- ClearBridge conducted a deep dive into corporate tax proposals, leveraging internal and external sources, enabling us to frame a range of possible outcomes.
- Eliminating the interest expense deduction in favor of expensing capex will have far reaching impacts for valuations, investment and financing.
- A territorial tax system with border adjustments would level the playing field for domestic manufacturers and exporters facing international competition.
It is rare for markets to go through long periods of time without major political or economic change. As stunning as the election of Donald Trump was, it was just the latest in a series of unlikely macro events that has caused us to assess potential implications for our portfolio companies. In the past few years, we have analyzed the impact of Brexit, Greek default risk, quantitative easing and its unwinding, slowing growth in China, an oil price shock, rising interest rates and a strengthening dollar as well as turmoil in the Middle East.
For each of these less predictable events, we identify in a systematic fashion what can be analyzed and what is unknowable, and the applicable risks and benefits of these events to sectors or individual stocks. This analysis, conducted collaboratively by our portfolio managers and analysts, entails discussions with the management teams of the companies we own and follow, external analysts, regulatory specialists, political consultants and industry experts.
"The impacts of expensing capex are far reaching in terms of valuation, investment and financing."
We then go company by company and analyze their exposure to specific outcomes to understand the real potential impact on future cash flows, earnings and valuation. In many cases, our long-term focus allows us to ignore short-term transitory risks. In other cases, the long-term cash generating potential of the company may have changed materially, necessitating portfolio adjustments.
The Trump election introduced unusual complication and uncertainty due to: 1) the breadth of the potential changes and 2) the fact that legislative and regulatory changes have yet to be enacted. Our health care and industrials analysts recently assessed potential changes to the Affordable Care Act and likely impacts of increased infrastructure spending. A closer look at the Trump and Republican plans for corporate tax reform further illustrates how ClearBridge, as a fundamental research-driven active manager, analyzes significant macro changes. Some of our companies are clear winners or losers from potential tax changes, while it is less clear for other companies.
Corporate Tax Reform
Our chief investment officers have long advocated for tax reform, which would make U.S. companies more competitive and would generally be beneficial for economic growth and spending. This may be the most important issue to understand in a long list of potential reforms, as every ClearBridge investment, including non-taxpayers and foreign companies, will be affected by it.
After analyzing the Trump Plan and House Republican Plan, the key goals are to make U.S. companies more competitive in cross-border trade, promote capital investment in the U.S. economy and eliminate the desire for corporations to move their headquarters and manufacturing overseas. These can be accomplished by lowering the tax rate and eliminating complexity through deductions and loopholes. However, tax cuts alone would lead to an expanding deficit, which is undesirable in the current political climate. In order to pay for a reduction in the overall corporate tax rate and achieve revenue neutrality, several deductions and loopholes might need to be cut. The key considerations of tax reform include:
- Reducing the corporate tax rate to 20% in the House plan and 15% in the Trump plan
- Expensing capital expenditures in lieu of interest expense
- Establishing a territorial tax system with border adjustability
- Repatriating overseas cash at a low rate
1. Reducing the corporate tax rate
For several of our companies, the impact is straightforward: a reduction in corporate tax rates equates to higher earnings for our investments and ultimately higher stock prices. Companies with tax rates in the mid-to-high 30s that are not eligible for many deductions or loopholes could see earnings increase over 20% in the event of a reduction of the corporate rate to 20%.
Some companies, however, have minimized their tax rates using transfer prices to maximize profit offshore or used sophisticated tax loopholes or credits to avoid paying tax altogether. Some of these companies with tax rates in the teens or 20s will lose their deductions, offsetting the benefit from the lowering of rates. Some, in fact, may actually see their tax rates rise. In addition, many companies with tax shields and large net operating losses will see these benefits reduced or eliminated.
2. Expensing capital expenditures in lieu of interest expense
The Trump and House plans will allow companies to expense their capital investments in the first year and eliminate the requirement to depreciate assets over their useful life. The goal is to increase incentive to invest for economic growth as capital investment seems to have taken a back seat to share repurchases. Manufacturing and equipment companies should benefit from this change.
