Obama threatens deductions on debt interest

President Barack Obama’s recent proposal to lower corporate tax rates and streamline the US tax code could drive down returns for mainstream private equity and private equity real estate firms and their portfolio companies.

Private equity’s 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.

Such businesses as private equity and their brethren in private equity real estate 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 real estate that rely on debt financing to complete transactions, the reduction could make deal financing more difficult as well as drive down returns.