Trump on corporate income taxes

I think corporate tax reform is potentially the most significant item on the Trump administration agenda, as far as US stocks are concerned.

The Trump plan appears to have two parts:

–reduce the top corporate tax rate from 35% to, say, 20%.  For a firm that has 100% of its income in the US and which has no substantial current tax breaks, reducing the corporate tax rate would mean a one-time 23% increase in after-tax profit.

–eliminate foreign tax reduction devices.  American multinationals, facing high domestic corporate taxation, have resorted to two general types of tax avoidance devices.  They have: (1) transferred intellectual property (brand names, patents…) to low-tax foreign jurisdictions like Ireland, and (2) located distribution subsidiaries in similar places.  Hong Kong, where the income tax on profits generated by foreign companies is zero, is a favorite.

How this structure works:  a US-based multinational uses a Hong Kong subsidiary to pay a contract manufacturer in China $150 for a mobile telecom device.  The Hong Kong subsidiary sells the device to its US marketing subsidiary for $250.  The US company pays the Irish subsidiary a $100 royalty for the use of the firm’s proprietary technology and brand name.  It sells the device to a US customer for $600, recognizing, say, a $200 pre-tax profit in the US, and paying $70 in federal income tax.  Without Hong Kong and Dublin, the firm would have a pre-tax profit of $400 and pay $140 in tax.

If I understand correctly, President Trump’s intention is to tax this hypothetical multinational on the entire $400 of pre-tax earnings on sales made in the US–no longer allowing cash flow to be syphoned off to foreign tax havens.  At a 20% rate, the firm would pay $80 in federal income tax.

The bottom line:  while tax reform of the type I think Mr. Trump has in mind might leave large multinationals no worse off than they are today, it would be a significant benefit to small and medium-sized firms, which tend not to have elaborate tax departments and to be much more US-focused.  Just as important, it would eliminate the motivation to create offshore profit centers.

As/when the timing of corporate tax reform becomes clearer, I’d expect further rotation on Wall Street away from multinationals and toward domestic-oriented stocks.  A quick-and-dirty way of locating beneficiaries–look for corporate tax rates at or near 35%.

US corporate tax reform (ii)

There are likely to be losers from corporate income tax reform.  They’re likely to be of two types:

–companies that currently have sweetheart tax deals, which, as things stand now (meaning:  subject to the success of intensive lobbying), will go away as part of reform.  A related group is multinationals who’ve twisted their corporate structures into pretzels to locate taxable income outside the US

–companies making losses currently and/or that have unused tax-loss carryforwards.  The value of those unused losses will likely be reduced by a lot.  This is a somewhat more complicated issue than it seems.  In their reports to public shareholders, money-losing firms can use anticipated future tax benefits to reduce the size of current losses.  The ins-and-outs of this are only important in isolated cases, so I’ll just say that for such firms book value is likely overstated

Another potential consequence of tax reform is that investors may begin to take a harder look at tax-related items on the income and cash flow statements.  Could markets will begin to apply a discount to the stocks of firms that use gimmicks to depress their tax rate?  Thinking some what more broadly, it may mean the markets will take a dimmer view of other sorts of financial engineering (share buybacks are what I personally hope for).  It might also be that companies themselves will reemphasize operation experience rather than financial sleight of hand when choosing their CEOs.

US corporate tax reform

 why look at the corporate tax rate?

As I’ve mentioned on occasion in other posts, one of the features of today’s US stock market is that it seems to pay no attention at all to the rate at which publicly traded companies pay tax.  All that counts is (after-tax) eps and eps growth.

A generation ago, when I entered the market, the opposite was the case.  Acting on the assumption that a company couldn’t sustain a super-low tax rate for a long time, analysts scrupulously adjusted, or “normalized,” a company’s tax rate, usually to the statutory maximum.  Of course, it has turned out that some firms–and some industries–have been able to maintain a sub-par tax rate for far longer than anyone imagined possible back then.

the US tax system

There are two main issues with the current US corporate tax system, as I see it.  The statutory rate of 35% is very high in comparison with the world average of around 20%.  So, if there isn’t a crucial reason to locate here, the US is financially a bad place for a company to have operations.  Also, politically savvy industries–oil and gas drilling, for example–have been able to lobby for special breaks that make the tax code unduly complex and the amount that the IRS collects less than it should be.

reform likely

President-elect Trump is promising to address this issue by lowering the federal corporate tax rate to perhaps 15%.  Implied, but not yet stated, is that the tax code will also be simplified by wiping out special exemptions for certain industries.  There seems to be widespread support for both parts of such reform.  So it seems to me that the effort, which has always previously been derailed by special interests, has a good chance to succeed.

market consequences

This means, though, that for the first time in a long while, analysts will be scrutinizing company financials to try to separate winners from losers.

potential winners

The obvious winners are firms that have large amounts of US taxable income and that pay cash taxes at the full 35% rate.  The pharmaceutical industry is one.  No surprise that most of the tax inversions of the recent past have been in pharma.

