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Reports that InBev's acquisition of Anheuser-Busch will generate a large interest expense deduction for the Belgian company may be overstated.
Robert Willens, CFO.com | US
July 21, 2008
Tucked away in the various reports about the acquisition of the St. Louis-based Anheuser-Busch Companies by Belgium's InBev NV, is an interesting tax-related issue. In the Wall Street Journal's regular "Breaking Views" column, the author reckons that the debt that InBev would need to incur to acquire Anheuser-Busch would be so large that it would generate some $2 billion of interest expense each year.
That would mean that with a "reported" tax rate of approximately 40 percent, Anheuser-Busch, if it incurred the acquisition debt, would pay enough interest expense to produce an annual tax savings of approximately $800 million. As a result, InBev's return on its investment in Anheuser-Busch, once the tax savings are accounted for, would exceed the American company's "cost of capital" — the theoretical hurdle for a "successful" acquisition.
It is certainly possible to arrange the deal so that the debt that will finance the stock acquisition will be incurred by Anheuser-Busch itself. If that is the case, and Anheuser-Busch becomes primarily liable for the debt incurred, the transaction will be treated for tax purposes as a redemption — as if Anheuser-Busch itself acquired the stock from its shareholders in exchange for the borrowed funds. (See Revenue Ruling 78-250, 1978-1 C.B. 83.)
The tax code, particularly Section 162(k)(1), states that, except as otherwise noted, no deduction is allowed for any amount paid or incurred by a corporation in connection with the reacquisition (i.e., redemption) of its stock. Fortunately, the same provision (Section 162(k)(2)(A)(i)) carves out exceptions to that rule, including an exemption under Section163, which specifically deals with interest expense paid or accrued on indebtedness. So it would seem that Anheuser-Busch would be able to keep its large interest expense deduction. However, there is another tax rule to consider before that happens.
"Earnings Stripping" Rules
If the Anheuser-Busch buyout debt is guaranteed by InBev, even on a deeply subordinated basis, then the so-called "earnings stripping" rules would limit Anheuser-Busch's ability to freely deduct its interest expense. To be sure, a portion — perhaps even a substantial portion — of the $800 million tax savings referred to in the Journal might not be realized.
The earnings stripping rules are found in Section 163(j) of the tax code and provide that "if this subsection applies to any corporation for any taxable year" no deduction shall be allowed for "disqualified interest" paid or accrued by such corporation during such taxable year. 1 This subsection applies to any corporation for any taxable year if: such corporation has "excess interest expense" for such taxable year (in fact, the amount of interest expense disallowed as a deduction shall not exceed the corporation's excess interest expense for the taxable year)2; and the corporation's ratio of debt to equity, as of the close of the taxable year, is equal to or greater than 1.5 to 1. 3
For this purpose, the key term, "disqualified interest," is defined (in Section 163(j)(3)) as any interest paid or accrued by the taxpayer to a related person — but only if no tax is imposed by this subtitle with respect to such interest. As a result, disqualified interest encompasses interest paid to any related person who is a foreign person or a tax-exempt organization.
Therefore, interest paid to Anheuser-Busch with respect to debt it owe to InBev could be disqualified interest, the deductibility of which is interdicted by Section 163(j).4 Most notably, disqualified interest also includes any interest paid or accrued with respect to any indebtedness to a person who is not a related person if there is a "disqualified guarantee" of such indebtedness and no "gross basis" tax is imposed by this subtitle with respect to such interest. So, interest paid by Anheuser-Busch with respect to debt guaranteed by InBev may also constitute disqualified interest.
For this purpose, a disqualified guarantee is defined as any guarantee by a related person which is an organization exempt from tax under this subtitle or a foreign person. That means that even if the interest is paid to a U.S. lender, which is fully taxable (in the U.S.) on such interest income, the interest can still be categorized as disqualified interest if the indebtedness is backed by a disqualified guarantee. (See M. Ginsburg and J. Levin, Mergers, Acquisitions and Buyouts, Paragraph 1305.)
Moreover, the concept of guarantee, for purposes of the earnings stripping rules, is an exceedingly broad one. Therefore, a guarantee is defined as "any arrangement" under which a person assures, on a conditional or unconditional basis, the payment of another person's obligation under any indebtedness. So it seems likely that some portion of the interest expense paid or accrued by Anheuser-Busch on the indebtedness incurred to finance the acquisition of its stock will be disqualified interest. As a result, interest will not give rise to a current tax deduction in the U.S. What's more, it appears that the potential $800 tax savings discussed in the Journal is overstated and, in fact, the deal may not, after factoring in tax savings, produce a return that equals or exceeds Anheuser-Busch's cost of capital.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 Any amount disallowed for any taxable year shall be treated as disqualified interest paid or accrued in the succeeding taxable year and may be deducted to the extent of any excess limitation for the carryforward year. In determining the deductibility of disqualified interest carryforwards, the requirement of a debt/equity ratio in excess of 1.5 to 1 (in the carryforward year) is deemed to be satisfied.
2 Excess interest expense is defined as the excess of the corporation's "net interest expense" (the amount by which interest paid or accrued on indebtedness exceeds the interest includible in the debtor's gross income) over the sum of (i) 50 percent of the corporation's "adjusted taxable income," and (ii) any "excess limitation" carryforward. The excess limitation is the amount by which 50 percent of the corporation's adjusted taxable income exceeds its net interest expense. Such an excess limitation can be carried forward to the three taxable years following the taxable year in which it arises. However, the amount of such a carryforward taken into account (for any such succeeding taxable year) shall not exceed the excess interest expense for such succeeding taxable year.
3 The ratio of debt to equity is the ratio that the corporation's total indebtedness (excluding certain short-term liabilities) bears to the amount by which the corporation's assets (measured by the tax basis and not the fair market value of such assets) exceeds the corporation's total indebtedness (including the short-term liabilities excluded from the numerator of the fraction).
4If a tax treaty reduces the rate of tax imposed by this subtitle on any interest paid or accrued by the taxpayer, such interest shall be treated as interest "on which no tax is imposed by this subtitle" to the extent of the same proportion of such interest as the statutory rate (30 percent) reduced by the treaty rate bears to such statutory rate.