Manufacturers beat rising interest and sinking deductions

 

Manufacturers need to keep moving ahead of competitive pressures, but the terrain is getting tough.

Headshot of Kelly Schindler

“The cost of financing a CapEx project, acquisition or expansion is higher now, because interest is higher. Coupled with that, you can no longer deduct as much as you were able to before. It's a double whammy.”

Kelly Schindler

Grant Thornton Manufacturing Industry National Leader

 

“The cost of financing a CapEx project, acquisition or expansion is higher now, because interest is higher,” said Grant Thornton Manufacturing Industry Leader Kelly Schindler. “Coupled with that, you can no longer deduct as much as you were able to before. It's a double whammy.”

 

The Tax Cuts and Jobs Act amended IRC Section 163(j), limiting the deduction for net business interest expense in excess of interest income. Now, interest deductions are limited to 30% of tax-adjusted earnings before interest and taxes (EBIT), so manufacturers can no longer add back depreciation and amortization in computing their adjusted taxable income.

 

“The tax change to 163(j) hit manufacturers harder than some other industries,” said Grant Thornton Strategic Federal Tax Services National Tax Leader Ellen Martin. “Manufacturers tend to have a lot of assets that they’re depreciating, and they have more depreciation if they’re acquisitive.” In 2022, manufacturers also had to start capitalizing and amortizing any research and development costs in Section 174. “It is a perfect storm where they're certainly feeling the hit.”

 

Yet, manufacturers need to keep moving ahead.

 

“Of the CXOs I’ve spoken with recently, none of them want to slow down on expansion — because of the risk they’ll get passed by their competitors,” Schindler said. “There’s so much evolution and change coming into manufacturing that they can’t take a breather. They have to stay in front, or they will get put behind in a very quick and significant way. So, companies are saying, ‘Yes, it’s going to cost me more, but I can't stop moving.’”

 

 

 

Keep moving ahead

 

Headshot of Mike Hennessey

“It comes down to how we manage our free cash flow when some of the barriers are within our control and some are out of our control — and interest rates are out of our control.”

Mike Hennessey

Grant Thornton CFO Advisory Principal

To drive growth over rising interest rates and sinking deductions, manufacturers need to take a fresh look at their business options. “It comes down to how we manage our free cash flow when some of the barriers are within our control and some are out of our control — and interest rates are out of our control,” said Grant Thornton CFO Advisory Principal Mike Hennessey.

 

To manage those controllable factors, Hennessey said that many manufacturers in recent months have focused on two important opportunities. “For one, there has been a lot of focus on cash flow forecasting. You can identify areas that may be within your control where you can offset the cost of rising rates.”

 

“The second is your finance and accounting infrastructure costs, and how you reduce those,” Hennessey said. That can mean looking for ways to streamline and automate your finance function. Manufacturers might also need to look at their broader business to consider what they can automate, relocate or consolidate to create more cash flow. Creating cash flow starts with improving your earnings before interest, taxes, depreciation and amortization (EBITDA), so you need visibility across all of the factors driving your EBITDA. Tax can be a central factor. 

 

 

163(j) tax planning

 

Martin said that it’s important to refine your 163(j) planning in particular. “163(j) Interest Expense Planning can be a real game changer in the deductibility of interest. Essentially, it involves allocating interest to other items, such as inventory or fixed assets, to remove the interest limitation.” Consider your organization’s activities and whether elective provisions in the code could allow you to capitalize interest to a different asset or activity, taking it out of the category of interest for tax purposes. You will then recover those capitalized amounts over the recovery period for that category. Items like inventory or fixed assets eligible for bonus depreciation will have a shorter recovery period, freeing up those cash taxes sooner.

If manufacturers allocate capitalized interest to inventory, for instance, they can get the full deduction of the cost because an inventory cost goes through their cost of sales. Then, for tax purposes, the cost becomes an inventory cost and follows the timing of that cost.

 

 

Cash tax planning

 

“Outside of 163(j) planning, you can also consider other types of cash tax planning,” Martin said. “Look for other ways to defer income or accelerate deductions to help manage cash taxes that you are paying out, which can in turn help your cash flow.” Your planning can involve a review of accounting methods or credit opportunities.

 

 

Energy credits

 

The Inflation Reduction Act’s energy credits are another important consideration. “If manufacturers are going to move ahead with investments in new facilities, they shouldn’t sleep on the fact that there might be ways energy-efficient property could help them get credits or increased year-of deductions when they place the property in service,” Martin said.

 

Also, taxpayers can now buy certain tax credits as part of their tax strategy. “That’s still a little new on the market, but it’s definitely ramping up in 2024,” Martin said. Manufacturers might be able to buy a credit for 90 to 96 cents on the dollar, depending on the types and amounts of credits available and their risk appetite. 

 

 

 

Take a broad view

 

The compounded challenge of rising interest rates and sinking deductions can pose difficulties for any manufacturer — especially new companies, which already face the industry’s traditional high barrier to entry. “This does become a headwind for their ability to invest in new facilities,” Hennessey said. “We're talking large investments, and a half point of interest can have a very material impact to the free cash flow.”

 

Still, your competitors are likely facing the same headwind, and the companies that fare the best will be the ones that manage the conditions while aligning their businesses for future markets, customers and opportunities.

 

“Your interest rates are going to be high, but that doesn't mean you can’t do what you think is right for the business,” Schindler said. “There’s a way of reexamining the factors — maybe some of them outside of your normal focus — to create free cash flow.”

 
 

Contacts:

 
 
Mike Hennessey

Mike Hennessey is a Principal in the CFO Advisory practice of Grant Thornton located in Charlotte, NC.

Charlotte, North Carolina

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