In December, President Trump and Republican members of Congress passed the most significant changes to the US tax system since the Reagan administration in 1986. While the changes are extensive and widespread, there are four key provisions that are likely to have the largest impact on the investment grade corporate credit market: 1) a reduction in corporate income tax rate, 2) a limitation on the deductibility of interest, 3) the expensing of capital expenditures and 4) the forced repatriation of untaxed foreign earnings.
Starting in 2018, US corporations will be subject to a flat corporate income tax rate of 21%, down from the top current tax rate of 35%. This reduction is projected to have a substantial impact on earnings, but will not necessarily immediately improve corporate leverage, which is calculated using earnings before taxes or EBTIDA. However, more after tax cash flow is certainly supportive of credit. A lower corporate tax rate also dilutes the tax shield on debt. As a result, there has been a material increase in liability management exercises with companies electing to take a loss on retiring high dollar priced bonds in 2017 when that loss is more valuable from a tax perspective. The lower tax rate is also causing companies to write-down their deferred tax assets. While these write-downs may result in a one-time earnings hit, they should not impact credit fundamentals.
The new tax bill also changes the rules regarding the deductibility of interest expense. Under the current law, interest expense is fully deductible. Under the new bill, deductions are disallowed for interest in excess of 30% of EBITDA. Starting in 2022, the rule becomes more restrictive as EBIT will be used instead of EBITDA to determine the allowable limit. Furthermore, there is no grandfathering of existing debt. This change should have limited implication on the investment grade credit market as a relatively small percentage of the investment grade universe has interest expense above the 30% limit. High yield companies may see more of an impact and debt-funded acquisitions such as leveraged buyouts may become less attractive. However, the negative effects will be partially offset by a lower tax rate discussed above.