A perfect storm for some companies: Interest deductions down, interest rates up

Last year, the tax law further lowered the cap to 30% of profit before interest and tax, and prohibited companies from taking depreciation into account. For some companies, the move has reduced the amount of taxable income that can be offset against interest costs.

Under the 2022 changes, certain companies are now reducing their interest expense deductions. For example, a capital-intensive company has more assets and equipment than a typical company, and these assets typically depreciate over time due to depreciation. These companies borrow money to invest in production, but the change will make their ability to deduct related interest more limited.

At the same time, corporate cash flows are declining as the Federal Reserve (Fed) continues to raise the benchmark federal funds rate to combat inflation. Generally, as interest rates rise, interest expense associated with a company’s variable rate debt, new borrowings and refinancings increases.

central bank on wednesday Quarter point rate hikes It is in the 4.5% to 4.75% range, extending the fastest pace of rate hikes since the early 1980s.

Although not necessarily reflected in the financial statements due to differences in when the deduction is claimed, the cap can have an immediate impact on a company’s cash flow.

Compounding the impact of the tax change, some businesses are making lower profits than in previous years as they struggle to pass on increased costs to consumers. Companies are also dealing with increased taxes resulting from: Change in treatment of R&D expenses.

Interest deduction changes to Section 163(j) of the Internal Revenue Code were intended to ensure that the tax code would reduce the liability benefits of companies with substantial leverage. The change was also intended to raise funds to offset the reduction in the overall corporate tax rate from 35% to 21%.

Not being able to deduct as much interest as before is likely to become a greater burden as interest rates rise further, according to businesses and tax accountants. As more companies file their annual financial reports in the coming weeks, the full picture of the cash flow impact will become clearer.

“If you wear layers [the rate hikes and other headwinds] In addition to 163(j), we’re actually seeing a fair amount of pain, especially towards a potential recession,” said tax partner in the Federal Legislative Services Group at professional services firm KPMG LLP. Jennifer Acuna, a former Republican Congressional employee, said: He contributed to the drafting of the 2017 tax law.

Indeed, companies that exceed the interest deduction cap in a particular year can carry forward the excess expenses into later years. This means that the deduction may be delayed rather than denied.

Capital-intensive companies such as wood product manufacturers

Coppers Holdings Ltd.

Novelis, an aluminum manufacturer and recycler, faces higher interest expense due in part to higher than average depreciation and write-off rates. The U.S. Chamber of Commerce said in December that he wrote to members of Congress’ tax committee on behalf of more than 230 companies, revoking the changes and extending his 30% cap on EBITDA for at least four years. I asked you to

Congress failed to reach an agreement in its final session in December.Some Democrats want deduction requirements Expanding Enhanced Child Tax Credit.

Democrats and Republicans must work together to ensure companies aren’t penalized for investing in their businesses and employees, said Rep. Vern Buchanan (R. Florida) said. Methods and Means Committee.

Corporate response

Coppers is reviewing its capital allocation strategy, which includes the possibility of spending more money to pay down debt, chief financial officer Jimmy Sue Smith said. The company’s net debt is nearly 3.5 times her EBITDA, and she has a long-term goal of lowering it to twice her EBITDA, she said.

More than half of Coppers’ interest expense is non-deductible, Smith said, adding that almost all of it was deductible before the tax reform. The Pittsburgh-based company reports that interest expense for the quarter ended Sept. 30 was $11.4 million, up 12% from the year-ago quarter.

Smith said Congress should address the change as it discourages capital spending. “Higher interest impacts your cash, and if you have non-deductible expenses, your taxes will be higher,” says Smith. “Certainly, it doesn’t help in the broader context.”

Other companies are making moves to offset rising costs. Novelis plans to allocate less cash to its venture capital arm due to higher interest payments, said his CFO Dev Ahuja.An Atlanta-based company that is a subsidiary of an Indian aluminum producer

Hindalco Industries Ltd.

he said he expects to spend tens of millions of dollars a year to comply with tax requirements, but declined to provide specific figures.

“The timing couldn’t be worse,” Ahuja said, referring to the tax change amid the Fed’s rate hike cycle. The company will also be “more cautious” in capital spending, including efforts to expand production capacity, he said. The company reported capital spending of $174 million for the quarter ended Sept. 30, up from $93 million in the same period last year. Novelis said he plans to announce quarterly results on February 6th.

heavy debt burden

Indebted companies, especially those with leveraged loans, have also been hit hard by the tax changes. These companies are typically leveraged until their debt is highly speculative. Floating interest rates on leveraged loans typically reset every 1-3 months based on short-term interest rates. If interest rates rise, issuers of these loans could face a surge in interest expense.

Companies with speculative-grade credit ratings are likely to see interest expense rise 30% to 80% this year from levels before the Fed rate hikes began last March, depending on hedging strategies. said Scott Macklin.investment manager

AllianceBerstein Holding

LPs.

“These companies weren’t able to generate much free cash flow before the Fed hiked rates, but they are likely to burn cash when the Fed raises rates,” Macklin said.

In response to changes in tax law, companies are working to better manage their cash flows by restructuring their debt, said Mary Duffy, managing director of the U.S. tax division at tax firm Under-Sentax LLC. I’m here. “You can go back to your creditors and negotiate or try to take out additional lines of credit or additional funding,” Duffy said.

David Liebman, tax partner at law firm Skadden, Arps, Slate, Meagher & Fromm LLP, said companies might consider issuing preferred stock instead of increasing debt. However, preferred stock is usually less secure than bonds, and its holders have no creditor rights, which poses a problem in and of itself. These generally come at a higher cost, he said.

Business options may be limited as profitability declines in a weakening economy. “I don’t think 2023 will be better than 2022,” said Liebmann, referring to the impact of the tax change. “For many companies, it will be a more severe hit.”

—Richard Rubin contributed to this article.

write destination Mark Maurer Mark.Maurer@wsj.com