractive, causing companies to reassess their optimal level of debt.
In addition to lowering the overall benefit amount, the Act’s provisions generally limit the deductibility of net interest expense to 30% of tax-based EBITDA (after 2021, deductibility will be based only on EBIT), effectively penalizing higher levels of leverage. Certain real estate businesses are generally exempt from these limitations, and certain farming businesses may also be exempt.
EY preliminarily estimates that the amount of debt held by public companies could decrease by as much as 25%. A number of factors — e.g., a company’s financial position, risk preference, company and industry attributes — drive a company’s optimal capital structure. Companies should also be aware of how peers’ capital structure changes could affect the competitive landscape.
- If you have a flexible capital structure, you may want to consider more aggressive actions to improve market position.
- Reassess how you price and structure investments or acquisitions.
Does the Act affect only US debt?
No, companies should re-evaluate their entire global financing structures. The effective limitations on high amounts of leverage in the US, combined with new provisions on the treatment of foreign income and dividends and the repatriation of foreign earnings, may change the effectiveness of current financing and organizational structures.
- Consider sources of funding through your global structure; you may have the potential for intercompany lending from the US or repaying external debt in the US while incurring debt directly at the foreign subsidiary level.
- Consider how the excess borrowing capacity of your foreign acquisitions could be utilized for intercompany lending.