If I told you I was going to tax you at the highest rate in the world on earnings but allow you to deduct your interest expenses, what do you imagine you’d do?
Well, you’d probably try to earn offshore and issue debt at home. That way you can enjoy lower tax rates and get the benefit of deducting the expense associated with debt issued to fund “important” things like buybacks (which of course boost share prices and thereby inflate equity-linked executive compensation packages).
Ok, so let’s say that tomorrow, I decide to turn the tables. Now I’m no longer going to allow you to deduct your interest expenses. What do you imagine you’ll do?
Well, you’ll likely do the exact opposite of what you did before. That is, you’ll issue debt in locales that allow you to deduct your interest payments.
So could Trump’s tax proposals actually create more inversion trades in a truly ironic twist? If so, what would that mean for onshore IG spreads?
Good questions, all.
Here’s Citi’s Matt King with some characteristically great analysis.
When it comes to multinational corporates with the ability to issue offshore, the unilateral removal of deductibility in the US seems likely to have a very clear effect: companies would have an incentive to pay down domestic bonds and loans and issue from their offshore affiliates instead.
This would be a strange and ironic echo of previous complaints surrounding earnings stripping and inversion trades, but we find it hard to see a way round it. We do not profess to be tax experts, so perhaps there will be a constraint we have not thought of. But just as a high corporate tax rate and interest deductibility incentivized companies to move earnings and cash offshore, and then issue domestic bonds to fund capex or share buybacks, so the removal of interest deductibility would create an incentive to locate interest payments offshore — where in most jurisdictions they would remain tax-deductible.
Presumably this would only work if there were profits in the offshore jurisdiction against which taxes would be payable. As such, it might work better for proper multinationals than for US domestic corporates which fancied setting up a subsidiary in Ireland or Luxembourg. But given how adept companies have proved at optimizing their international activities in an era when it is much harder to say where a company’s operations — and profits — are truly based, it could have the perverse consequence of causing more inversion trades rather than putting a stop to them. At a minimum, we think it represents a complication to the presumption of widespread and willing profit repatriation.
Even if such interest offshoring proves small, the likely effect would be an exacerbation of the already large surfeit of demand over supply in the domestic $ IG market. Whether companies choose to repatriate profits and use these to fund existing share buyback programmes rather than issuing onshore bonds as they had been doing previously, or to repatriate profits and use them to buy back some of the now-inefficient onshore bonds, or to buy back domestic bonds to issue new, more efficient, offshore bonds, a squeeze in domestic IG seems likely. In principle this could be offset if there were sufficient demand to issue new bonds to fund capex or share buybacks — but even if such demand existed, we still expect some companies would find ways to issue these offshore instead.