After removing loopholes and deductions, eliminating the interest expense deduction is the key method to achieve revenue neutrality within the new tax regime. The government does not want a company to be able to expense capital investment and then also expense the method for financing – double counting. The government also gets the side benefit of deleveraging the corporate sector.
The impacts of this reform are far reaching in terms of valuation, investment and financing. By eliminating the tax deductibility of debt, finance textbooks will have to be rewritten. Basic valuation relies on discounting cash flows with the weighted cost of capital, which now may be higher as a result of eliminating this deduction. Discounting cash flows at higher rates would lower valuations across the board; however the higher cash flows from a lower overall tax rate will be an offset in some cases. Acquisitive public companies and private equity may be motivated to pay less to buy companies. Leasing companies will find it more expensive to finance their equipment. Real estate investment firms that buy commercial properties with up to 80% loan-to-value ratios will seek to pay lower prices for buildings.
3. Territorial tax system with border adjustments
A territorial tax system with border adjustments taxes goods and services where they are consumed and ignores business conducted overseas (which is taxed locally). This is a departure from the income-oriented tax in the U.S. that encourages businesses to locate subsidiaries overseas to maximize income in low tax rate countries. Such a system is complicated and is likely the most difficult reform to interpret – it is also the subject of disagreement between Trump and House Republicans. The goal is simple: to put U.S. trade on equal footing with our trading partners that utilize a value added tax (VAT).
When the U.S. exports a good, it is taxed with a VAT in the country in which it is consumed while the income produced by that company is taxed in the U.S. – a double tax. When the U.S. imports a good, the exporting country waives its VAT tax (a border adjustment) and the U.S. does not tax the value of that good (no border adjustment) – resulting in imported goods not being taxed at all.
Exhibit 1: Gross Imports by End Use in 2015 ($ billions)
This example shows that our current tax system puts the U.S. at a disadvantage in cross-border trade. The House Republican Plan wants to tax the value of the imports coming in (like our trading partners do) and eliminate any income tax on goods exported from the U.S. This should put U.S. companies on equal footing with trading partners as their goods will only be taxed one time - not twice - while imported goods will equally be taxed once where they had escaped taxation in the past. It should also discourage companies from moving production of goods outside the U.S.
Such border adjustments are strongly positive for our investments with domestic manufacturing operations and that export to other countries. They are likely to see a dramatically lower tax rate, likely under 20%. The multi-national companies with complicated supply chains and high levels of foreign manufacturing – apparel companies, auto OEMs and others listed in Exhibit 1 – will be disadvantaged with a tax on the full value of the goods they are importing, rather than the income they are earning.
The most difficult part of a territorial system to interpret is what happens to the price of goods at the consumer level. If a t-shirt or pair of sneakers is made overseas and imported into the U.S., the cost of the 20% tax will likely be shared by the consumer, the retailer and the manufacturer. What proportion they will share will be determined by the elasticity of the product and the negotiating leverage between retailer and manufacturer.
To make things even more complicated, some economists expect the U.S. dollar (USD) to appreciate by the amount of the expected tax to maintain purchasing power parity and keep pricing level. In that case, the importing companies would be unscathed (in the long run), but companies with foreign profits would see their earnings power diminish as profits are translated back into USD.
Another impact of this tax would be to eliminate the benefits of companies setting up foreign subsidiaries in low income tax countries and utilizing transfer pricing to minimize income taxes. Goods will be taxed where they are consumed. Where the company earns the income is irrelevant.
Democrats and Republicans tend to agree that repatriating cash trapped overseas to avoid high tax rates would be best for the U.S. economy, but have been unsuccessful at accomplishing that reform. The current House Republican proposal would tax cash returning to the U.S. at 8.75%, and the Trump plan at 10%. The primary beneficiaries of repatriation are multi-national corporations primarily in the technology and consumer staples sectors.
The election of Donald Trump, however stunning, was the latest in a series of political and macroeconomic events that caused us to analyze and frame a range of possible outcomes. We have done this in a systematic manner, enabling us to have confidence in the risk and reward that resides in our individual stock investments. As specifics about regulatory reforms, tax and legislative changes become clearer, we can confidently sharpen our expectations for the economy and our portfolio companies.