What Lenders Need To Know About Tax Reform – Part 2

Banking and the Tax CUt and Jobs Act

In Part 1, we discussed how the Tax Cut and Jobs Act of 2017 is the perfect medium to allow bankers to carry on a high quality, “Trusted Advisor” conversation with commercial clients. We covered how pricing will impact credit quality and loan pricing while highlighting the importance and method to have a conversation around deposits, balance timing, earnings and cash flow. We also focused on the application of the “Pass-through Deductions” and not only gave bankers an easy algorithm to follow but covered how this could impact several types of commercial loans. We then ended the article with a video on how best to market around these tax reform changes. In this piece, we cover one of the most important aspects of the new tax legislation – interest deductibility. We also provide a prioritized list of industries to target and look at how to advise companies with international operations.


Interest Deductibility


Discussion Point: Interest Deductibility For Larger Customers – Bankers need to pay particular attention to their mid-market customers (businesses with over $25mm of revenue) that are leveraged as the limit on the deductibility of interest expense that is set at 30% of earnings before interest depreciation and amortization (EBITDA) for 2018 through 2021. Starting in 2022, depreciation and amortization are excluded from the calculation so bankers would just be looking at 30% of EBIT as the deductibility limit. Furthermore, the amount of net operating losses that can be carried forward and applied to offset pretax income declines from 100% to 80%.


Here is an example of how it could be applied:


Interest Deductibility Example


Banker Leadership: Here, bankers need to target their stressed and higher leveraged commercial customers to help them understand the general impact of how Tax Reform will impact their credit. On the one hand, you have the benefit of the lower tax rates and the ability to expense more depreciation. While on the other hand; companies might lose the ability to fully deduct interest expense.


Any leveraged customer where your bank is charging Prime + 2% is a candidate for being worse off under the new tax regime. We went through several bank portfolios, and our findings are that approximately 5% to 20% are going to be worse off and subject to a higher net tax liability. As a rule of thumb for bankers, if the company has low leverage, high capital expenditures, has a domestic focus and faced high corporate tax rates in 2017, they will be better off and will likely have lower credit risk going forward. Alternatively, borrowers that are leveraged, have large net operating loss carry-forwards, have historically had low capital expenditures, and faced low effective tax rates last year, will likely be worse off and face increasing credit risk.  

Bankers, when structuring debt, now need to understand how the cap plays into the calculations. Fixed rate debt will be preferred to floating rate debt due to the greater certainty. Higher future rates may increase the amount of limited interest just when the cap phases out the use of depreciation in the calculation.


Target Industries


Not all industries are treated the same. For bankers, it pays to have a working knowledge of the industry and target the higher effective tax paying industries first before other bankers have a chance to get to them. These industries will not only be the industries that undergo the largest credit improvement but will be the ones that increase profitability the most because of their improvement in credit, increase in cash balances and need for debt financing for a larger number of projects that now meet the lowered hurdle rates thanks to tax reform. While a sample of these industries is below, a list of more than a 100 industries and sub-industries complete with 2017 effective tax rates and effective cash tax rates, ranked in order of priority can be found in our Resource Center that banks can access for free (HERE). 


HIgh Tax Rate Industries


Discussion Point: Investment – Once a banker has a basic understanding if a firm is benefited or hurt by TCJA, they can then render some investment advice on both lending and cash management. Remember, theoretically, a business would want to invest in their business to the extent that the net present value of the investment is greater than zero net of risk. For the majority of companies described above, that will benefit from Tax Reform, the expense of taxes get reduced thus more investments become possible. To the extent this is true for a business, there will be more demand for debt and more of a definitive time horizon for a portion of a business’s cash balances. This makes advising on loans and deposits fairly straightforward, and bankers should be participating on helping their businesses decide on their best use of capital and then help them reverse engineer their need and term of debt before deciding where excess cash needed for the project should be invested.


