Corbin Insights: Tax Reform

We begin 2018 with greater certainty – about tax reform, if nothing else. The president signed the Tax Cuts and Jobs Act into law on Dec. 22, so the conversation has moved from “Will it really happen?” to a preliminary assessment of the immediate and longer-term consequences of the most sweeping tax legislation in three decades.
 
Of course, opinions remain sharply divided about the merits of the new tax law. Supporters say tax cuts will spur broad economic and employment growth; boost tax receipts as companies are required to pay a one-time tax on an estimated $2.8 trillion in accumulated post-1986 overseas earnings; and improve the competitiveness and strategic flexibility of U.S.-based multinationals by encouraging the free flow of their capital across the globe. Critics express concern about a higher federal deficit and expect only a narrow economic benefit from lower corporate taxes – for example, by enabling corporate share repurchases that benefit institutional investors and the 54% of American households that own stocks. Only time will tell. 
 
In the meantime, public companies continue to assess the new tax law. We expect many organizations to communicate the estimated material impact before their next scheduled earnings announcement to allow investors extra time to digest the news. While effects vary by sector and are subject to pending IRS guidance, the key changes for public companies include:

  • A Lower Tax Rate. Public companies will pay a flat 21% rate in 2018 and beyond, versus a top domestic corporate tax rate of 35%. (On average, the effective tax rate will be lower.)
  • Deduction Changes. The law limits the net business interest deduction; reduces the benefit of deductions linked to pension contributions, asset sales and past losses or other deferred tax assets and eliminates deductions for performance-based pay, as well as state and local lobbying expenses.

  • Expensing Changes. Companies can fully and immediately deduct the cost of their spending on capital equipment through 2022. The benefit phases out after that. Previously, spending on equipment was depreciated over a period of years.

  • Multinational Effects. The law imposes a one-time, mandatory repatriation tax on U.S. companies’ post-1986 overseas earnings – 15.5% for cash and 8% for illiquid assets. U.S.-based multinationals must pay tax whether or not they bring this cash back to the U.S. but are permitted to pay the tax in installments over eight years. Congress expects an estimated $339 billion in repatriation tax revenue over the next decade. The legislation also repealed the corporate Alternative Minimum Tax for tax years beginning Jan. 1, 2018 and provides that existing AMT credit carryovers are refundable beginning in 2018. This is especially beneficial for the energy sector that was hard hit in recent years with the downturn in oil prices.

In the first two weeks after the bill’s signing, more than 100 companies announced business decisions and financial impacts triggered by the law. Here are a few examples of how companies are communicating with stakeholders.

  • Bonuses and Raises. Most of the initial news releases explicitly link the tax act to one-time bonuses and pay hikes for U.S. employees. Cynics point to the tight labor market, 2017 tax benefits and ulterior public relations motives as additional incentives to take action.

    AT&T (Telecom | $230B market cap | 6% non-U.S. revenues | 32.7% effective tax rate): “AT&T plans to invest an additional $1 billion in the United States in 2018 and pay a special $1,000 bonus to more than 200,000 AT&T U.S. employees...Every $1 billion in capital invested in the telecom industry domestically creates about 7,000 U.S. jobs, research shows.”

    Wells Fargo (Financials | $307B market cap | 0% non-U.S. revenues | 31.4% effective tax rate): “We believe tax reform is good for our U.S. economy and are pleased to take these immediate steps to invest in our team members, communities, small businesses, and homeowners,” including raising its minimum hourly pay rate 11% to $15 per hour; increasing corporate philanthropy to $400 million in 2018 and 2% of after-tax profits in 2019 and beyond; and targeting $100 million for a small business/diversity program over three years and $75 million for a homeownership program in 2018.
  • Employee Benefits.

    Aflac
    (Financials | $35B market cap | 71.6% non-U.S. revenues | 34.6% effective tax rate): Aflac “intends to invest in several key areas that will provide long-term benefits for employees in the form of helping them plan for healthy retirements, enable strategic investments aimed at growing the overall business and strengthen the company’s 22-year commitment to supporting childhood cancer initiatives.” The commitment to increase U.S. investment by about $350 million over three to five years includes a one-time, company-wide 401(k) contribution of $500, an increased 401(k) match, free employee coverage of certain hospital and accident insurance products, and additional charitable contributions for research and treatment of childhood cancer.

    Netflix (Services | $91B market cap | 36.4% non-U.S. revenues | 28.3% effective tax rate): As disclosed in an SEC filing, the legislation eliminates IRS rule 162(m) that capped the deductibility of executive salaries over $1 million.  As a result, all salary paid in 2018 will be paid in cash and it will eliminate the separate Performance Bonus Plan that had previously been used to shelter salary payments over $1 million. (The management team still receives most pay as stock-based incentive compensation.)
  • Hiring. Few companies committed to additional hiring due to tax savings.

    CVS Health (Healthcare | $79B market cap | 0% non-U.S. revenues | 38.4% effective tax rate): While the Washington Post reported that CVS Health announced in October it would create 3,000 permanent jobs if corporate tax rates decreased, the company’s January outlook statement was less specific given the uncertainties of its pending acquisition. “The company will benefit from the recent comprehensive tax reform signed into law last month. Taking into account the change in the statutory federal rate as well as the law’s effects on state taxes and other permanent items, the company expects its effective tax rate to be approximately 27% in 2018. This reduction in the tax rate represents an increase in cash flow of approximately $1.2 billion. With the financial flexibility that tax reform provides, the company anticipates making strategic investments in future areas of growth in its business, particularly as CVS Health and Aetna combine to remake the consumer health experience, and will have more to say as plans are finalized.”
  • Business Investment. Companies are also positioning tax savings as a reason to invest in business growth.

