On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (TCJA) into law, significantly altering the U.S. tax landscape. The reform brought about the most substantial changes in corporate, international, and individual taxation in over 30 years. This article focuses on one of the key corporate tax changes: the limitation on tax deductions for interest expenses, particularly its impact on EBITDA deductions.
What is EBITDA?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It represents a company’s profit before accounting for interest expenses, taxes, depreciation, and amortization. EBITDA is commonly used to assess a company’s operational performance, providing a clearer picture of profitability by excluding financing and accounting decisions. It also plays an important role in determining eligibility for certain tax deductions on business expenses under U.S. tax law.
The State of EBITDA Before the Reform
Before the TCJA, business interest expenses could generally be deducted in the year they were paid, with limitations under Section 163(j). Section 163(j) of the Internal Revenue Code (IRC) limited interest expense deductions to 30% of EBITDA for most businesses. This limitation applied to interest paid to both related and unrelated parties and was particularly relevant for highly leveraged businesses. However, it mainly affected large corporations and was subject to certain exceptions and thresholds, including small business exemptions.
The Reform: A Shift in Interest Expense Deduction Rules
The TCJA introduced significant changes to Section 163(j), effective for tax years beginning after December 31, 2017. Under the reform, the interest expense deduction was limited to 30% of EBITDA for tax years 2018 through 2021. Beginning in 2022, this limitation was further tightened, applying to 30% of EBIT (Earnings Before Interest). This shift fundamentally altered the landscape for businesses with significant interest expenses, especially those in capital-intensive industries.
Who is Not Affected by the Reform?
The reform includes several exceptions and exemptions for specific businesses:
- Small businesses: The TCJA provides an exemption for businesses with average annual gross receipts of $25 million or less over the prior three tax years. If a business exceeds this threshold, the interest deduction limitation applies.
- Real estate and agriculture businesses: These businesses may elect to be exempt from the interest expense limitation by applying certain depreciation rules. This election allows them to continue deducting interest expenses as before.
- Interest expense on financial leverage for certain assets: Interest related to financing for cars, boats, or machinery held for sale or lease purposes is also exempt from the limitation.
What Does the Reform Determine?
The TCJA imposes the following restrictions for businesses exceeding the $25 million gross receipts threshold:
- Interest deductions are limited to 30% of EBITDA for 2018-2021, and 30% of EBIT from 2022 onwards.
- The reform applies only to net business interest expenses, meaning the surplus of interest expenses over interest income. Financing interest related to exempt assets is excluded from the limitation.
Additionally, businesses will now calculate taxable income with depreciation and amortization included, which could lead to greater taxable income for businesses with significant capital expenditures.
The Impact of the Reform on Leveraged Companies
The reform primarily affects larger, more highly leveraged businesses. Before the reform, many corporations with substantial debt loads could deduct interest expenses without limitation, reducing their taxable income significantly. Under the new rules, these businesses face higher tax liabilities as their interest deductions are capped.
Moreover, businesses experiencing cash flow difficulties may find it harder to service debt, especially if interest rates rise, further exacerbating their financial challenges. This can lead to increased risk of insolvency for businesses that were relying on the ability to deduct large interest payments.
Coping with the Reform: Strategies to Minimize Tax Liabilities
There are several strategies that businesses can use to mitigate the impact of the new limitations on interest expense deductions:
- Leverage Net Operating Losses (NOLs): Businesses can use NOLs to offset taxable income, though the TCJA limits this offset to 80% of taxable income (effective for tax years beginning after December 31, 2020).
- Refinancing and Debt Restructuring: Companies can review their debt structure and consider converting debt into equity or refinancing to reduce the interest burden. This can lower the total interest expenses and potentially allow for larger deductions under the new rules.
- Operational Improvements: Companies may seek ways to improve cash flow, such as increasing revenue, reducing operating costs, or divesting non-core assets. Improving EBITDA by increasing profits or reducing operational expenses can help mitigate the impact of the deduction limitation.
- Timing Deductions: Businesses can plan for future years by deferring interest expense deductions that exceed the limit in a given year. This can be beneficial if interest expenses in a future year are lower than the annual limit.
- Capital Structure Review: Assessing and possibly adjusting the capital structure (e.g., converting debt to equity or seeking alternative financing) can help reduce reliance on interest deductions.
Conclusion
While the TCJA’s changes to the interest expense deduction rules introduced complexities for many businesses, there are strategies available to minimize the impact. Business owners should conduct thorough reviews of their capital structures, operations, and tax positions, and consider working with tax professionals to navigate these changes effectively.
As always, staying informed about changes to the tax code and seeking professional advice are crucial to optimizing tax strategy and maintaining financial health.
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This should not be seen as legal advice. It is recommended to consult with the MasAmerica team of US tax experts in Israel before taking any action. Our service is provided by a professional team fluent in English and Hebrew, including lawyers and accountants with American licenses.
