A recent WSJ article highlighted that, given the tightened equity financing market for early and growth-stage companies and the corresponding decrease in valuations, more such companies might be turning to venture debt to bridge the gap in their financial needs. This shift appears to be driven, at least in part, by a desire to avoid selling equity in a down round at lower valuations than the previous round of financing. However, there can be several risks associated with such debt, as described in the article, including high and increasing floating interest rates, loans that may still involve the issuance of equity kickers such as dilutive warrants to purchase equity, and the potential for balloon payments that may come due when the company does not have sufficient readily available cash or an alternative source of funding. This is “real” debt as opposed to the traditional convertible note financing that is very customary and converts into equity on the next equity round.
The risks highlighted in this article for companies taking on additional debt may be further amplified if these borrowers are unable to fully deduct interest payments on their debt.
The Tax Jobs and Cuts Act (TJCA) included, among other things, a new restriction in Section 163(j) of the Internal Revenue Code of 1986, as amended, that limits certain borrowers’ ability to claim deductions for interest payments attributable to their business activities. A borrower that cannot fully deduct business interest payments would suffer adverse impacts to cash flow since it would not be able to effectively recover a portion of its interest payments via tax savings.
In recent years, Section 163(j) has typically not been relevant due to historically low interest rates and, in many industries, strong economic performance. However, some borrowers could soon find themselves unable to fully deduct interest payments as a result of interest rates continuing to rise, coupled with declining revenue.
In general, a borrower may be subject to Section 163(j) if its average annual gross receipts for the previous three years exceed $25 million. Such a borrower, as a practical matter, would only be able to deduct business interest payments up to 30% of their “adjusted taxable income” for the applicable tax year (subject to certain, more bespoke adjustments).
For this purpose, “adjusted taxable income” is the borrower’s taxable income as calculated with certain exclusions, such as any non-business income, gain, deduction or loss and any net operating loss deductions.
Importantly, for tax years beginning before Jan. 1, 2022, depreciation, amortization and depletion deductions were also excluded for calculating adjusted taxable income. Thus, for those tax years, the limit imposed by Section 163(j) would not be reduced even if a borrower had significant deductions of those types (which are often very useful for reducing a borrower’s actual taxable income and tax liability).
However, for tax years beginning on or after Jan. 1, 2022, depreciation, amortization and depletion deductions are no longer excluded from, and thus will reduce, adjusted taxable income.
Consequently, applicable borrowers are now at greater risk of adverse tax consequences under Section 163(j) – not only from a confluence of rising interest rates and depressed economic performance but also due to depreciation, amortization and depletion deductions now adversely impacting how much business interest can be deducted.
It would be advisable for borrowers to consult their tax advisors when taking on debt to determine whether Section 163(j) might limit their business interest deductions and, if so, how that might impact their business projections or cash flow models.