The proposal to eliminate the interest deduction may have a material adverse impact on U.S. middle-market companies.

In March, Republican presidential candidate Senator Marco Rubio, together with Senator Michael Lee, released their Economic Growth and Family Fairness Tax Reform Plan (the Plan). The Plan would eliminate taxation on interest, dividends and capital gains. It also would eliminate the deduction for interest expense. Several other Republican presidential candidates have generally described ideas for tax reform that would involve eliminating many deductions, though it currently is unclear whether, or the degree to which, the interest deduction would survive.

Rationale Behind Proposal

Senators Rubio and Lee described the rationale for eliminating the interest deduction. Importantly, they believe that the change would not result in any economic disadvantage for borrowers. Rather, they maintain that, if a lender does not have to include the interest income in taxable income, the lender would be willing to accept a lower rate of interest. The sponsors drew an analogy to the current municipal bond rules (i.e., state and local governments pay lower interest rates on their tax-exempt municipal bonds). Another stated reason for the proposal is that eliminating the interest deduction (as well as the tax on interest and dividends) would allow an issuer to determine whether to issue debt or equity without regard to the interest deduction. The thought is that companies will be less inclined to issue debt, thus making American corporations financially stronger. Unfortunately, the loss of the interest deduction is likely to hurt, rather than help, middle-market American companies.

U.S. Lenders Will Be Taxed and Demand Higher Interest Rates

Although the Plan would exempt most taxpayers from tax on interest income, this is not the case for financial services companies. These companies will continue to pay tax on interest income and be entitled to a deduction for interest expense. While those financial services companies that would continue to be subject to tax on interest are not delineated in the Plan, banks and insurance companies certainly would continue to be subject to tax on interest. These entities constitute the primary lenders to middle-market companies.

Accordingly, banks, insurance companies and other financial services companies will not benefit from the exclusion of interest from taxable income and, thus, will insist on a higher rate of interest on loans. As the prime rates, LIBOR and other “market” rates are determined by financial services companies, it does not seem likely that interest rates will drop as a result of the Plan. Thus, middle-market companies are likely to pay a higher effective rate of interest when the loss of interest deductibility is factored in.¹

U.S. Borrowers Will Be at a Competitive Disadvantage

Many U.S. trading partners, including the United Kingdom, Germany and France, provide a deduction for interest against taxable income. The interest deduction helps to reduce the effective rate of interest on debt. Without an interest deduction, U.S. companies may pay a higher effective rate of interest on borrowings than their foreign competitors, thus putting them at a competitive disadvantage.

There Are Business Reasons for Issuing Debt Rather than Equity

The primary business of a bank is to make loans, not provide equity investments in privately held companies. These lenders generally expect a return based on the passage of time, and not on the success or failure of the issuer. Accordingly, the typical debt instrument provides for repayment at a specific time, with a stated interest rate. In the event of an issuer’s insolvency or bankruptcy, debt holders are paid before equity owners. Even among debt holders, it is typical to have agreements indicating which creditors get paid first in the event that the assets of the issuer are insufficient to pay all debt holders. For such lenders, common stock is not a substitute for debt, as repayment is subject to the success or failure of the business. Before the redemption of common stock, all senior equity and debt holders must be repaid. Moreover, the payment of any return (dividends) is at the discretion of the directors. Additionally, from the issuer’s standpoint, the issuance of common stock has a dilutive impact on the equity of the issuer that debt does not have. Thus, a certain amount of debt in a structure is healthy.

Even preferred equity may not be an adequate substitute for debt. In the event of a bankruptcy, debt holders will be paid first. Although a preferred stockholder typically has certain protections to ensure payment of dividends, corporate law typically restricts the payment of dividends and the redemption of stock in certain cases (including where such payments would make the company insolvent). As a matter of corporate law, the payment of dividends generally is a matter for the directors to decide. Additionally, a company that issues significant preferred stock may be considered no healthier (from a financial standpoint) than a company with significant debt. The type of preferred stock that may come close to being a substitute for debt (i.e., that with a stated return, set maturity date, default provisions designed to ensure current payment of yield and redemption upon bankruptcy) may well be treated as debt for accounting and rating agency purposes.

Conclusion

The interest deduction is an important component of our Internal Revenue Code, and eliminating the interest deduction may have a material adverse impact on middle-market companies.

Endnote

¹ The sponsors draw an analogy to the lower borrowing costs achieved in the municipal bond market. However, even in that market, interest on some bonds is subject to the alternative minimum tax, and other interest is not. Credit ratings being equal, bonds that generate interest that is subject to the alternative minimum tax typically have higher yields.