US Tax Reform: Three Q1 Considerations for Investors
As US companies begin to report their first quarter results, investors will need to consider the ongoing effects of the 2017 US Tax Cuts and Jobs Act (Tax Act).
These impacts fall into three categories:
1. 2018 Updates to 2017 Enactment
The “Two Boogeymen” of the Tax Act are the repatriation tax, or toll charge, and the adjustment in deferred taxes. Though most of the bill’s provisions didn’t come into play until the first quarter of 2018, these two showed up in 2017 year-end financial statements, just days after President Donald Trump signed the bill.
Most multinational corporations took charges for the repatriation tax, and many with deferred tax assets took charges to reflect the reduced value of these assets. While some firms reported them as “non-cash charges,” make no mistake: These items represent real losses, as assets previously valued at 35 cents on the dollar are now only worth 21 cents since companies can no longer collect the higher value from the US Treasury.
Other firms with deferred tax liabilities benefited from reduced liabilities to the US Treasury. With the SEC permitting firms to improve and update these estimates throughout 2018, investors must review the tax footnote and query management to ascertain how much such estimates have been refined during the first quarter and keep an eye on this throughout 2018.
Regarding the toll charge, there are two separate cash considerations for investors. First, companies should disclose whether they intend to remit the tax over the next eight years under the delayed payment offered under the Tax Act, with 8% due in the first five years, 15% in the sixth year, 20% in the seventh; and 25% in the eighth year. Second, the repatriation tax is based on deemed rather than actual repatriations of earnings, as described more fully below.
2. 2018 Changes
While the complexities of the bill are many, keeping the following factors in mind when reviewing first quarter 2018 financial statements is critical.
- New Effective Tax Rates: The first quarter 2018 filings will offer a glimpse into the new actual effective rate as US corporate taxes fall to 21% from 35%. So pay attention to the effective rate reconciliation in the first quarter to understand the change in the overall effective rate and remove the true-ups to the 2017 enactment effects. The size of the effective rate’s decline will offer insight into the breakdown between a company’s foreign and domestic earnings. That said, the Financial Accounting Standards Board (FASB) has not passed income tax disclosure reforms that would provide greater transparency into the geographic mix of earnings.
- Deductibility of Interest: The Tax Act limits the deductibility of interest expenses to 30% of adjustable taxable income — defined similarly to EBITDA — until 31 December 2021, when it will be limited to 30% of an adjusted taxable income which will be defined similarly to EBIT (generally a smaller number). While limited, this disallowed interest will be carried forward indefinitely. Investors should consider to what degree companies have been limited and the impact this has on the cost of debt versus equity capital and evaluate the growth in deferred tax assets relative to interest deductibility limitations.
- Capital Expenditures: The Tax Act allows companies to expense 100% of the cost of qualified property placed in service after 27 September 2017 and before 1 January 2023. While companies will receive a benefit for certain items placed in service in the fourth quarter 2017, since the Tax Act was not enacted until the last week of December, they had little opportunity to avail themselves of this rule change in 2017. Beginning in 2018, capital expenditures made under this provision won’t have a significant effect on earnings before taxes as limited depreciation will be recognized for book purposes. However, these expenditures will result in a significant deduction for current tax purposes. Investors will want to carefully review the investing section of the statement of cash flow to understand the extent of cash outflows on capital expenditures and the increase in the deferred tax liabilities for book versus tax deductions.
- Additional International Taxes: US multinational companies will have two new international taxes as the country moves from a territorial to a worldwide tax system. The global intangible low-taxed income (GILTI) and anti-base erosion and anti-abuse tax (BEATS) are complex computations of taxes — too complex to be covered here — that seek to ensure US firms pay a minimum level of tax and do not erode the taxable base of US corporations. The FASB has pledged to monitor how corporations account for these taxes as there is some debate over whether the existing tax literature offers sufficient guidance on how to account for them. Specifically, there are questions as to whether the GILTI tax should be accounted for as period costs or have a current and deferred tax element. How much of these taxes a company pays and how they are accounted for will affect the effective tax rate. If a period cost, they will have a less predictable impact.
The Tax Act also places limits on executive compensation and includes other provisions, such as the deductibility of certain entertainment expenses, the repeal of the corporate alternative minimum tax, changes in the net operating loss (NOL) deduction, incentives for US production, and changes in foreign tax credits which may impact investee companies.
3. Strategic Considerations: Cash Flows and Capital Structure
The Tax Act’s strategic implications, though listed last, are probably most important to consider over the coming months.
Parent Company Cash Flows: Cash Available for Dividends and Stock Repurchase
When it comes to the cash flow impacts of the Tax Act, the payment of the toll charge — and that it is backend — has been well publicized in the press. That the tax is a “deemed” rather than an actual repatriation tax, however, has not received as much attention. Simply put, the toll tax is due whether or not the company repatriates the foreign earnings. Payment of the toll charge or repatriation tax does not mean cash has been returned to the US parent company.
During the first quarter, throughout 2018, and possibly over the next eight years, investors should ask their investee companies about their plans to repatriate cash back to the US parent. How the tax will be paid and the cash transactions among subsidiaries and the parent company are important to keep an eye on. Investors should carefully review the liquidity section of the Form 10-Q as well as the parent company-only financial statements and statement of cash flows since the value of an investment in the parent company depends on the dividend (or share buyback) capacity of that entity. Consolidated financial statements will not provide the necessary insight on this issue since they won’t show the movement of cash among the consolidated entities and the parent.
Many times these parent company financial statements are only provided at year-end, but as firms develop their strategic plans about repatriating foreign cash and borrowing among parent and subsidiaries, they should provide such information quarterly if there are significant changes in the parent company’s financial position or cash flows.
Capital Structure: Tax Reform Likely to Change
Asking management where changes in cash flow and in the deductibility of interest expense are impacting the organization’s capital structure and mix of debt and equity is also vital. With the ability to move cash flow more freely among the entities and the limitations on the deductibility of interest, companies will likely be considering the optimal capital structure and this should be of keen interest to investors.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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