Tax Reform and the Decision to Borrow

03.22.18

The Tax Cuts and Jobs Act Of 2017 Represents the Most Sweeping Overhaul of The Federal Tax Code in Three Decades. To Take Full Advantage of it, Some Companies May Want to Accelerate Their Capital Spending and Borrowing Plans.

The headline provision of the recently enacted Tax Cuts and Jobs Act is the reduction in the federal corporate tax rate to 21 percent from 35 percent. It’s a simple but powerful change that will benefit most companies by bolstering cash flow and profits.

The new law is brimming with other notable changes, though, including two with particular relevance for companies with significant capital expenditures and borrowing habits. The first grants a temporary authorization, beginning this year, to claim an immediate deduction for new investments in property and equipment. The second puts new limits on the deductibility of interest expenses. Many companies will want to undertake a nuanced analysis of their capital strategy to determine whether these changes should impact their spending and borrowing plans.

FULL EXPENSING: A POSSIBLE GREEN LIGHT FOR CAPITAL EXPENDITURES

Under previous tax law, companies could depreciate up to 50 percent of eligible new property—generally, property with a depreciable recovery period of 20 years or less—in the year it was acquired. Starting this year, companies can immediately depreciate the full amount of such property, provided the property was placed in service after September 27, 2017, and before January 1, 2023 (or one year later for certain property with long production periods). What’s more, this “bonus” depreciation schedule applies not just to new property but also to used property, as long the used property is “new” to the taxpayer claiming the deduction and is not acquired from a related party.

Importantly, though, this tax benefit is temporary. After 2022, bonus depreciation gradually begins to phase out over a five-year period, with the amount eligible for immediate deductibility decreasing by 20 percentage points each year (see Chart 1).

For companies that have been on the fence about whether it makes financial sense to invest in plant or equipment, this new but temporary option to expense it fully in the year of acquisition argues in favor of making that investment now—or at least within the next five years.

The decision becomes even easier for companies that believe the new tax law, perhaps augmented by cutbacks in business regulations, will boost the overall economy. Why? Stronger economic activity should lead to stronger demand from customers, which should help to justify investments in plant and equipment. If a stronger economy also translates into higher wages, and thus puts more money into consumers’ pockets, it could be especially helpful for companies whose sales and profits are directly dependent on retail customers.

M&A AND INDUSTRY CONSIDERATIONS

The latest changes to the tax code will impact some industries more than others. In the energy sector, for example, the ability to fully expense used property could make it more attractive for companies to acquire operating projects, including repowered projects—although any decisions to do so will have to take into account the full impact of the reduction in the marginal corporate tax rate. Some experts have estimated that the lower rate will raise the cost of renewable energy by 10 percent to 20 percent, a consequence both of the reduced value of tax deductions and possible increases in the after-tax cost of debt.

Elsewhere, companies in industries where used equipment often remains viable (even beyond its depreciation schedule) could find that it makes even more sense now to buy such equipment, including airplanes, railcars and industrial machines.

Regardless of what industry they operate in, some companies may want to reconsider how they handle merger and acquisition activity. Where feasible, they may find it advantageous to structure acquisitions as asset purchases rather than stock purchases. The more property their target has that qualifies for immediate expensing, the more attractive that approach might be.

A POSSIBLE CAVEAT: INTEREST EXPENSE LIMITATIONS

The new tax law makes decisions about investing in property or equipment slightly more complicated for highly leveraged companies than it is for competitors with less debt.

In the past, when all business interest was generally tax deductible, companies were effectively incentivized to favor debt over equity to fund everything from operations to capex to stock buybacks. For the next five years, however, starting with taxable years beginning after December 31, 2017, deductions for business interest will be capped for most companies at 30 percent of their adjusted taxable income, a tax-code metric that’s comparable to EBITDA—earnings before interest, taxes, depreciation and amortization. Then, for tax years beginning after December 31, 2021, the ability to deduct business interest will become even more limited as the definition of adjusted taxable income changes to earnings before interest and taxes, with no accommodation for depreciation and amortization.

For most investment grade companies and others with low levels of debt or that have sources of business interest income, these new caps will have little to no impact on their financial statements or tax bills. But for those that are highly leveraged, it will make borrowing of any kind less attractive. The caps could be particularly problematic for companies that fall on hard times and see their earnings decline, limiting their interest deductions at the very time their cash flows are most pressured. For these companies, any decisions to borrow—even to take advantage of the full and immediate expensing of capital expenditures—will need to be weighed against the impact of the new caps on deducting business interest.

Companies that do choose to go forward with new borrowing may want to consider how the economy is likely to perform under the revised tax code. If, as some economists anticipate, the economy accelerates, it could lead to higher rates of inflation and ultimately higher interest rates. Under that scenario, fixed-rate debt could prove more attractive than floating-rate debt.

A SECOND POSSIBLE CAVEAT: THE MUNICIPAL BOND MARKET AND INFRASTRUCTURE SPENDING

The Trump administration recently floated the idea of encouraging $1.5 trillion in infrastructure spending via $200 billion in incentives and investments from the federal government. Those investments would be made over a 10-year period, with state and local governments, and private industry, picking up the rest of the costs. Even if one accepts that plan as workable—and many economists question whether state and local governments could afford to play their role—it could face headwinds from the new tax law. This could impact decisions about investing in property or equipment based on the idea that infrastructure spending is about to take off.

Here’s the issue. State and local governments already fund the bulk of infrastructure programs, often raising the necessary capital through the sale of municipal bonds. Banks and insurance companies are big buyers of municipal bonds; they’re estimated to own nearly 30 percent of all municipal debt. Now that the top federal tax rate for corporations has been cut to 21 percent from 35 percent, however, the advantage to banks and insurers of owning municipal rather than taxable debt has narrowed. The only way this would change is if yields on municipal bonds increase, relative to yields on corporate bonds, to compensate for the new tax law. If that happens, though, it will drive up state and local borrowing costs, leaving less money to spend on infrastructure projects.

OUR VIEW

The changes embedded in the Tax Cuts and Jobs Act of 2017 should prompt many companies to revisit their capital spending and borrowing plans. While each company’s circumstances will be different, these general considerations should apply:

 

 

Overall, we see the Tax Cuts and Jobs Act as positive for most businesses in most industries. While limits on the deductibility of interest expense may hurt some borrowers, the temporary expansion of the bonus depreciation rules suggests this is an opportune time for many companies to accelerate their capital spending plans.

For additional insights from Prudential Capital Group on how your organization can take advantage of the new tax law, please contact us:

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1 “Tax Bill Modestly Reduces US Renewable Build Expectations,” Power and Renewables Insight, 12/22/17
This article does not constitute tax advice, and neither Prudential Capital Group nor its affiliates may provide tax advice. It is the responsibility of persons to which this article is directed to discuss their particular tax situation with their advisors.
 
This article was researched and written by Randy Myers, Independent Business and Financial Writer as of March 2018