The Effect of Tax Reform on Capital Markets Transactions

Transcription

1 International Tax Institute January 16, 2018 The Effect of Tax Reform on Capital Markets Transactions Will Dixon, Citigroup Global Markets Inc. Erika W. Nijenhuis, Cleary Gottlieb Steen & Hamilton LLP Elena Romanova, Latham & Watkins LLP

2 Agenda Introduction Political landscape and policy issues Reducing the impact of the thin cap and BEAT rules Credit agreements Investor-side issues (section 451(b)) Disclosure and valuation issues 1

3 Political Landscape and Policy Knock-on effects of partisan process of enactment Prospects for corrections to bill? Or substantial revision when political power shifts? Greater substantive uncertainty due to rushed legislative process and relative lack of regulatory authority? Do these lead to envelope-pushing or greater caution? How will companies carry out long-term planning? Reactions by other countries Tax war between the U.S. and E.U.? Or other countries (China)? Responses in kind (overreaching, arbitrary, punitive rules)? 2

4 Reducing the impact of the thin cap rule (section 163(j)) and BEAT (section 59A) 3

5 Investment Grade Issuers Thin cap rules may not affect investment grade issuers in near term. But may be caught starting 2022, because of EBIT as base (earnings minus depreciation/amortization). Example: Incentive to accelerate investments into pre-2022 years (pre-ebit) 4

6 EBIT(DA) vs ATI Are analysts properly taking into account the differences between EBIT(DA) and adjusted taxable income? Consolidation GAAP Worldwide earnings Treatment of non-wholly owned subsidiaries Tax US group (+ foreign entities checked open). Or maybe subgroups? Consolidated return threshold Depreciation Slower Faster Stock-based compensation Deduct at time of grant Deduct when exercised, or later (later timing, higher amounts) Tax-exempt income Included in earnings Not included Portfolio investments, derivatives Marked to market, unless hedge accounting Generally realization method 5

7 More on Investment Grade Issuers May have an incentive to borrow to fund investment in CFC equity or have CFC borrow to fund dividends, since dividends are tax-free from a U.S. perspective. Need to consider foreign tax and non-tax law implications Tax call redemption for hybrid debt and other long-term debt? May depend on the language of the particular provision and on the ability of the issuer to establish that the limitation applies now or in the near term. Is interest non-deductible in indefinite carryforward world? Effect of M&A transactions should be taken into account. Acquisition of highly leveraged target, or sale of low-leverage/steady-earnings business, may cause thin cap to apply 6

8 Highly Leveraged Issuers For highly leveraged companies, including inverted companies, recently acquired (or refinanced) U.S. targets and private equity portfolio companies, the thin cap rule may be significant. Cost of lost deduction is lower (21+% instead of 35%) some offset The effect of the thin cap rules is magnified if earnings are low or volatile Inverted companies may also have used hybrid debt now non-deductible Additional considerations apply to investment vehicles Need to determine whether interest expense is business or investment expense Need to think about the application of the thin cap rule to partnerships, especially tiered partnerships. 7

9 Strategies for Highly Leveraged Issuers There are various strategies for dealing with the new limitation. 1. Pay down or redeem outstanding debt 2. Internal restructuring 3. Change the type of debt/financing 4. Hedging strategies 8

10 Pay down or redeem outstanding debt Repatriation cash can be used to pay down existing debt and/or be used to fund operations directly. Redemption or exchange offer for excess or high coupon debt? But repurchase premium = interest expense, so just accelerating interest expense into transaction year. May still be worth doing because of lower cap (EBIT) starting

11 Internal restructuring U.S. multinational: push debt to offshore affiliates (possibly with U.S. guarantee). Need to consider whether interest expense deduction can be used offshore. Debt push-down can trigger foreign withholding tax costs. Foreign multinational: if BEAT is a concern for U.S. subsidiaries, U.S. subsidiary can issue debt to third parties with foreign guarantee. Possible Plantation Patterns issues. Revival of bank letters under old section 965? Issue debt out of non-consolidated subsidiary with steady earnings? Check the box on foreign affiliate? Brings earnings into adjusted taxable income. But lose interest expense deduction if foreign affiliate is lender to U.S. group unless foreign affiliate also has borrowings. May be more useful to address BEAT concerns. 10