    Southwest Airlines (Services | $37B market cap | 1.9% non-U.S. revenues | 36.7% effective tax rate): “We are excited about the savings and additional capital, which we intend to put to work in several forms – to reward our hard-working Employees, to reinvest in our business, to reward our Shareholders, and to keep our costs and fares low for our Customers…Southwest also is increasing its fleet investment with its longtime business partner, Boeing, to support future growth opportunities and fleet modernization at favorable economics. The company exercised 40 Boeing 737 MAX 8 options for 15 firm orders in 2019 and 25 firm orders in 2020, and deferred 23 Boeing 737 MAX 7 firm orders from 2019 through 2021 to 12 firm orders in 2023 and 11 firm orders in 2024.” The company also plans to pay $1,000 bonuses to employees and increase charitable contributions by $5 million.
  • Deferred Tax Asset Write-Downs. Numerous firms are expected to record large fourth quarter non-cash deferred tax asset write-downs.

    Allegion plc (Services | $8B market cap | 31.6% non-U.S. revenues | 21.9% effective tax rate): In a filing, the Company said, “Following the enactment [of the tax law], the company performed a preliminary assessment of the tax reform impact and expects to take a $25 - $50 million non-cash write-down of deferred tax assets in the fourth quarter of 2017, due to the reduction in the U.S. Federal statutory tax rate from 35% to 21%. In addition, the company’s preliminary estimate of its future effective tax rate attributable to tax reform is mid- to high-teens. The company continues to evaluate the impact of tax reform, and will update its estimates when it announces its 2017 year-end results in early 2018.”

    Morgan Stanley (Financials | $96B market cap | 26.4% non-U.S. revenues | 30.8% effective tax rate): In a filing, Morgan Stanley estimated “based on currently available information, that net income for the quarter ending December 31, 2017, will include an aggregate net discrete tax provision of approximately $1.25 billion, comprised of an approximate $1.4 billion net discrete tax provision as a result of the enactment of the Tax Act, primarily from the remeasurement of certain net deferred tax assets using the lower enacted corporate tax rate, partially offset by an approximate $160 million net discrete tax benefit, primarily associated with the remeasurement of reserves and related interest relating to the status of multi-year Internal Revenue Service tax examinations.”
  • Repatriation. The tax overhaul paves the way for U.S. companies to bring back hundreds of billions of dollars in profits held overseas and reduce taxes on those earnings going forward, but could increase the tax rate of some non-U.S.-based companies.

    Amgen (Healthcare/Biotech | $133B market cap | 20.3% non-U.S. revenues | 15.7% effective tax rate): “The company expects to have access to its accumulated global cash as well as access to its future global cash flow” due to the tax law, Amgen said in a filing, projecting net tax expense of $6.0 - $6.5 billion related to the repatriation tax and revaluation of net deferred tax liabilities.” 

    Eaton (Industrials | $36B market cap | 44.6% non-U.S. revenues | 9.5% effective tax rate): “For the fourth quarter of 2017, Eaton expects the TCJA [Tax Cuts and Jobs Act] to result in a one-time tax expense of between $90 and $110 million. About half of this expense is related to remeasurement of U.S. deferred tax balances and the other half is related to taxation of unremitted earnings of non-U.S. subsidiaries owned directly or indirectly by U.S. subsidiaries of Eaton. The taxation of unremitted earnings will be paid over 8 years, as required by the TCJA. The above estimate is preliminary, as the exact expense in the fourth quarter can only be determined once fourth quarter activities have been concluded. For 2018, Eaton anticipates that its effective tax rate, factoring in the impact of the TCJA, will be between 14% - 16%, which represents an increase of 3 percentage points over its prior estimate of 11% - 13% before the impact of the TCJA.”

    Goldman Sachs (Financials | $96B market cap | 40.7% non-U.S. revenues | 28.2% effective tax rate). In a filing, the company “estimates, based on currently available information, that the enactment of the Tax Legislation will result in a reduction of approximately $5 billion in the firm’s earnings for the fourth quarter and year ending December 31, 2017, approximately two-thirds of which is due to the repatriation tax. The remainder includes the effects of the implementation of the territorial tax system and the remeasurement of U.S. deferred tax assets at lower enacted corporate tax rates.” Goldman declined to comment to the media on whether it would bring back money from overseas after paying this charge.

    IDEXX (Healthcare | $14B market cap | 38.6% non-U.S. revenues | 31% effective tax rate): IDEXX “expects the recently passed Tax Cuts and Jobs Act to benefit the company by reducing its recurring effective tax rate beginning in 2018 by approximately 750-850 basis points. The company also estimates that the enactment of the Tax Legislation will result in a one-time reduction of approximately $35 million - $45 million in the company’s earnings for the fourth quarter and year ended December 31, 2017, due to the deemed repatriation of the company’s foreign profits, net of the remeasurement of U.S. deferred taxes at the lower enacted corporate tax rate and other adjustments.”

How much cash will be repatriated, how quickly, and how will it be used? A Bank of America Merrill Lynch risk management survey last July revealed 65% of executives surveyed would use repatriated cash to pay down debt, 46% would repurchase stock and 42% would make acquisitions. Goldman Sachs analysts reported a tax repatriation holiday enacted in 2004 led to stock buybacks increasing to 84% in 2004 and 58% in 2005. 

As you prepare for communicating the impact of tax legislation on your company, it’s important to be transparent and comprehensible. Few, if any, investors will be concerned about the non-cash write-offs and will be far more concerned about the ongoing benefits and other effects. You should also be prepared to discuss any strategic implications (e.g., capex is now immediately deductible, therefore, will you be increasing or accelerating investment in capital equipment?).