On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act. The law has caused a tax revolution not seen in the United States in the past 30 years, creating extreme changes in the taxation of individuals, corporate taxation, and international taxation. In the article here before you, we will deal with one of the changes that have taken place in the field of corporate taxation, the limitation of the tax deduction on interest expenses, or in short, the effect on EBITDA deductions.
First, we will examine the situation before the reform, then, we will continue to examine the reform itself and its effects on the various companies, and finally, we will propose optional ways of coping with the change.
What is EBITDA?
The term EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, Amortizations, that is, the company’s profit before deducting interest expenses, taxes, depreciation, and amortization. This is a financial index that examines the company’s operating profit before the said deductions and amortization. The index is used for various purposes, but the American taxation method also uses it for the purpose of limiting / increasing the deduction of companies’ expenses.
The state of EBITDA before the reform
Prior to the change in the law under the reform, business interest expenses could be deducted in the year in which the interest was paid, excluding the exception to the rule that was established under section 163(J).
The exception to the rule specifying which interest expenses can be deducted was set in section 163(j). According to section 163(j), the deduction was limited to 50%. However, the exception referred to interest expenses paid to related companies, family members, or audited entities. Therefore, the effect of Section 163(j) was relatively insignificant and rather limited to a small number of circumstances.
EBITDA – The Reform
The reform in fact created a new exception that replaced the exception under Section 163 (J) and limited the deduction of interest expenses of businesses from taxable income to a threshold of only 30 percent, which is for the period between 2018-2021. Contrary to Section 163(J), this restriction is not limited to a situation in which interest expenses were paid to related companies or relatives. In this sense, the effect of the change is extensive.
Who is not affected by the reform?
The reform lists several exemptions from its implementation:
Small businesses that do not meet the “Gross Receipt Test”-
The reform provides for an exemption from limiting the tax deduction on small businesses that do not meet the “gross receipt test”. The test examines whether the company’s average annual gross receipts did not exceed $25 million over the past three years. If the company was founded less than three years ago, the average annual gross receipts of the duration of its existence will be checked.
If the company’s average exceeds $ 25 million, the reform will apply and the ability to deduct interest expenses will be limited. However, if the company’s average annual gross receipts are less than $ 25 million, the Company will be excluded from the implementation of the reform and will not be limited in its ability to deduct interest expenses.
Real estate and agriculture companies with a one-time exemption-
Some real estate and agriculture companies can choose to exempt themselves from the restriction. However, this choice will be accompanied by certain depreciation rules to which they will be obligated.
Interest expense on financial lever plans
Interest expense on financial lever programs, that is financing for the purchase of cars, boats, agricultural machinery held by the taxpayer for sale or lease purposes.
What does the reform determine?
If a company’s average gross receipts exceed $25 million, the reform will apply and the company will be examined under the criteria of the “ceiling test” set forth in Section 13301 of the law. The test limits the deduction of expenses given the following amounts:
- The company revenue from interest.
- 30% of the EBITDA rate, that is 30% of operating profit less interest, tax, depreciation, and amortization expenses.
- Interest in a financing program.
The 30% limit actually applies only to net business interest expense. That is the surplus of business interest expenses according to the company’s interest income, all in neutralizing the interest it is for financing plans as described above.
The 30% limit actually only applies to net business interest expenses. That is, the excess of interest expenses according to the company’s income from interest, all this without including interest used for the purposes of financing plans as described above. From 2022 the taxable income will include a deduction of depreciation and amortization, or in other words, income before taxes and interest.
The significance of the reform – the main casualties of large leveraged companies
The reform applies only to certain small businesses and leaves the largest and most leveraged companies exposed to greater tax liability. This is extremely significant due to the fact that before this law was changed when the unlimited deduction was possible, many companies used to pay paid minimum tax liabilities if any.
Now, after the reform, companies that are already at risk of over-leverage find themselves with greater tax liabilities. Moreover, when companies experience a cash flow shortage, they tend to take out more loans and under higher interest rates. Their EBITDA exceeds 30%, especially when recovering from the situation. This reform can make it difficult for such companies to recover and in fact lead to an ongoing struggle and sometimes to eventually lead to bankruptcy.
Coping methods – Is there a possibility of reducing tax liability despite limiting the deductions?
One way of coping with the reform is the use of net operating losses (NOL) to offset tax liabilities. The reform limits the offset to only 80% and does not allow the use of operating losses of previous years to offset the tax.
Another way of coping is conducting an organizational control check, which means conducting a full review of all assets, such as subsidiaries, business units, and intangible assets. As part of the review, it is necessary to examine the possibility of selling assets or increasing production in order to reduce the debts, and thus lead to a reduction in the interest expense rate.
In this context, it is also necessary to examine the company’s capital structure and examine the possibility of converting debt into capital in a way that will reduce the interest rate. Another aspect that requires examination is an attempt to create an operational improvement that will improve the state of the cash flow in the business and reduce the impact of the reform.
It should also be noted that there is a possibility of deferring the deduction of interest expenses that exceed the limit for the coming years in which interest expenses do not exceed 30 percent. Moreover, it is necessary to examine the possibility of optimizing the company’s operating profits, whether by selling assets, turning debts into capital, and reducing interest rates, etc.
Whatever way you choose to cope, if your company is exposed to the consequences of the reform, professional strategic advice is necessary.
MasAmerica experts are familiar with the various trade secret and coping strategies and will be happy to help you reduce tax liability and increase profits.
This should not be seen as legal advice. It is recommended to consult with Masamerica’s team before This should not be seen as legal advice. It is recommended to consult with the team of MasAmerica before any action. The service is provided by a professional team, who speak English and Hebrew fluently, and includes lawyers and accountants with American licensees.