Tax Reform's Deduction Limits See US Firms Eye Foreign M&A

One of the most sweeping tax reforms in generations was passed back in December, but it is still the talk of the town in the US as the media and businesses alike continue to dig into its wide-ranging implications.

Tax reform, as envisioned by President Trump and congressional Republicans, - which we previously discussed here - was designed as a shot in the arm to corporate America, but private equity firms are fretting about its impact on their ability to profitably invest in companies.

What does this mean for domestic acquisitions?

Mergers and acquisitions, leveraged buyouts and dividends are often funded, at least partially, with debt. Companies were previously unrestricted in the amount of interest they could deduct before tax, which helped the economic model for these debt-financed investments.

However, businesses now face a cap on these deductions equal to 30% of their 12-month earnings before interest, taxes, depreciation, and amortisation (EBITDA). After 2021, the limitation becomes more constrictive by switching to 30% of EBIT only - that is, the deductions for depreciation and amortisation are removed from the calculation, thus lowering the cap even further.

There is some flexibility; where a company didn't reach its cap in previous years, it can deduct interest payments above the 30% cap until it reaches the bridge amount. That bridge can roll on ad infinitum, too. But, as cash flow scenarios and interest rates fluctuate, interest expense deductibility caps will inevitably have an adverse impact on the expected returns of more highly leveraged deals.

In fact, Moody's Investors Services say results for around a third of all leveraged buyouts are expected to be worse off under the new system. This could discourage private equity firms from overburdening companies with debt, while eroding returns by forcing companies to hand over more cash as equity to fund acquisitions.

US companies turn to foreign M&A

Given that the limitations on these deductions only apply to domestic acquisitions, foreign businesses are becoming relatively easier to finance via debit, and therefore will likely be more attractive to acquire. Plus, the move to the participation exemption system means US corporations have a 100% deduction for dividends by a foreign controlled corporation, which could include a newly-acquired subsidiary.

This will be added fuel to the already emerging trend of US businesses looking abroad for growth and expansion. According to the...