[BASIC Event Recap] Investor Implications of Tax Reform
by Emily Lambert
BASIC’s tax reform event focused on both individual and investor implications. Rob Wilson, Research Analyst at MFS, outlined investor implications while Boston University Law School’s Director of Graduate Tax Reform, Christina Rice, detailed individual-level impacts. Please check out additional resources from Civic Series, our co-host for the event, here. Thanks to Sharon Bort for cultivating this list.
Analyzing corporate taxation can help analysts assess a company’s potential earnings and governance, including management and the Board’s risk tolerance.
On a macro level, tax avoidance has societal impacts including deficits in developed markets (with hundreds of billions (USD) annually lost to tax avoidance), an impact on emerging markets (OECD: Africa loses more money in tax avoidance than it earns in aid annually), and increasing inequality (as a lower tax rate arguably benefits the top 5% of earners who have investments in public markets via share buybacks). A potential “race to the bottom” could develop as the U.K. recently dropped its tax rate to 17% by 2020, France is debating lowering its rate, and the U.S. has lowered its rate to 21%. The Roche CEO recently lobbied Switzerland to keep pace by lowering its tax rate.
On a company level, quality companies will aim for the lowest sustainable tax rates. Tax savings enable higher earnings, investment in employees and lower consumer prices. But lower taxes are not always “better” – (1) there is an impact to societal tangibles (infrastructure) and intangibles (legal system, education, public services), (2) there needs to be a balanced assessment of the legal interpretation of laws and the spirit of various tax laws, (3) tax management needs to match the firm’s business model and flow of goods/services, and (4) tax management should be consistent in a peer landscape. Tax oversight includes weighing short and long term consequences and requires Board oversight.
What has changed with tax reform? Tax reform lowered the corporate tax rate to 21% permanently, changed immediate capital expensing, developed a new territorial system that eliminates trapped overseas cash, and introduced new limitations on interest deductibility. These cuts will result in $1.3T in lost revenue over 10 years excluding dynamic scoring. Interest expense is limited to 30% of EBITDA but will shift to 30% of EBIT after 2021. Shire, domiciled in Ireland, is one of the few publicly available examples of the complications with interest expenses (due to a recent investigation). The company has $800M in external debt and $10B in inter-company debt, used to massively decrease U.S. taxes paid via interest deductibility. Prior to tax reform, the U.S. was one of 7 countries globally with worldwide taxation. The repatriation holiday in 2005 resulted in a significant increase in share buybacks but did not spur economic growth. It remains to be seen how significantly these tax benefits will help employees and consumers.
Equities. Shareholders will benefit in some industries, but tax reform benefits will be competed away in other industries. For example, in aero/defense, shareholders will benefit due to high barriers to entry but will not benefit in auto OEMs due to high levels of competition. At a stock level, companies employing very aggressive tax minimization strategies will not necessarily benefit. For example, Hanesbrands disclosed an increase in its tax rate from mid-single-digits to high-single digits.
Fixed Income. 40% of high-yield issuers will not see a net benefit from tax reform. For U.S. IG corporates, interest deductibility is a non-issue. The key issue is if firms will de-lever balance sheets due to changes to interest deductibility. It’s possible that tax reform will limit IG supply (although credit remains cheap and the economy is strong). Perhaps the biggest impact is how tax reform will impact the Fed as tax reform is really added stimulus.
What’s next? There are other tax related updates coming. The OECD is issuing new regulations which require country by country tax reporting. Rob is working with the GRI to include a tax disclosure requirement in the next round of CSR/ESG reporting. In Europe, the EU is looking at a common consolidated corporate tax break (which would create a single set of rules for how EU corporations calculate EU taxes) and is developing a digital revenue tax. Certain governments have started cracking down against tax minimization (including Chevron in Australia and Cameco in Canada) and public pressure has forced to companies to update their tax policies, including FB and SBUX.
What are best practices? Analysts should look for tax policy statements from companies, and see if tax practices match the company’s business model and outlined priorities. Rob asks companies how tax policies fit with business models, how tax policies align with Code of Conducts and general management philosophies, and if the company is paying a low rate, if it is sustainable. Responsible tax oversight is critical to avoid reputational risks (like FB) given possible regulation with digital revenues, country-by-country reporting, and increasing investor scrutiny and transparency demands when speaking with companies. Questions on tax oversight from investors are driving corporate change. Responsible tax management is a proxy for proactive management teams. There is evidence that the EU’s requirement of country by country tax reporting at banks actually led banks to use less aggressive tax policies and provide added transparency. Rob cited Unilever’s tax policy as best-in-class (as it cites examples of following the letter and spirit of the law) and commended Vodafone for its country by country reporting.