12 Leasing transactions Convertible debt Change the type of debt/financing May be more attractive relative to high-yield debt Trade-off between coupon and conversion premium Fewer call spreads? Changes to terms of call spreads? Short-term debt May not be a satisfactory solution, because of different commercial consequences. 11

13 Hedging strategies Use of swaps to hedge interest rates ( selective integration ) 1) Fixed swapped to floating: if integrate transaction synthetic debt instrument and lower interest expense 2) Floating swapped to fixed hedge but don t integrate. Query: interest equivalent expense? IRS authority to recharacterize as interest? Interest defined as such; no regulatory authority to expand definition. The absent of regulatory authority implies that one could synthetically reduce interest expense without recharacterization. Your mileage may vary. Legislative action might address this if it becomes a popular strategy. 12

14 Credit Agreements 13

15 Credit Agreements: Section 956 Retained U.S. borrowers rarely benefit from collateral support or guarantees from foreign subsidiaries because of deemed dividend under section 956 Standard credit agreements prohibit guarantees from CFCs and restrict pledges of stock of CFCs and CFC holding companies Lenders often ignore foreign subs earnings/assets in modeling credit Now have a full deduction for actual dividends why keep section 956? Certain dividends from foreign corporations now are exempt from US tax There was an expectation of repeal of section 956, at least for corporations Some existing credit agreements have provisions for springing guarantees and collateral adjustments to become effective if section 956 is repealed But section 956 remained. Why? Trap for the unwary? 14

16 Credit Agreements: Section 956 Reach Expanded Section 956 may become relevant to more borrowers, as new rules create more CFCs Definition of U.S. Shareholder now includes at least 10% vote or value (effective 2018) New downward attribution rules for purposes of CFC status turns a foreign sibling of a US sub of a foreign parent into a CFC (effective 2017) Who may be affected: U.S. subs of foreign parented groups owning at least 10% of stock directly in the CFC sibling Investors with no vote, but with at least 10% value of foreign parent (but based on legislative history unclear if meant to apply in this situation) 15

17 Credit Agreements: Expanded Scope for 956 (2) FP 100% Lender US Sub >10% value 100% vote Guarantee F Sub 16

18 Credit Agreements: Expanded Scope for 956 (3) US Person >10% by vote or value FP Lender US Sub F Sub * based on legislative history unclear if section 956 was meant to apply in this situation Guarantee 17

19 Credit Agreements: Does Section 956 Matter? For borrowers who don t need additional credit support, business as usual; borrowers that may benefit from guarantee may have more flexibility Technically, deemed dividend taxed at 21% (with FTC) while actual dividends would be US tax free Traditional planning opportunities if there is sufficient previously taxed income ( PTI ) CFC provides guarantee only up to the amount of PTI? Section 965 (transition tax) will transform E&P into PTI as of end of 2017 (for calendar year CFCs), even if US parent defers the transition tax Global Intangible Low Taxed Income ( GILTI ) also would produce PTI, but unclear if section 956 (applied after 965 and Subpart F) applies after GILTI What about post-repatriation earnings? Can you distribute all earnings annually (distributions apply before section 956) as tax-free dividend? Cash sweep vs. non-cash dividend distributions 18

20 Credit Agreements: Lenders to US borrowers Foreign DRD availability lenders may now price foreign cash flows and assets of the borrower s foreign affiliates in evaluating credit Lenders may push for expanded credit support from CFCs if an accepted way of managing 956 emerges But U.S. borrowers in foreign parent group may now need to avoid foreign sister guarantees if there are inclusion US shareholders Lenders may ask for and US borrowers may be more receptive to commit to repatriate cash periodically from foreign subs, subject to local tax and other considerations Are formal agreements to sweep cash from subsidiaries or otherwise provide cash a form of credit support that may implicated 956? US parent may want to push debt into CFCs and lenders may try to limit and have higher permissions for debt in foreign subs lower foreign earnings due to higher interest expense? 19

