Companies could find their borrowing costs going up because of a 2017 tax change taking effect this year that limits their net business interest expense deduction to 30% of earnings before interest and taxes (EBIT) rather than before interest, taxes, depreciation and amortization (EBITDA), a more generous measure.
The limitation is “designed to capture those [companies] that borrow money in what Congress felt was an excessive amount,” Kevin M. Jacobs, managing director of tax advisory firm Alvarez & Marsal Taxand, told CFO Dive.
The impact will be felt most by companies operating in highly leveraged, capital-intensive industries, like manufacturing, particularly startups, because debt tends to be key to their growth plans. The change can also impact calculations of companies doing a lot of acquisitions.
“It’s something we’ve had conversations with our clients about,” said Jacobs, a national tax practice leader with the firm. “The cost of borrowing is going to be greater. So, it raises the question of, what are the interest rates you’re paying? Do you need to have those borrowings?”
A second change taking effect impacts companies’ research and experimentation (R&E) calculations. Money spent on developing products can no longer be immediately deducted but must be capitalized and amortized over a handful of years, and the period over which that happens is tied to whether the work is done domestically or outside the United States.
Higher borrowing costs
Although accounting teams have had since 2017 to prepare for the change in the net business interest deduction calculation — it was enacted as part of the Tax Cuts & Jobs Act (TCJA) — it could catch some finance teams off guard.
“Many people were anticipating that the change was going to be delayed or not go into effect, and for many people it’s gone off of the radar,” said Jacobs.
At the time they debated the change, to Sec. 163(j) of the tax code, Congress received some push-back from tax specialists because it departed from how the deduction is generally applied.
“The limitation on interest generally focuses on EBITDA,” said Jacobs. “They were hoping there would be enough pressure [in the tax community] to force Congress to address this. You saw the ‘DA’ [the depreciation and amortization portion of EBITDA] movement starting in 2018. I remember people walking around in D.C. with shirts that said, ‘Save the DA.’ They’ve been trying to move this for a while. But now that it’s taking effect, you’re really not seeing anybody talk about it.”
In addition to tying the 30% interest expense deduction to EBIT, the interest that is disallowed is carried forward. For startups and other companies that are not yet bringing in much income, the extent to which they’ll be able to earn enough in future years to apply to the carried-over interest could be a high hurdle to pass.
“If my adjusted taxable income is $100 each year, I can only deduct $30 of interest,” said Jacobs. “If I’m paying $40 of interest each year, I’ll deduct $30 and $10 will be carried forward, such that, after 10 years, I have $100 of interest carried forward. I’ve already paid [that interest] out, so over the 10 years, I’ve paid $40 for 10 years, [or] $400. But over that 10 years, I’ve only deducted $300, so I have a carry-forward of $100.... It’s possible that you’ll never earn enough income to deduct that disallowed business interest expense. As companies continue to grow, they continue to borrow. That’s the capital structure.”
The switch from immediate deduction to the capitalization and amortization of R&E costs under Sec. 174 of the tax code is on Congress’ radar and could go away if the Biden Administration’s Build Back Better Act passes. A provision getting rid of the provision passed in the House version of the bill a few weeks ago and just needs to stay in any version the Senate passes to go away.
Should it not go away, though, company leadership would need to look at where their R&E work is being done. The point behind the change, which was also passed as part of TCJA, is to give companies an incentive to conduct their R&E in the U.S. Work that’s done domestically is amortized over a more favorable period, making it more attractive for companies to reshore that work.
“So, TCJA was trying to encourage the onshoring of research and experimentation,” he said.
But that reshoring isn’t cost-neutral, since moving that kind of work to U.S. facilities, with its different cost structures, would need to be modeled out to see if the costs stack up well against the more favorable tax treatment.
“Obviously [reshoring] brings added costs,” he said.
To get ahead of the change, accounting teams should modify their processes to track not just the money being spent on R&E but where it’s being spent geographically and also what’s being developed, because the provision includes changes to what qualifies as R&E.
“Under the new rules … you have to further subdivide expenses between geographic [considerations] as well as looking at things that were previously not treated as R&E,” he said. “So, for example, amounts paid in connection with development of software are now treated as R&E experimentation expenditures.”
Jacobs recommends finance leaders model out scenarios to determine, when it comes to software, whether it makes sense to develop applications in-house or buy something that already exists.
“If I create my own software, then I need to capitalize it and amortize it,” he said. “If I just buy the software, I get an immediate deduction. So, there’s a modeling exercise as far as the potential cost savings of making my own software vs. buying the software. But then, when figuring out that cost savings, you now need to factor in the tax cost, because you’ll get an immediate deduction if you buy it vs. making the software, [when] the cost will be amortized.”
Both the new 163(j) and the 174 changes should be on the radar screen of accounting teams when companies make their first-quarter estimated tax payment this year.
“If the law doesn’t change, they’re going to have to figure out the amount of the 174 deduction,” he said. “That means they’re going to have to capitalize and amortize. Just like for 163(j), they’re going to have to say, ‘Okay, my interest is limited based off of EBIT, not EBITDA.”