Potential M&A Boom from Tax Cuts Hinges on Interest Deductions

  • United States
  • 09/27/2017
  • Bloomberg Law

By Laura Davison and Colleen Murphy

An uptick in mergers and acquisitions could result from steep tax cuts, but the size of a deal-making frenzy is dependent upon how aggressive lawmakers are in paying for those rate reductions.

“Rate reduction is a good thing for M&A, but how much of a good thing depends on what else is going on,” said Eric Sloan, a partner at Gibson, Dunn & Crutcher LLP who advises private equity firms.

House Republicans are scheduled to release a tax plan calling to cut the corporate rate to 20 percent and the passthrough rate to 25 percent, tax lobbyists told Bloomberg BNA. The lobbyists spoke on the condition of anonymity because the framework is not yet public. The plan, intended to generate support for tax legislation among rank-and-file members, will likely be vague about how the GOP plans to offset these tax cuts.

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The private equity industry, which relies heavily on debt to fund acquisitions, is closely watching how lawmakers decide to treat the deduction for interest expense, which will affect how profitable deals can be. House Ways and Means Committee Chairman Kevin Brady (R-Texas) has said the tax framework, set to be released this week, will address interest deductibility. A House GOP tax reform plan from 2016 suggested eliminating the tax break.

Permanently reducing corporate and passthrough rates to 20 percent and 25 percent, respectively, would require Republicans to agree on curtailing popular tax breaks, such as the mortgage interest deduction or the research and experimentation credit, indicating that the cuts could be limited to 10 years.

“This framework is walking the fine line of having enough detail to get rank-and-file Republican support,” said Marc Gerson, chair of Miller & Chevalier Chartered. “But at the same time it has to balance not having too much detail on the revenue offsets.” Specifics on tax breaks to be eliminated could rouse political opposition to the plan, he said.

Increased Demand

A 10-year corporate rate cut would likely increase the number of private equity deals and the price that people are willing to pay, Sloan said. But limiting or eliminating the deduction for interest expense could temper the appetite for acquisitions, he said. Within 10 years of reduced rates, private equity firms could complete about two deal cycles, which tend to last three to five years.

The prices that private equity firms have been willing to pay are already trending upward. U.S. leveraged-buyout firm Hellman & Friedman LLC this week agreed to acquire Nordic payments provider Nets A/S for 40 billion Danish kroner ($6.4 billion), including assumed net debt. The price is almost 15 times estimated earnings before interest, taxes, depreciation, and amortization.

Sharp reductions to the corporate rate could also increase the number of businesses interested in making an acquisition, or being acquired themselves, said Mel Schwarz, director of legislative affairs in Grant Thornton LLP’s Washington National Tax Office.

“Taxes are the biggest bite out of the profitability of companies, so anything to reduce cash expenses is good,” Sloan said.

Lawmakers and White House officials have been considering a rule that would tax 70 percent of passthrough income as wages and subject the remaining 30 percent to the special passthrough rate. Such a restriction would motivate many large, well-established S corporations to convert to a C corporation, Schwarz said.

Those companies could then be more open to making investments or being acquired since they wouldn’t be limited by S corporation rules that restrict the number and type of investors.

“S corps converting to C corps increases the universe of players of target or portfolio companies that will be more readily in play,” Schwarz said.

A 10-year rate cut doesn’t provide the certainty that a permanent change does, but some companies assume Congress won’t let rates increase back to the level they are now, he said. A two-year reduction wouldn’t generate much M&A activity, but 10 years should lead to an uptick, he said.

Inversion Disuasion

A 20 percent corporate rate is likely low enough that companies would reconsider inversions, international tax attorneys told Bloomberg BNA.

“I think people are going to say, ‘Wait a second, is it worth it?’” said Peter Connors, a tax partner at Orrick, Herrington & Sutcliffe LLP and a member of the Bloomberg BNA Tax Management Corporate Tax Advisory Board.

Connors pointed to the U.K. as an example of what the U.S. is up against as Republicans try to make the tax code more competitive. The U.K has a corporate rate of 19 percent, exempts foreign earnings, and doesn’t have a withholding tax on dividends.

Practitioners also said that while permanence is important for planning purposes, corporations may decide 10 years is sufficient—and lawmakers may decide to extend the cut rather than watch rates increase.

“There is a broad sense in recent years that the federal government isn’t able to withdraw benefits once extended,” said David R. Hardy, a tax partner at Osler, Hoskin & Harcourt LLP.

Some Republicans have said that no base erosion prevention measure is needed in a tax bill if the corporate rate is sufficiently low. Republicans initially planned to use the border adjustment provision—a 20 percent import tax—as an anti-base erosion measure.

“The lower you drive the rate, it takes pressure off those type of rules,” Gerson said. “I don’t know where the balance is of when the rate is low enough that the rules aren’t necessary.”

To contact the reporters on this story: Laura Davison in Washington at lDavison@bna.com; Colleen Murphy in Washington at cmurphy@bna.com

To contact the editor responsible for this story: Meg Shreve at mshreve@bna.com

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