21 Credit Agreements: Lenders to Non-US Groups Foreign parented groups with US operations may use more US/non-US co-borrower structures Both notes and credit agreements may be directly with the ultimate user of the funds and less on-lending Interest expense paid to a foreign affiliate can be limited by 30% cap, plus could trigger (and be subject to) BEAT Debt allocation management and collateral allocation management (CAM/DAM) agreements may be more common Foreign parented groups now may be subject to CFC rules even if the US subs had no voting stock in foreign siblings Need to immediately evaluate existing collateral package for US borrower: issues if there are sibling guarantees and there are existing inclusion US shareholders (CFC status retroactive to 2017) Unclear if there is flexibility under existing contracts to adjust collateral package Sophisticated PE funds appear to be set up to avoid 10% U.S. shareholders 20

22 Credit Agreements: Tax Distributions For borrowers set up as pass-throughs, usually restrict payment covenants distributions to their equityholders to pay income tax liability Calculated based on rough justice combined effective rate of highest individual rate (formerly 39.6%) and top NY or CA state tax rate, close to 50% Viewed as equivalent to entity-level taxes if borrower were a corporation and paying tax at 35% federal rate, plus state rate The increased difference between corporate and individual tax rate shines the light on tax distributions: Delta more than 14% (state and local taxes mostly nondeductible for individuals) Reduced pass-through rate? Can that be used? Transition tax may be deferred, but the inclusion may still permit distribution What will happen when the payment of 2017 taxes (including Transition tax) will become due? Estimated taxes? 21

23 Investors (section 451(b)) 22

24 451(b): Possible Applications to Debt Instruments Possible circumstances where 451(b) would apply Mandatory mark to market OID accruals: general rules, election to accrue, section 1272(a)(6) De minimis OID Market discount, bond premium, acquisition premium Complex VRDIs, CPDIs Puts, calls, redemption rights Interest rate adjustments: registration rights, gross-up, ratings-linked Foreign currency-denominated debt Convertibles and other hybrids Debt modifications: 1001 event but no comparable accounting event History of all events test as applied to debt Capital One and interchange fees Evolving market practice 23

25 Valuation and Disclosure 24

26 Valuation Many new and complex rules for investors and other market participants to digest, including the interaction of the new rules with the old rules Valuation, liquidity, capital structure, business model, etc. Valuation orthodoxy is one key component to M&A activity Several new rules potentially affect valuation, most notably: Lower corporate tax rate / 100% DRD for 245A dividends Interest expense limitation New rules on taxing foreign profits (GILTI) / BEAT New limitations on NOL usage Key one-time or short-term rules: One-time repatriation/transition tax Full expensing of tangible depreciable property in the U.S. (new or purchased) 25

27 Valuation Substantial noise and one-time announcements likely in company disclosure Companies are in the process of describing relevance of tax reform to investors SEC guidance indicates companies have until 12/22/2018 to finalize the impact of the tax law changes on their financial statements Preliminary and then revised statements Companies likely to take varying approaches to timing, level of detail, etc. SEC practice unclear Historically, the SEC has generally not required much explanation regarding key tax conclusions Will investors demand more? 26

28 Valuation (continued) How might the new rules affect valuation or traditional behavior? New interest expense limitation rules affect the general cost of capital calculations by increasing the after-tax cost of debt with the loss of shield for interest expense Yet, in many cases, debt will likely still be an attractive form of financing New rules could render certain players relatively more or less strong Potential for new rules to affect the relative competitive power of private equity firms as bidders or owners of assets? Relative competitiveness of U.S. vs. Non-U.S. corporations in the U.S. and outside the U.S. Might the new rules alter business strategy or other decisions? For example: Pay out foreign profits to investors or use U.S. corporation as tax-efficient reinvestment vehicle? Increase use of third party debt? More incentive to locate certain activities on-shore or off-shore, as applicable 27

29 Valuation (continued) Potential for new rules to affect supply/demand for certain categories of securities Will repatriation tax reduce demand for short-term corporate debt? Will interest expense rules reduce overall supply of corporate debt? Increase in supply of other securities, such as preferred equity or foreign sub debt? Favored treatment of REITs / Energy MLPs Transition / repatriation tax: potential for large buy-backs reducing the supply of equity? Demand for new time value of money instruments that are not debt? 28

30 Valuation (continued) New investor conversations anticipated More tolerance for taxable divestiture transactions? Offshore cash/profits: lack of U.S. tax barrier to return of capital to shareholders More demand for non-u.s. growth / planning? Relative competiveness of U.S. vs. non-u.s. competitors Capital structure discussions? Applicability of inversion transactions post-tcja? 29