However, before reaching those conclusions, bankers must calculate depreciation of any project as the new TCJA has a profound effect on a firm’s decisioning. Since depreciation essentially shelters income, speeding up depreciation allows firms to get more cash flow sooner thereby helping the net present value calculation of the project. Conversely, the longer it takes to depreciate the project, the more free cash flow gets out to the later years, and the lower the net present value will be. A longer depreciation cycle serves to discourage investments.


In a similar vein, bankers need to consider the interest expense and timing as it relates to any investment. While the maximum maturity and amortization of a loan will be set by a bank’s credit policy as it pertains to the project and its collateral, the timing of interest and depreciation needs to be taken into account to best help advice clients.


Since adding an asset, be it intellectual property, equipment or a building, increases a borrower’s debt capacity and increasing the rate of depreciation helps increase the profitability of a project, bankers need to understand the nuance that the ability to deduct interest expense also serves to shelter some income. Thus, when the TCJA limits the amount of interest deductions AND the corporate tax rate gets lowered, both serve to discourage some investments. What bankers obviously want is lower tax rates, generous depreciation deductions and full deduction of interest expense. This perfect scenario would increase the demand for debt the most. While close, this isn’t exactly what we got in TCJA.


Companies with International Operations


Discussion Point: International Operations – To the extent the bank customer has subsidiaries overseas, the TCJA dramatically shifts the calculation. Before, U.S. companies would first pay tax to the country where the revenue was produced and then if that tax is lower than the 35% U.S. rate, the company would effectively make up the difference IF the company wanted to bring the funds back to the U.S. As a result of this structure, U.S. firms hold an estimated $2T at their overseas subsidiaries as they wish to avoid the higher U.S. tax rate. Now, Tax Reform moves the U.S. to a “territorial system” where there will be no additional U.S. tax save for some notable exceptions. The TCJA allows for a one-time, repatriation of past earnings that are currently held as cash at a 15.5% tax rate. Other, less liquid assets such as overseas real estate or equipment can be declared and taxed at an 8% rate. Note that the foreign, non-liquid asset 8% tax would apply whether or not the assets were brought to the U.S. A company can elect to make a lump sum declaration or can opt to spread the tax liability out over up to eight annual installments.


Finally, the new tax law puts what is effectively a minimum, 10.5% tax on all foreign revenue above a “normal return” called the “global intangible low-taxed income” provision that is designed to keep U.S. companies locating assets to the lowest taxed countries. In a similar vein, there is also an effective 10% alternative calculation that is designed to stop the subsidiaries of U.S. companies charging a higher transfer price for good and materials being shipped to U.S. parent companies or subsidiaries.


Banker Leadership: Bankers should discuss with their customers that have overseas operations what their plans are both for repatriation and overseas investments. U.S. companies that are now able to bring cash back to the U.S. will need savings and investment ideas to the extent U.S. returns are greater than the overseas alternatives. In terms of new investments, U.S. firms must now decide whether to move current or future operations overseas or bring current overseas operations back to the U.S. The core of this planning revolves around the tax rates of where the sub is domiciled, the type of goods produced and the extent to which a good is produced overseas. In general, the lowering of the U.S. tax rate makes production in higher taxed countries such as Mexico less advantageous, makes Canada a close call, but now creates an incentive to move more production to lower-taxed areas such as Hong Kong.


Next Up


The takeaways for Part II are for bankers to be more relevant to their larger customers.  Lenders need the ability to understand and discuss interest deductibility, the big picture of tax-advantaged investment decisions and the decisioning around international operations.  Having a clear understanding of what industries will benefit the most from an effective tax reduction helps bankers better allocate their time and marketing resources. It is within this top group, where bankers are likely to earn the best return on their time.


In Part III, we will focus on how the TCJA impacts both equipment and real estate financing. Tax reform has far-reaching and positive consequences for real estate, so this is one area all bankers need to focus their advisory work. Also, we will also look at particular industries and lending segments such as agriculture and tax-exempt financing to help lenders better understand how the market will change.