The Republican bill represents a starting point for tax and budget negotiations. While details are lacking, the current plan offers some interesting angles for market participants to think about their liquidity investment strategies. We highlighted parts of the bill relevant to corporate cash investors and their potential impact on issuers and investors in the short-term debt market. We advise our readers to be patient, stay liquid and think strategically during this waiting period.
After weeks of negotiations behind closed doors, Republican leaders unveiled a nine-page document on reforming the tax code on September 27, 2017. Politicians and market pundits quickly jumped into action, looking at every angle to determine potential winners and losers from the proposal. The long-on-promises and short-on-details nature of the so-called “Trump tax plan” left out many details, rendering many of the projections little more than conjectures and educated guesses.
Since the tax framework touches many important subjects that impact the corporate treasury management community, we want to keep the dialog going by addressing the plan’s potential impact on market liquidity and treasury investment strategies. Although the plan represents an early blueprint of the finished legislation, understanding the key issues at stake may assist our readers with their internal discussions and perhaps advanced planning.
For the purpose of this commentary, we focus on the aspects of the tax plan we deem to have direct impact on treasury portfolio strategies.
Summary of the Tax Plan
Below is a high level summary of the “unified framework for fixing our broken tax code” released on September 27, 2017.
1) Personal Taxes
- The seven tax brackets are consolidated into three (12%, 25% and 35%). Income levels associated with each bracket are unknown. It leaves the possibility open for an additional top tax rate for high earners.
- The framework roughly doubles the standard deduction while removing allowance for personal exemptions.
- It eliminates most itemized deductions, but retains deductions for home mortgage interest and charitable contributions. Tax benefits to encourage work, higher education and retirement security will also remain.
- It calls for increased child tax credit and higher income levels at which the credit begins to phase out.
- It repeals the alternative minimum tax (AMT) and the estate tax.
- It envisions the use of a “more accurate measure of inflation” to index the tax brackets and other tax parameters.
2) Corporate Taxes
- It reduces the corporate tax rate from 35% to 25% and eliminates corporate AMT. It limits the maximum tax rate for pass-through entities to 25%.
- It allows businesses to immediately write off the cost of capital investments for at last five years.
- It partially limits the deduction for net interest expenses by corporations. It repeals or restricts most. exclusions and deductions. It explicitly preserves tax incentives towards research and development (R&D) and low-income housing.
- It will subject foreign profits of US corporations to a lower tax rate on a global basis than domestic earnings.
- Accumulated offshore profits will be considered already repatriated. No specific repatriation tax rates were supplied, but illiquid assets will be subject to a lower tax rate than cash or cash equivalents. Payment of the liability will be spread over several years.
Items of Interest to Institutional Cash Accounts
The lack of details makes it difficult to gauge with accuracy how the new law will impact the corporate cash investor. With this caveat, we provide a few items of relevance.
A) Lower corporate tax rate to 20%
A lower corporate tax rate would immediately boost profitability and business activities, leading to more hiring and capital spending, higher dividends and share buybacks, higher equity valuation and the wealth effect. The list of potential positive effects of corporate tax cuts is understandably long. The biggest beneficiaries would be firms with higher effective tax rates, including banks.
Banks will benefit from lower corporate tax rates in two ways – from direct tax savings and from robust client activities such as higher business loan demand and higher investment banking activities. As an example, executives of Citigroup and Morgan Stanley estimated that the reduction of the corporate tax rate to 25% (the Trump plan calls for 20%) would lift the banks’ earnings by 5% and 15%, respectively1.
Issuers with high effective tax rates tend to access the short-duration debt market more frequently due to the tax benefits. We think that, over the long-term, investors will benefit from better credit ratings of corporate borrowers in a low tax rate regime when economic growth picks up and firms’ fundamental credit strength improves. Borrowers with tarnished credit profiles that languished in a sluggish economy may become creditworthy enough to return to the short-duration debt market.
B) Full depreciation of capital spending
The immediate full expensing of capital investments for five years encourages companies to make more capital purchases more quickly. Understandably, this provision will benefit firms in industries that are more capital intensive and with high effective tax rates, including manufacturing, materials and resources and telecommunications. Increased capital spending is no doubt stimulative to the economy, and one would expect higher debt issuances from these industries to fund capital expenditures.
C) Reduced deductibility of corporate net interest expenses
Offsetting the immediate tax write-offs of capital expenditures, the elimination or reduction of tax deductions of net interest expenses may hurt companies relying on borrowed funds for growth. The current tax system of giving preferential treatment to interest over dividend receives frequent criticism for encouraging firms to take on more risk by funding themselves with debt instead of equity shares. The new proposal would likely increase funding costs for firms with below invest grade credit ratings, issuers of high yield bonds, and mergers and acquisitions deals funded with leveraged loans.
Banks as a special class of borrowers may be exempt from this provision. The tax plan said negotiators “will consider the appropriate treatment of interest paid by non-corporate taxpayers.” Banks could argue that in the course of conducting normal banking businesses, their interest expenses are akin to costs of goods sold for non-financial firms.
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1Telis Demos, Liz Hoffman, Justin Baer and Rachel Loise Ensign, What awaits Wall Street in Trump tax plan, the Wall Street Journal, Markets section. September 29, 2017. https://www.wsj.com/articles/what-awaits-wall-street-in-trump-tax-plan-1506596402