September 2017 Issue
Nothing could be more topical than taxes as we are anticipating not one, but two plans for major overhaul of the US tax code. One comes from members of the House of Representatives, the other from the White House, and either would substantially alter individual as well as business taxes. Regarding the latter, both these proposals contemplate materially lowering corporate taxes by a direct reduction in rates applied to pre-tax net income or the substitution of a lower effective tax on cash flow. In addition, both contemplate doing away with major deductions. Notable components highlighted as part of a possible revamp include elimination of interest expense deductions, substitution of an immediate write-off of capital investments for depreciation over time, a repatriation holiday for overseas profits, as well as some form of value added tax (VAT) or ‘border tax’ meant to favour exports over importing goods. The political debate over these alternatives, should they proceed, is likely to be protracted. The consequences of any action on business activity, personal incomes or federal budget deficit are already contested. Be that as it may, these prospective wholesale changes focus attention on the underlying conundrum – how do corporate taxes bear on specific companies and capital market valuations?
The practical v. theory
Though they impact companies differently, based on profitability, depreciable assets, capitalisation and corporate structure, taxes can be characterised as having three effects on business operations and enterprise value: (i) corporate income; (ii) capital structure; and (iii) cash flow.
First, taxes are based on income accounting. Statutory rates adjusted to effective tax charges bear on reported net income, and thus equity value. Notably, after adjustments for the byzantine provisions of the Code for tax credits, deferrals, special exceptions and offsets, frequently statutory rates bear little resemblance to actual taxes paid. In any event, these metrics are often overlooked as markets focus on non-tax earnings before interest, tax, depreciation and amortisation (EBITDA) multiples for enterprise valuation.
Second, taxes affect a company’s balance sheet. The most direct example is deferred liabilities, primarily representing the difference between book and tax accounting for depreciation or deferred tax assets due to accumulated net operating loss carryforwards. Less evident is funded debt which, to some extent, is incurred based on the tax shelter afforded through the allowed deduction of interest expense, in contrast to the non-deductibility of stock dividends. While deferred taxes have theoretical significance but little practical impact on public value, financial leverage is a determining factor in business operations, stability and valuation. Tax rates are also a key variable in the weighted average cost of capital (WACC), in turn influencing capital allocation and strategy.
Third, a tangible impact of tax statutes is on cash flows reflecting the combination of allowed non-cash expenses, such as depreciation, credits for investment and carryforwards, deferrals, as well as accounting for international operations. Through these adjustments in Sources and Uses statements, there may be significant changes in cash flows and working capital. While of considerable practical import, the degree to which these changes in cash affect value is less clear.
Market’s certain uncertainty
The saying, ‘nothing is certain but death and taxes’, is belied by the differential impact of taxes between corporations. This dichotomy has been magnified of late with Congress poised to take up tax reform with the stated objectives of reducing statutory rates and incorporating mechanisms to promote exports, as well as pursuing an ambiguous goal of ‘simplification’. However well intended, whether as a substantial cut in income tax rates or the replacement with a tax on cash flow and offsetting loss of deductions, a major reduction in statutory corporate taxes to more closely conform to global trading partners, coupled with a possible inclusion of a tax on imports to redress trade imbalances, pose huge uncertainties. Risks extend well beyond particular companies to the broader economy, based on potentially substantial collateral effects. These include macroeconomic impacts of changes in projected federal receipts and corresponding deficit, value of the US dollar, retaliatory actions of trading partners, as well as such secondary effects as the general level of interest rates, consumer prices and GDP.
In contrast to these considerable market uncertainties, however, experience is unambiguous in one regard. Whether federal deficits go up or down, trade balances improve or deteriorate, US corporate profits and valuations gain or lose based on changes which may eventually be forthcoming, the code will remain complex and opaque.
In the long run
For specific corporations, the economics of taxes are founded on the idiosyncrasies of each business. Whatever reforms may be adopted, immediate gains, such as the repatriation of overseas profits, are easily valued. The impact of structural changes is much more difficult to gauge. For example, what are the likely effects of substantially lower tax rates or a hybrid VAT structure on the Federal budget and interest rates? How may the elimination of interest deductions affect debt issuance and the cost of capital? What will be the net result of expensing capital investment against a loss of depreciation, or the degree to which a border tax benefiting exports comes at the expense of importers and consumers? In their particulars, the impact of such broad ranging changes is further qualified by myriad efforts of individual companies and groups in lobbying to influence proposed legislation. Moreover, corporations will continue to be adept at managing tax exposure; this is apparent in a recent study by the Institute of Taxation and Economic Policy, which found that 258 profitable corporations between 2008 and 2015 achieved an effective federal tax rate of 21.2 percent, compared to the statutory rate of 35 percent. The study highlights the concentration of tax breaks, with 10 percent of the sample claiming over half the subsidies, indicating the degree to which certain companies effectively cut their tax bill.
There will be corporate gainers and losers in the event of any major Code changes. In due course, that determination will reflect both public policy and lobbying efforts, as well as priorities and sophistication of individual businesses. Short term, valuations will adjust for immediate impacts. Longer term, however, it continues to be the case that a company’s profitability and cash flow, competitive strategy and innovation drive value. Taxes remain inevitable, subject to negotiation and adjustment, but far from determinative of an enterprise’s value.
Anders J. Maxwell is a managing director at Peter J Solomon Company. He can be contacted on +1 (212) 508 1683 or by email: email@example.com.
© Financier Worldwide
Anders J. Maxwell
Peter J Solomon Company