Since the 2016 Presidential election, interest rates in the United States have risen all along the yield curve. That’s not terribly surprising, given that Donald Trump’s victory has increased expectations of fiscal stimulus, inflation and continued heavy issuance of U.S. Treasury debt. Many corporate executives, investors and economists are starting to suspect that this may finally be the beginning of the long-anticipated “normalization” of the U.S. Treasury yield curve.
If senior management does expect interest rates to rise in the U.S., there are many tools a corporate investor might use to help guard against, or take advantage of, rising interest rates, such as ETFs, TIPS, options, forwards, futures and swaps. Importantly, each of these tools can produce the desired economics, but they all can have very different tax consequences for a company. However, there is one interest rate strategy that can be employed to not only potentially benefit from the normalization of the yield curve, but also accelerate the deductibility of capital loss carryforwards.
Exploring the options
Let’s use an example.
ABC Corp., a large public company and a “C” corporation for tax purposes, has a capital loss carryforward of $50 million. ABC Corp. is profitable, and therefore pays federal tax at the 35 percent rate. ABC Corp. realized its capital loss back in December 2013, and the loss will therefore expire in December 2018 unless sufficient gains can be utilized to absorb the losses. ABC Corp.’s capital structure includes a considerable amount of floating rate debt, and a sizeable amount of corporate cash (that’s not needed as a cash alternative) is invested in a diverse portfolio of taxable fixed income securities with a duration from one to five years.
Since early 2014, senior management has explored a number of potential solutions that have been proposed by ABC Corp.’s legal, tax and accounting advisors; however, senior management concluded that most of these strategies, by their very nature, did not have a meaningful business purpose and robust economic substance. Therefore, for financial reporting purposes, senior management took a valuation allowance against those losses, having determined that it was more likely than not that the losses will expire worthless in December 2018.
Nevertheless, the investment community remains mindful of ABC Corp.’s capital loss carryforwards. During quarterly conference calls, shareholder meetings, investor conferences and other meetings with investors, institutional investors ask detailed questions to gain insight into what senior management’s plan is, if any, with respect to the potential utilization of its capital loss carryforwards.
Since the presidential election, senior management has become concerned that the U.S. yield curve will continue to normalize, significantly increasing the cost of the company’s floating rate debt, while reducing the value of its corporate cash bond portfolio. Senior management recently met with the company’s financial, legal and tax advisors to explore how the company might guard against the risk of rising rates in the most cost-effective and tax-efficient manner. Along these lines, senior management explored numerous tools the company could use, but all of them have very differing tax consequences for the company.
The best option
Given ABC Corp.’s circumstances, senior management decided that the most straightforward, cost-effective and tax-efficient strategy was to simply establish a short position in U.S. Treasuries with a fairly short duration (i.e. approximately 24 months). With interest rates still near historic lows, the company’s worst case scenario can be defined with a fair degree of precision, and the company’s potential loss is quite limited (i.e. the company can benefit from what is effectively free “put protection”). In the event that rates begin to normalize, as senior management expects, the company will be in a position to profit handsomely.
This strategy is intriguing to senior management for another reason: the company’s otherwise non-deductible capital loss carryforward. Given current interest rate levels, if structured properly, establishing a short position in U.S. Treasuries will generate both capital gain and interest expense. Put simply, the company’s capital loss will be deductible against the capital gain generated by the strategy, while the interest expense the strategy generates will be deductible against the company’s ordinary income. In effect, this strategy converts ABC Corp.’s otherwise non-deductible capital loss into currently deductible investment interest expense.
Senior management decided to implement this strategy and the results were attractive. It not only generated a robust return and helped ABC Corp. guard against the prospect of increasing interest rates, but also afforded the company an opportunity to fully utilize its capital losses instead of allowing them to expire worthless.
Tom Boczar is the CEO of Intelligent Edge Advisors. He can be reached at [email protected]. Jeff Markowski is Managing Director of Capital Markets at Intelligent Edge Advisors. He can be reached at [email protected].