Module IV· Operating ForecastAdvanced
Question
What is the interest deductibility limit (interest barrier) and how does it affect LBO modeling?
Answer
Mechanics
Interest expense is only deductible up to 30% of tax EBITDA once net interest (interest expense − interest income) exceeds a de-minimis threshold (e.g. ~$3m). Excess interest is carried forward (an 'interest carryforward'), usable indefinitely. This 30%-of-EBITDA rule is now near-universal in developed markets (ATAD in the EU, §163(j) in the US, similar elsewhere).
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Example
| Item | Value |
|---|---|
| Tax EBITDA | $50m |
| Gross interest expense | $22m |
| Limit (30% of EBITDA) | $15m |
| Immediately deductible | $15m |
| Interest carryforward (non-deductible) | $7m |
| Effective tax shield | $15m × 30% = $4.5m |
Impact on LBO modeling
- You have to model the limit annually — with growing EBITDA the carryforward can be used later
- The tax shield is lower than a naive calculation suggests
- With aggressive leverage the limit almost always bites in Years 1–2
Common pitfalls
- Forgotten: the limit also applies to shareholder-loan interest (PIK interest)
- Wrong: applying the 30% to book EBITDA — it should be tax EBITDA (often lower)
- The equity / escape-clause exemption is overlooked
Pitch tip
In LBOs the interest-limit calculation belongs in every model. Seniors often test 'What happens to the carryforward at exit?' — answer: it stays with the target company, but can be forfeited at exit under the change-of-ownership rules that restrict loss and interest carryforwards.