More tomorrow.

 

 

US corporate tax reform (iii)

For years ago I wrote in detail about today’s topic, which is deferred taxes.

The basics:

–deferred taxes are an accounting device that reconciles the cheery face a company typically present to shareholders with the more down-at-the-heels look it gives the IRS, while accurately reporting to both parties the cash taxes paid

–look at the cash flow statement, which, as the name implies, shows the cash moving in and out of the company or in the income tax footnote to get the particulars for a firm you may be interested in.

accounting for a loss

The issue I’m concerned about in this post is what happens when a company makes a loss.

reporting to the IRS

The income statement  for the IRS looks like this:

pre-tax income (loss)      ($100)

income tax due                          0

after-tax income (loss)     ($100).

reporting to shareholders

Financial accounting books, in contrast, look like this:

pre-tax income (loss)         ($100)

deferred tax, at 35%                 $35

after-tax income (loss)        ($65).

what’s going on

The financial accounting idea, other than to cosmetically soften the blow of a loss, is that at some future date the company in question will again be making money.  If so, it will be able to use the loss being incurred now to offset otherwise taxable future income.  Financial accounting rules allow the company to take the future benefit today.

It’s important to note, however, that the deferred tax is an estimate of future tax relief, based on today’s tax rates.

why does this matter?

Profits add to shareholders’ equity; losses subtract from it.  Under the GAAP accounting used for reports to stockholders, a loss-making company only has to write down its shareholders’ equity (aka net worth, book value) by about two-thirds of the actual loss.  To the casual observer, and to the value investor using computer screening, it looks stronger than it probably should.

Financial stocks typically trade on price/book.  This is also the sector that took devastatingly large losses during the financial crisis (that they caused, I might add).

Suppose the corporate tax rate is reduced to 15%.

This diminishes the value of any tax loss carryforwards a firm may have.  It also may require a substantial writedown of book value, making that figure more accurate.  But the writedown may also underline that the stock isn’t as cheap as it appears.

 

US corporate income tax reform (ii)

To summarize yesterday’s post:

firms with taxable income

Lowering the corporate tax rate in the US, while eliminating special interest tax preferences/exemptions, will benefit companies that have a high current tax rate.  It will boost such a firm’s earnings by as much as 30%.

On the other hand, companies that have a low income tax rate will receive little or no benefit.  Continuing to spend resources on what are in effect tax shelters for themselves will make no sense.  To the extent that they are able to unwind these arrangements, they will benefit by doing so.  If, however, they are recipients of special interest tax reduction deals, they may be absolute losers, as well as relative ones, if/when these special preferences are eliminated.

The greatest uncertainty here is whether industries that are recipients of large tax breaks, like real estate and oil and gas, will have their special interest preferences eliminated.  This will be a key indicator of whether the “Drain the Swamp” rhetoric is more than an empty slogan.

firms with losses

This case is not as straightforward, thanks to wrinkles in the Generally Accepted Accounting Principles used by publicly traded companies in their reports to shareholders.

for the IRS

Let’s assume a firm makes a pre-tax loss in the current year.

 

The company has a limited ability to use this loss to offset taxes paid in past years ( it carries the loss back).  It restates its past returns and gets a refund.

If it still has a portion of the loss that can’t be used in this way, it carries the loss forward to potentially use to shield income in future years from tax.

If the corporate income tax rate drops from 35% to 15%, the amount of pre-tax income that can be sheltered from tax by loss carryforwards remains the same.  But the value of the carryforward is reduced by 60%.

for financial reporting

That’s tomorrow’s topic.

 

US corporate tax reform: stock market implications (i)

high US corporate taxes

The headline rate for US federal tax on corporate profits is 35%.  That’s higher than just about anyplace else on the planet and, in itself, a deterrent to business formation in the United States.  It’s also the reason for the big business of advising corporations on how to finesse the tax code that has sprung up over the past decade or so.  In addition, it’s also why tax havens such as Ireland, Switzerland, Hong Kong and assorted islands in the Atlantic Ocean have become so popular with Americans.

A generation ago, world stock markets paid particular attention the rate at which a given company paid corporate tax.  The assumption back then, which has turned out to be incorrect, was that a firm could only sustain a low tax rate for a limited period of time.  So no matter what the rate shown in the financial statements, professional securities analysts would “normalize” it  to the top marginal rate.  Portfolio managers wouldn’t pay a full price for a low tax payer, either.

Not so in today’s world.  As far as I can see, Wall Street has long since stopped believing that the “quality” of earnings taxed at below the statutory tax rate is less than those same earnings taxed at a higher one.

