stock market implications of a global minimum corporate tax (ii)

The S&P 500 gained just under 20% in 2017, the year the large cut in the US corporate tax rate was passed. The new law, which took effect on 1/1/2018, boosted US-sourced earnings by about 21%. In 2018, however, the index lost a little over 6%. That’s because, I think, the stock market began to discount the better earnings prospects as soon at it became clear that the law would pass.

The same will likely happen in the case of a global minimum tax as well. Only this time the effect will be negative, and likely most keenly experienced by companies who have placed the greatest reliance on financial engineering, rather than operations, to boost their profit growth.

It’s also possible that this will be the trigger for investors to once again begin to read a low tax rate as a bad sign for a company, and to adjust the PE multiple down because of this vs. full tax rate-paying competitors as they commonly did a generation ago.

It’s thinkable, as well, that deeper consideration of the information in corporate tax disclosures will lead to a more seismic shift in the assessment of company value of the kind that Warren Buffett caused a generation ago in his stress on the value of intangible assets–intellectual property, brand names, distribution networks…–that the market regards as obvious plusses today, but had ignored until Buffett came along.

There’s already a bit of worry in the air about managements losing touch with the nuts and bolts of the industries they compete in, focusing on propping up current earnings rather than on creating cutting-edge products. Witness investor dismay at the apparent loss of operational competence in once iconic names like Boeing or Intel or ATT. At the very least, in my view, the draining of the ocean of monetary stimulus we are now swimming in will force investors to discriminate more sharply between potential winners and losers as the cost of funding operations begins to rise. As I’ve mentioned before, the only environment remotely like the current one that I’ve experienced is the high-yen, low interest rate environment of Japan in the late 1980s. The early Nineties there were particularly ugly for hidebound traditional zaibatsu/keiretsu firms whose greatest merit was their being in the rising tide of the previous decade. I can imagine a similar changing of the guard happening here.

This would tilt the field of play away from factor investing and toward the more traditional skills of analyzing balance sheets and income statements, and projecting them forward.

stock market implications of a global minimum corporate tax (i)

1980s tax planning

I got my first job as the lead (and only) manager of a global fund in 1986. I’d worked for six years as an analyst and manager in the US market and for a couple in the smaller Asian markets. I knew my first task would be to understand Japan, then the largest–and hottest–stock market in the world.

Commissions and fees were high there, trading volume was enormous. At the same time, local brokers had no interest in foreign customers, whom they regarded as not fully human, and were analytically pretty backward anyway. So I was surprised to learn that virtually all the big international brokers operating in Tokyo were posting gigantic losses from their Japan business–high expenses, understandable given the high price of real estate and of imported goods like food, but low revenues. Then I learned why.

Corporate taxes were very high in Japan back then. So foreigners executed all their trades through their Hong Kong offices, where the corporate tax for foreign companies was zero.

today’s world

Ireland is the poster child of large-cap corporate tax avoidance because its corporate income tax rate is 12.5%.

How the shelter works:

–a non-Irish multinational bundles up its intellectual property–brand names, R&D…–, consolidates it in an Irish subsidiary and for its use around the world agrees to pay a royalty to the Irish sub.

–the firm has sales of $1,000,000 in Germany, where the corporate tax rate is 30%. Let’s say expenses, ex royalty, are $600,000, meaning pre-tax income is $400,000. The firm pays a royalty of $200,000 to the Irish subsidiary, however. This is another expense for German operations and cuts pre-income there to $200,000.

–in Germany, after-tax income is $140,000. The royalty income is taxed at 12.5% in Ireland, netting the firm $175,000. Total income for the firm is therefore $315,000. Without the financial engineering, total income would have been $280,000. Overall, good for the firm, good for Ireland, bad for Germany.

my experience

When I started on Wall Street, such financial engineering was frowned upon. Most analysts and portfolio managers at least mentally reduced the resulting earnings downward to remove the zaitech benefit. One prominent UK broker even made it a feature of its research to “normalize” earnings to reflect the home country statutory rate.

Two reasons for this:

–with US companies, at least, repatriating foreign earnings means paying US income on them, minus a credit for foreign taxes paid. So the financial engineering savings are in a sense stranded abroad and not available for capital investment here or for paying dividends to shareholders. Corporate lawyers have long since found ways to make the funds available domestically without incurring a tax liability, however. Dividends are no longer as important to Wall Street as they were back then. And the emergence of Trump and his acolytes as standard bearers for the Republican party has pushed the US way down the list of places companies feel comfortable investing in.

–the thought in the early days of financial engineering was that any such ploy would be short-lived because governments would quickly shut down corporate loopholes.

more tomorrow