Wall Street has a problem with this part of the new tax plan

Speaker of the House Rep. Paul Ryan (R-WI) speaks as Chairman of House Ways and Means Committee Rep. Kevin Brady (R-TX) (L) and House Majority Whip Rep Steve Scalise (R-LA) (R) listen during a news conference on the tax reform legislation November 2, 2017 on Capitol Hill in Washington, DC.

The long-awaited tax bill has finally arrived, and it does indeed reduce the corporate tax rate to 20 percent from 35 percent. But buried in the bill (page 217 of the 429-page bill) are a few short paragraphs that appear to limit the deductibility of corporate debt.

The outcome of this is not exactly clear, but it has Wall Street talking.

“This may curtail issuance of corporate debt to buy back stock, and it may limit some LBO [Leveraged Buyout] activity, which creates high levels of debt,” said Peter Tchir of Academy Securities.

Shares of private equity players like KKR and Blackstone, which are heavily involved in LBOs, tumbled today on the news.

Here are the three relevant paragraphs:

”(1) IN GENERAL.-In the case of any taxpayer for any taxable year, the amount allowed as a deduction under this chapter for business interest shall not exceed the sum of-

‘(A) the business interest income of such taxpayer for such taxable year, plus

‘(B) 30 percent of the adjusted taxable income of such taxpayer for such taxable year “

I spoke with Andrew Brenner at NatAlliance Securities, who provided me an example of how this might affect a company’s deductions.

Say you are a company that has $1 billion in adjusted taxable income and $200 million in interest expenses. Under this bill, it appears you will be able to deduct the entire expense because it is only 20 percent of adjusted taxable income.

However, things would be different if interest expenses were $400 million. In that case, you would only be able to deduct $300 million, or 30 percent of your adjusted income. The remaining $100 million could not be deducted that year.

Does that means it’s lost forever? Not necessarily.

Buried even deeper in the bill is a paragraph called “Carryforward of disallowed interest.” This proposal allows you to deduct the remaining $100 million of interest expense in the following year up to the fifth year after the expense is incurred.

What’s going on?

“They seem to be interested in trying to curtail issuance of debt,” Tchir noted, probably because the deductibility of interest makes debt financing more attractive than equity financing.

Curtailing debt issuance would have one obvious effect, Tchir told me. It would reduce supply in the corporate bond market, which may be good for bond prices.

But one thing’s for sure, anything that curtails buybacks will catch the attention of the Street.

Corporations bought back roughly $250 billion in the first half of this year, according to Standard & Poor’s. Goldman just released its 2018 forecast of fund flows and forecasts that next year corporations will again be the single biggest buyers of stock because of share buybacks.

Corporations are not just the single biggest buyers of stock. Without their participation, flows would be negative, according to Goldman.

2018 Equity Demand Forecast: Who will buy stock?

Corporations $590 billion inflows

ETFs $400 billion inflows

Foreign $100 billion inflows

Households $ 10 billion inflows

Mutual funds $125 billion outflows

Pensions $250 billion outflows

Foreign equities by US $250 billion outflows

Credit ETF $ 75 billion outflows

Source: Goldman Sachs, Federal Reserve Board

See what I mean? Without buybacks, instead of net equity demand of $400 billion in 2018, there would be nearly $200 billion of outflows.

Yikes! No wonder the Street is worried about anything that upsets this apple cart.

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