Interest limitation rules turn excess leverage into deferred deductions. Whether they cost real money depends on whether the company grows out of the cap before exit.
A 30 per cent of EBITDA interest cap starts to bite once debt exceeds 0.30 divided by the interest rate, which is 3.33× EBITDA at a 9 per cent cost of debt. On an illustrative buyout levered 5.5×, it disallows 22.5 of interest over five years, adds 5.0 of cash tax and takes 6.6 off the exit equity, lowering the IRR from 17.93 to 17.56 per cent. Most of the damage is timing: 21.5 of deductions are still unused at exit, worth 5.4 of tax only if a buyer can use them.
Worked in full in The Buyout Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Interest limitation rules built on 30 per cent of a tax EBITDA now sit in most buyout jurisdictions: the EU's anti-tax avoidance directive, the UK corporate interest restriction, and the US section 163(j) limit on business interest, which is also set at 30 per cent of an adjusted taxable income. The details differ (de minimis allowances, group ratio elections, how long disallowed interest can be carried forward), but the arithmetic below is common to all of them. Treat it as a model of the mechanism, not tax advice on any one regime.
| Input | Value |
|---|---|
| Entry EBITDA, growing 6% a year | 50.0 |
| Entry and exit multiple | 9.0× |
| Debt at closing (5.5×) | 275.0 |
| Cost of debt | 9% |
| Fees | 10.0 |
| Equity invested | 185.0 |
| Tax depreciation, flat | 10.0 |
| Capex and working capital, share of EBITDA | 20% |
| Tax rate | 25% |
| Interest cap, share of EBITDA | 30% |
Interest ≤ 30% × EBITDA ⇔ Debt / EBITDA ≤ 0.30 / rate
At 7 per cent the threshold is 4.29×, at 9 per cent 3.33×, at 11 per cent
2.73×. In Excel: =Cap/Rate. Every turn of leverage above that line produces
interest the company pays in cash but cannot deduct this year.
At closing this deal pays 24.75 of interest against a cap of 15.0 on the entry EBITDA. In year 1, with EBITDA at 53.0, interest is 47 per cent of EBITDA and 8.9 of it is disallowed.
| Year | EBITDA | Interest | Cap | Disallowed | Carried forward | Tax, capped | Tax, no cap |
|---|---|---|---|---|---|---|---|
| 1 | 53.0 | 24.8 | 15.9 | 8.9 | 8.9 | 6.8 | 4.6 |
| 2 | 56.2 | 23.8 | 16.9 | 6.9 | 15.8 | 7.3 | 5.7 |
| 3 | 59.6 | 22.5 | 17.9 | 4.7 | 20.4 | 7.9 | 6.8 |
| 4 | 63.1 | 21.0 | 18.9 | 2.0 | 22.5 | 8.5 | 8.2 |
| 5 | 66.9 | 19.1 | 20.1 | 0.0 | 21.5 | 9.2 | 9.6 |
| Total | 22.5 | 21.5 | 39.8 | 34.8 |
In year 1 the company earns 18.2 before tax and pays 6.8 of tax: an effective rate of 37 per cent, against 25 per cent without the cap. The disallowed 8.9 costs 2.21 of cash tax, which is simply 8.85 × 25 per cent. By year 5 EBITDA has grown and debt has fallen enough for interest to sit under the cap, and the first 1.0 or so of carried-forward interest is used. Not much more: 21.5 is still unused at exit.
The equity loses 1.6 more than the extra tax, because every unit of tax paid is a unit of debt not repaid, and that debt keeps charging 9 per cent. The 21.5 of carried-forward interest is worth 5.4 of future tax at 25 per cent, but only if the buyer can use it and pays for it. Many regimes restrict carry-forwards on a change of control, and buyers rarely pay full value for deductions they may not get. Price it at nil and the full 6.6 is gone; price it at full value and the net loss is 1.2.
| Debt at entry | Extra tax at 9% | IRR cost at 9% | Extra tax at 11% | IRR cost at 11% |
|---|---|---|---|---|
| 4.0× | 0.0 | 0.00 pts | 0.1 | 0.05 pts |
| 5.0× | 1.7 | 0.14 pts | 8.2 | 0.59 pts |
| 5.5× | 5.0 | 0.37 pts | 12.2 | 0.95 pts |
| 6.0× | 8.2 | 0.65 pts | 16.3 | 1.39 pts |
The cost is not linear. At 4.0× the cap binds early but the company grows out of it, and the carried-forward interest is used before exit: the cap only moves tax between years. At 6.0× and 11 per cent the company never catches up, extra tax reaches 16.3 and the IRR falls from 17.80 to 16.41 per cent. Higher rates do double damage: they lower the threshold and raise the interest above it.
Modelling tax on EBITDA minus all interest, as if every unit were deductible. In this case that overstates year 1 cash flow by 2.21, and the error compounds through the cash sweep. The opposite mistake is treating disallowed interest as lost: it is carried forward, and in a deal that grows out of the cap, as the 4.0× row shows, the cost is mostly timing. The model has to carry the balance forward and test spare capacity every year, which is exactly what most one-page LBOs skip.
The worked case of The Buyout Investor runs tax with the interest cap inside a full model with a term loan, second lien and revolver: it is in the free workbook for this case on the companion page. For how the same deal's leverage shows up in the returns, see how to solve a paper LBO by hand, or build your own in the LBO model template.
When interest exceeds 30 per cent of EBITDA, which happens once debt divided by EBITDA is above 0.30 divided by the interest rate. At a 7 per cent cost of debt that is 4.29x, at 9 per cent 3.33x and at 11 per cent 2.73x. Most buyouts are levered above these thresholds at closing, so the cap usually binds in the early years.
Usually not immediately: most regimes let it be carried forward and deducted when interest later falls below the cap. In an illustrative 4.0x buyout the company grows out of the cap and almost no extra tax is paid over five years. At 5.5x, 21.5 of interest is still unused at exit and its value depends on the buyer.
It rises with leverage and rates. In an illustrative five-year deal at 9 per cent the cost is 0.14 points at 5.0x and 0.65 at 6.0x; at 11 per cent it is 0.59 and 1.39 points. The loss exceeds the extra tax itself, because tax paid is debt not repaid.
This article is one calculation from The Buyout Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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