Trump’s proposed reform

Given that the Republican party controls both houses of Congress and the presidency, it seems to me that the corporate tax reform championed by Donald Trump has a good chance for becoming law.  This would mean that for a company having $100 in fully-taxed pretax US income, after-tax profit would rise from $65 to $85–a 30+% boost.

big stock market implications

A change like this would have enormous implications for US-traded stocks.  In particular:

–investor interest would rotate toward purely domestic companies.  This would favor mid- and small-caps over large, and dollar earners over multinationals.  I think this is already starting to happen

–to the degree that they could be, elaborate tax avoidance schemes that have become common for US firms will be unwound.  Tax havens will suffer.  On the other hand, profits from future earnings that would otherwise be held in tax-haven banks will begin to be repatriated to the US.  Trump is also proposing to allow money now “trapped” in tax havens to be brought back to the US on payment of a 10% income tax.

–tax inversions by US-based companies–that is, flight of high-rate US taxpayers to tax havens abroad (or, actually, just about anywhere else) will come to a halt.  Arguably, companies that have recently inverted may begin to trade at discounts to un-inverted peers

–the price US firms would be willing to pay for foreign companies using funds parked abroad should fall

–it’s possible that US investors will begin to become interested once again in the ins and outs of the tax line on the income statement.  That might mean that 1980-style quality-of-earnings differentials will be in vogue again

–there are also possible negative implications for firms that have substantial tax loss carryforwards or who benefit from the many industry-specific tax preferences of the current tax code.

 

More tomorrow.

publicly traded US companies have about $1 trillion in cash stashed abroad

That’s the best number I could come up with–admittedly through a fast internet search.

It’s not the exact figure that I find interesting, though, but the motives companies have for doing so.  Three of them are well-known, two less so.

the well-known

–Multinational companies have operations in many countries.  It may be that much of their growth–and all of their possible acquisitions–will be outside the US.  It makes no sense to move money back to the US, pay 35¢ on the dollar in Federal income tax and then resending the net amount abroad to make a foreign acquisition.  A CEO might, and probably should, lose his job for allowing this to happen.  Also the official reason companies cite for not returning cash to the US is that the funds are permanently invested internationally.

–Versus other countries, the IRS is unusually harsh in the way it taxes earnings repatriated from abroad.  There has already been one discount deal, the Homeland Investment Act of 2004, offered by the IRS to allow corporates to repatriate cash without the stiff tax bill.  The terms were:  tax at 5.25%, but all money brought back had to be invested in hiring new workers or building new plant.

As it turns out, aggregate hiring and plant construction didn’t rise during the amnesty period, even though about $300 billion was repatriated, making the case for another HIA a bit shaky.  Nevertheless, the possibility of a new HIA is a powerful deterrent to repatriation.  Who wants to be that idiot who paid $3.5 billion on a $10 billion repatriation a month before HIA II is enacted?

–Big corporates can borrow a ton of money very cheaply in the US.  APPL did it last year, for example, and the company seems to be warming up for another tranche in the near future.

the other two

–Companies have found a workaround.  It doesn’t count as repatriation if you keep the money in the US for less than 90 days and don’t get money again from the same source for a certain amount of time.  So multinationals have created daisychains of intracorporate loans, whose effect is to keep cash permanently in the US.  The first loan comes, say, from Hong Kong.  Three months later, it is repaid with cash from, say, Ireland.  That loan is repaid with money from, say, Switzerland.  And the Swiss loan is repaid with fresh funds from Hong Kong…  Ingenious, yes, but most owners would wish, I think, that corporate minds be put to more productive uses.

–In recent years, companies have boosted eps growth by tax planning, that is, by opting to recognize profits in low-tax jurisdictions.  A generation ago, investors wouldn’t have allowed this.  The market back then would only pay a discount PE for earnings that weren’t fully taxed at the rate prevailing in the firm’s home country.

No longer.  As far as I can see, investors are now indifferent to the tax rate firms pay.  The market no longer discounts earnings taxed at a low rate.  So managements have every incentive to recognize profits in low-tax countries.  After all, it takes $1.50 in pre-tax earnings in the US to produce a dollar of net.  That’s 50% more than a US firm needs to produce the same net from Hong Kong.

More than that, suppose a firm suddenly got it into its head to recognize all its earnings in the US.  What would happen to profits?  There’s an easy way to find out.  Just look at the actual corporate tax rate and adjust it to 35%.  If the actual rate is 25%, then each dollar of pre-tax becomes 75¢ of net.  At 35%, each dollar of pre-tax would be 65¢ of net–a 14% drop.  What CEO wants to report that earnings growth is slowing–or worse, disappearing–because he’s monkeying around with the tax rate?