[1]Most restructuring lawyers see “tax” and immediately run for help from specialists down the hallway or maybe at other firms. That’s the right thing to do, and we tax lawyers appreciate the job security. Still, there are a number of provisions that restructuring lawyers should be aware of in the once-in-a-generation tax reform bill signed by President Trump on Dec. 22, 2017.[2]
The Act generally reduces the tax payable by companies with good financial performance. The headline corporate tax rate was reduced from 35 percent to 21 percent, the corporate alternative minimum tax was eliminated, and a deduction (that happens to be incomprehensibly complex) was added that operates to reduce the tax rate for the income that flows out of some (but not all) entities that are subject to “flow-through” tax treatment.
Unfortunately, several of the Act’s “pay-fors” have the potential to significantly harm financially distressed companies.
The following discussion tries to give some color on how some of the Act’s key provisions might influence restructuring transactions on a going-forward basis.
Changes to NOL Rules
Under pre-Act law, net operating losses (NOLs) could be carried forward for 20 years, and carried back for two years to receive a refund of taxes that may have been paid in those years. That ability to carry back NOLs often served as a critical source of liquidity for companies that experienced sudden financial distress. The Act ignores 75 years of history and eliminates the ability to carry back NOLs generated in 2018 or later. We expect the elimination of the NOL carryback to inflict significant pain in the event of a market downturn of any significance.[3]
The Act also imposes an 80 percent limitation on the taxable income that can be offset by NOL carry-forwards that are generated in 2018 and later. Thus, if a company generates $100 of NOLs in 2018 and has $100 of income in 2019, the company can only offset $80 of income in 2019 and must pay $4.20 of tax (the remaining $20 of NOL is carried forward). This effectively imposes a 4.2 percent “minimum tax.” By comparison, under pre-Act law, there was, in effect, a 2 percent minimum tax under the now-repealed corporate AMT.
Debtors that are selling their assets or engaging in taxable “Bruno’s” exit structures will need to be particularly aware of this increase in the “minimum tax” from 2 to 4.2 percent.
Importantly, NOLs generated before 2018 are not subject to the 80 percent limitation, even though the Act eliminated the 2 percent minimum tax under the AMT. Thus, pre-2018 NOLs are more valuable than post-2018 NOLs. This increases the importance of equity trading orders and may increase the attractiveness of plans that seek to maximize the value of NOLs for a restructured company under IRC § 382(l)(5).[4]
Interest-Deductibility Limitations
The Act limits most companies’ ability to claim interest deductions to 30 percent of “adjusted taxable income,” which is roughly EBITDA (until 2022) or EBIT (in 2022 and later). As a result, a decline in a company’s financial condition will result in a reduction in its ability to claim interest deductions, and the company’s tax burden might not decline as much as anticipated. In fact, because there is no grandfathering for existing debt, this provision will cause many distressed companies’ tax burdens to increase in 2018 (and future years) compared to 2017.
Interest that is disallowed under this provision can be carried forward to subsequent years (subject to ownership-change rules under IRC § 382). But this potential future benefit is cold comfort to a financially distressed company paying taxes today.
These changes may make it beneficial to treat adequate-protection payments as payments of principal, rather than interest, where possible.[5] A debtor might not get a tax deduction for the payments if they are treated as interest, but if they are treated as principal, such payments would reduce the debtor’s eventual cancellation of indebtedness income.
Expensing
Under the Act, purchasers may write-off 100 percent of the purchase price of many tangible assets, rather than depreciating them over time. This tax benefit may increase the purchase price in asset-sale transactions and the attractiveness of “Bruno’s” transactions.
There are limitations to these provisions. They do not apply to various kinds of property (most notably, intangible property, oil, gas and mineral assets, and much real estate), so they are more valuable to some companies than others. Additionally, the debtor must consider the potential tax consequences of selling its assets in a taxable transaction (including the 4.2 percent minimum tax noted above). Still, expensing should be factored into emergence structure considerations.
International Tax Reform
The Act made significant changes to the international tax regime. Most of these changes are outside the scope of this brief summary. One key issue, though, is that DIP lenders and creditors negotiating adequate-protection packages may push back on the standard market practice of limiting foreign guarantees and pledges of the stock of foreign subsidiaries. These limitations are tax-driven and were designed to avoid “deemed” repatriation of foreign profits under IRC § 956. While IRC § 956 was not repealed by the Act, the negative U.S. tax consequences of IRC § 956 can be cured if the foreign subsidiaries actually repatriate cash (or, potentially, engage in other methods of self-help).[6] Debtors will need to evaluate whether self-help is actually possible and, if not, be prepared to push back against these requests.
Conclusion
This article barely scratches the surface of the Act. Many other provisions will be relevant to the tax considerations faced by debtors and their stakeholders. But the provisions discussed here represent what we believe are the critical issues that restructuring lawyers should be aware of.
[1] Anthony Sexton is a partner in the tax group of Kirkland & Ellis, LLP, where he focuses primarily on restructuring matters. He thanks his colleagues at Kirkland and Jay Crom of Bachecki, Crom & Co., LLP for reviewing this article. The article expresses the views of the author and does not represent the views of Kirkland or any of its clients.
[2] We refer to the tax reform bill as the “Act” throughout. References to the “IRC” are references to the Internal Revenue Code of 1986, as amended.
[3] The National Bankruptcy Conference submitted a letter to Congress that detailed these concerns. See National Bankruptcy Conference, NBC Letter re: Net Operating Loss (NOL) Deductions in Tax Cuts & Jobs Act of 2017 (Nov. 15, 2017), available at nbconf.org/our-work.
[4] We note that the Act does provide that NOLs generated in 2018 and later can be carried forward indefinitely, rather than limited to 20 years. Candidly, we do not view this as a meaningful benefit.
[5] In cases where secured creditors are oversecured, principal treatment cannot be supported from a tax or bankruptcy perspective. However, it should be possible to treat adequate-protection payments as principal payments without altering creditors’ recoveries where creditors are not oversecured.
[6] This is because actual repatriation (but not deemed repatriation) is now tax-free under the Act. There is no rational explanation for this outcome. Both the House and Senate versions of the Act repealed IRC § 956, but the enacted version did not.