Tax Policy Implications: Private Equity

January 12th, 2018

The new tax code is designed to spur business activity while eliminating certain accounting practices seen as loopholes. For private equity, new provisions are in effect for both the underlying companies and the funds themselves; it is of interest to note that the provisions also have different expiry dates. In general, the benefit from lower corporate tax rates should more than offset a new cap on the tax deductibility of interest expense. In addition, the ability to immediately expense capital expenditures may spur additional M&A activity. However, private equity sponsors may find it somewhat more difficult to compete with strategic acquirers, whose acquisition models rely more on consolidation than leverage while still receiving the benefit of the lower tax rates.

Changed Tax Provisions

First, corporate tax rates have been reduced from 35% to 21%, which should prove a significant benefit. This provision is a permanent change and does not have an expiration date.

Second, however, the cap on interest deductions is a negative. Starting in 2018, the cap is 30% of EBITDA—earnings before interest, taxes, depreciation, and amortization. In 2022, the cap will tighten to 30% of EBIT – earnings before interest and taxes but after depreciation and amortization. This cap negatively impacts returns to investors but may also favor strategic acquirers, who are able to take on less debt and realize synergies through cost cutting, over financial buyers.

Third, companies can now immediately expense capital expenditures for plant, property, and equipment. These expenditures are currently depreciated over the lifetime of the asset. The immediate expense is for 100% of the assets and is in place until 2022, when it begins to step down 20% per year. The ability to immediately expense may encourage additional M&A activity and business investments into capital-intensive industries like manufacturing.

Lastly, the structure of carrying back or forward net operating losses (NOL) has also changed. Under the old tax law, NOLs could be carried back two years and carried forward for twenty-five at 100%. However, the new tax law does not allow carry backs and while companies can now carry forward non-capital losses indefinitely, the NOL is capped at 80% of the original loss.

Additional tax provisions that affect private equity include changes to carried interest taxation, the pass-through income rule, and the elimination of the management fee deduction. However, we believe these would have very modest impact.

Comparison of Old and New Tax Provisions

The changes with the most immediate effect on business operations are the corporate tax cut and reduction in ability to deduct interest payments.

At current interest rates, the effect for private equity investors appears to be a modest net positive. The table below illustrates the impact of the tax changes on a typical private equity investment.

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