Obama threatens deductions on debt interest

Private equity’s current tax policy woes are no longer limited to the carried interest debate. President Barack Obama’s recent corporate tax reform proposal may spell trouble for leveraged buyouts in general.

Private equity firms have long relied on the deductibility of interest payments on corporate debt, the lifeblood of most private equity firms. While President Obama’s proposal does not outline the specifics on how it would reduce interest’s deductibility, its impact on the industry could be widespread. 

The President’s proposal, released last week, would reduce the corporate tax rate from 35 percent to 28 percent while reducing tax deductions that provide advantages to companies with high levels of debt financing, the White House said in a statement. 

According to the proposal: “The current corporate tax code encourages corporations to finance themselves with debt rather than with equity … on average, debt-financed investments are subsidised (i.e., their effective marginal tax rate is negative), as income generated by such investments is more than offset by deductions for interest and accelerated depreciation.”

President Obama has proposed a reduction in the deductibility of interest, which in turn would reduce the incentive to overleverage companies. However, for industries like private equity that rely on debt financing to complete transactions, the reduction could make deal financing more difficult as well as drive down returns. 

“Obviously, any limitation on the deductibility of interest affects the effective cost of financing,” said Peter Furci of law firm Debevoise Plimpton. “It increases the after-tax cost on the financing, and that increased after-tax cost could negatively affect the returns on the investments.”

The proposal, along with Obama’s recent effort to increase taxes on dividend income, would also make dividend recapitalisation strategies less attractive, Furci said, as it would eliminate some of the advantages debt financing provides. 

Other sources indicated that reducing the deductions accrued through interest payments could also increase the threshold on due diligence for future deals. 

“Because they can’t deduct it, it becomes [effectively] more expensive to buy a company,” one market source said. 

However, until the Administration develops its proposal to specify the degree to which it would reduce the deductions, it’s very difficult to assess the extent of its impact. Furthermore, industry sources have questioned whether Obama would be able to garner enough support for this level of reform during an election year. 

“I don’t think there is a single proposal coming from either party between now and November that isn’t more about politics than actual tax reform,” said Adam Max of The Jordan Company. 

The White House did not respond to a request for comment.