Wall Street Journal | |
June 16, 2007
As Congress looks at raising taxes on some publicly traded private partnerships, there is growing scrutiny from politicians and others of a possible erosion to the corporate tax base as companies go private.
One unintended consequence of the buyout boom kicking into high gear is that more companies will be able to lower their tax bills by deducting the hefty interest costs arising from their huge debt loads.
It is much like a homeowner who buys an expensive house, saddles it with a ton of debt and reduces his tax burden by deducting the interest costs from his taxable income.
Robert Willens, a tax expert at Lehman Brothers Inc., estimates that if buyouts run at current levels, the corporate tax base will be eroded by more than 5%, or as much as $20 billion, each year.
"The wave of buyouts is going to erode the corporate tax base in a very meaningful way," says Mr. Willens, whose firm helps private-equity firms take companies private.
It is an issue that is taxing Congress and others in Washington.
A Senate Finance Committee staffer said Friday that this is one of the many issues the panel is looking at as it reviews tax policy in this area. The Treasury Department hasn't looked at this particular issue yet but said it is examining all issues surrounding partnership taxation, according to a spokesman.
The scrutiny comes at a pivotal point and raises a broader question: Are buyouts "just a tax game," says Josh Lerner, a Harvard Business School professor specializing in private equity, or are private-equity investors "increasing the efficiency of companies so the gains in terms of improved economic dynamism could make up for the loss in tax revenue?"
Mr. Lerner says the answer isn't clear, though, private-equity firms are quick to point out that when they take companies private, they boost profits, ultimately raising the amount of taxable income produced. They also argue that they pay capital-gains taxes on sales of assets.
Over the past few years, corporate tax receipts have been surging amid a boom in profits; yet there has been a raging debate about erosion to the corporate tax base.
Besides the growing use of debt by private-equity firms, the corporate tax base is getting hit on other fronts: the growth of tax shelters and the "deferral" of taxation on foreign-earned income until it is repatriated to the U.S.
Jason Furman, senior fellow at the Brookings Institution, says the U.S. has the second-highest corporate tax rate among the 30 countries in the Organization for Economic Cooperation and Development, but ranks fourth-lowest in terms of corporate tax revenue as a share of gross domestic product -- in large part because of the tax benefits afforded to debt financing.
The focus comes as buyouts are booming with announced U.S. deals this year of $350.6 billion already poised to eclipse last year's heady levels of $443 billion for all of 2006, according to Thomson Financial.
Companies typically pay taxes on their profits, which run at about 40% when federal and state taxes are combined in the U.S. But when private-equity firms take companies public, they tend to load them up with debt, often financing the deals by borrowing as much as 70% and investing 30%. The interest payments on this debt are tax-deductible. Often the payments are so large they completely wipe out profits, triggering losses for a company.
"There is an artificial preference for issuing debt over equity, which is the tax code's original sin," says Edward Kleinbard, a lawyer at Cleary Gottlieb Steen & Hamilton LLP law firm in New York.
As part of TPG Capital and GS Capital Partners' $27.5 billion buyout of wireless company Alltel Corp., Alltel is borrowing a little more than $20 billion in additional debt. If Alltel borrows the money at an interest rate of 9%, it will have about $1.8 billion in incremental tax-deductible interest, estimates Lehman's Mr. Willens.
That would wipe out the $1.298 billion in pretax income Alltel had last year, Mr. Willens says, and create a net operating loss that can be carried forward to future years to offset pretax income in those years.
For TPG, previous buyouts -- such as Continental Airlines Inc., Oxford Health Plans and Burger King Holdings Inc. -- "have resulted in companies paying significantly greater taxes over time," says a spokesman, who adds today's successful buyouts "have much less to do with financial engineering and everything to do with growing earnings and therefore taxes."
Similarly, to finance its $26 billion acquisition of First Data Corp., a processor of electronic payments, Kohlberg Kravis Roberts & Co. has said it is borrowing as much as $24 billion in incremental debt to finance the acquisition.
If First Data borrows money at 9%, it would have $2.16 billion in additional tax-deductible interest, wiping out its 2006 pretax income of a little over $1 billion and creating a loss for future years, Mr. Willens says.
To be sure, any drop in corporate taxes because of bigger debt burdens will be offset somewhat by capital-gains taxes paid by shareholders who sell their companies and taxes on interest income.
But long-term capital-gains tax rates are 15% -- far lower than corporate tax rates, and a larger share of debt is in the hands of tax-exempt investors today than it was in the late 1980s during the last buyout binge.
So far, the erosion in the corporate tax base isn't noticeable. Revenue from corporate income taxes rose from 1.2% of gross domestic product in fiscal 2003 to 2.7% in fiscal 2006, the highest level since 1978, according to the Congressional Budget Office. Roughly two-thirds of that gain is attributable to increases in corporate profits.
The tax implications of buyouts have been fiercely debated ever since these deals blazed onto the financial landscape in the 1980s.
Back then, some academics argued that the loss in revenue from higher debt levels were offset by gains elsewhere, including taxes when investors exited investments and on interest income held by taxable investors.
But that mightn't be as powerful a force now.
Drawing on data from the Bureau of Economic Analysis, the share of personal interest income that is exempt from tax rose to 71% in 2004 from 53% in 1991, says Len Burman, director of the Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution in Washington.
Also, today's buyout wave is different because "even more investors are tax-exempt than in the '80s, so the capital gains from exiting deals don't actually generate much revenue for the Treasury," says Victor Fleischer, a University of Illinois College of Law associate professor.
Write to Anita Raghavan at anita.raghavan@wsj.com1
URL for this article: http://online.wsj.com/article/SB118195045949437286.html
Hyperlinks in this Article: (1) mailto:anita.raghavan@wsj.com
Copyright 2007 Dow Jones & Company, Inc. All Rights Reserved This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.