January 2018 | Cara Lafond, CFA, Multi-Asset Strategist; Michael Feder, Director of Global Tax
Tax reform, which has dominated news headlines, has been a powerful tailwind for markets in recent months. In December 2017, the long-awaited Tax Cuts and Jobs Act of 2017 — the biggest taxlaw change in over 30 years — was enacted, buoying financial markets. As the dust begins to settle, many investors and corporations will seek to grasp the law’s potential impacts and determine how to leverage its incentives. For investors, we believe that fundamental analysis will be essential for identifying areas of the market that stand to gain or lose from the new legislation and for delivering differentiated results. While we continue to be constructive on US stocks generally, given strong fundamentals, rising consumer confidence, and a pickup in capital expenditures (capex), the law will likely have uneven consequences and could drive dispersion.
We believe greater dispersion renders bottom-up analysis that much more important. Top of mind for our investment strategists are:
While the law lowers headline corporate tax rates from 35% to 21%, not every corporation will benefit from a 14% reduction in tax liability. Many US-based multinationals were already reporting a lower effective tax rate on their financial statements, typically as a result of business operations in low-taxed foreign jurisdictions. Some US multinationals could report increased tax expenses as a result of a new minimum tax rate on non-US earnings. As a result, we generally expect domestically oriented US companies with higher effective tax rates to enjoy a greater relative benefit.
We think potential winners may also include physical-capital-intensive businesses. To spur new investment, the law includes an incentive that changes how companies depreciate or expense assets. In many cases, companies can now expense capital expenditures outright, as opposed to depreciating them over a number of years. Furthermore, where multiyear depreciation continues to apply, it is often on an accelerated schedule. We think that US industrials, specifically capital goods and transportation companies, are likely to be beneficiaries of this change, in part because their customers should be able to claim tax benefits from their purchases more easily. This provision will apply in full until 2023 and be phased out by 2027.
In our view, domestic financials should also do well. The sector’s high relative tax rate will likely decline; and the continued regulatory rollback, sustained consumer confidence, and normalizing interest-rate environment should provide further support. Additionally, the new tax law benefits master limited partnerships (MLPs) and real estate investment trusts (REITs) by providing a 20% deduction against income derived from MLPs and certain REIT dividends. We expect that these assets will likely become more attractive to individuals in the highest tax bracket, as these classes of income will now be taxed at a rate of 29.6%, rather than the top marginal ordinary income-tax rate of 37%.
The law will not uniformly benefit the real estate sector, however. The bill lowers the mortgage-interest deduction cap to US$750,000 from the current US$1 million threshold, and introduces a new US$10,000 ceiling on state and local income- and property-tax deductions. The changes may temper demand for luxury homes in high-priced markets such as California and the northeastern US, potentially affecting some real estate companies as well as lenders and construction firms.
Broadly speaking, tax reform may benefit industry leaders, particularly those operating in oligopolies that have higher margins relative to competitors. In general, high-margin businesses should be able to reinvest more cash than their lower-margin peers, helping them become even more dominant. In our view, incremental investments made by skilled management teams could create advantages and dampen lower-margin competitors’ profitability. To that end, we believe that focusing on the differentiation within industries and understanding how competitive dynamics could drive relative advantages (or disadvantages) in the new tax regime will be critical for investors.
In assessing the ramifications of the new tax regime for US multinationals, we seek to understand the amount of cash to be repatriated, the amount of foreign retained earnings, and the regional revenue mix. Over the past several decades, many US multinationals have established significant retained earnings outside the US. Initially assumed to be confined to the technology and pharmaceuticals sectors, this practice turned out to be much more widespread.
The new tax law will impose a one-time charge on most US issuers with foreign subsidiaries. This charge will be equivalent to 8% of offshore retained earnings held in illiquid assets (e.g., amounts previously used to fund capex or merger and acquisition (M&A) transactions), and a 15.5% tax on offshore earnings held in liquid assets. This charge will start to appear in 2017 financials. We expect this rule to create some confusion as analysts review 2017 financial results, but over the long term we do not believe it will significantly move markets.
Balanced against this cost, the new law will likely remove most incentives for keeping offshore retained earnings outside of the US. It will also remove some preexisting tax incentives for locating business operations abroad. As a result, we expect to see a significant, sustained onshore flow of cash to fund the one-time “toll charge” tax payment and, over the near to medium term, to fund business expansion, debt retirements, and share buybacks and dividends.
Long term, we believe the law and its repatriation component will affect markets in several ways. First, anticipation of shareholder distributions and buybacks has recently helped drive up equity prices for many US-based multinationals, a move that may not be justified (or sustainable) in all situations. Second, we are concerned about the supply of fixed income instruments, particularly in sectors such as technology and pharmaceuticals, which historically have had large offshore cash balances. We believe that by eliminating incentives for keeping cash offshore, the law could boost the relative value of the US dollar. This could potentially harm emerging market issuers that are required to issue dollar-denominated debt, as well as banks that profit from offshore dollar-denominated financing. Repatriation will also likely make certain M&A transactions less attractive when compared to alternate uses of capital, such as domestic capex and debt retirements.
We are concerned that some elements of the new tax law could favor US companies over certain international competitors. Specifically, the new base erosion and anti-abuse tax (BEAT) is a 10% excise levy on gross payments to related parties that reduce US taxable income. (BEAT excludes payments derived from the cost of goods sold and those that fall under certain derivative financial instruments.) While the BEAT technically applies to US and non-US issuers, we expect its impact to be more significant for non-US companies. The BEAT may have a substantial negative effect on non-US reinsurers and banks, for example. Under the new law, a reinsurance premium paid by a US corporation to a related Bermuda reinsurer would be subject to a 10% excise tax, whereas the same premium paid to a domestic reinsurer would not. Similarly, a European bank running a repo or securities lending business in the US could be at a relative disadvantage to a US competitor, because intercompany funding transactions will be subject to the 10% excise tax when they involve payments to non-US affiliates.
The implications of the BEAT are not yet well understood and will likely affect companies differently, depending on their operating models. For instance, a US subsidiary of, say, a Japanese automaker would be hit with a tax when buying tools from a Japanese affiliate, but not when buying them from a US affiliate or a third party.
As the dust continues to settle on the sweeping new tax law, markets are expected to start determining which companies stand to gain or lose the most from the tax reform. As they do, we believe 2018 should prove to be opportunity-rich for bottom-up stock pickers who can combine fundamental analysis with a nuanced understanding of the new tax regime.
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