18 Jan 2018
How could the Changes to the US Tax Law Affect Your US Sector Allocations?
After months of wrangling and arguing, often even within the same party, a tax reform package was passed by both chambers of Congress and signed by the President. Now that the euphoria—or disappointment, depending on your point of view—is dying down, it’s time to look at how the changes may actually affect your investments.
Well, the one thing we do know for sure is that the corporate tax bill got reduced from a world leading 35% to a more competitive 21%. Or did it? The tax rate did indeed get dropped by that amount, but whether the tax bill is actually reduced will depend on the company. In fact, we’ve already heard from some major companies that they are initially going to take a fairly large tax hit due to changes in the way certain items are accounted for and now taxed. For example, one seemingly overlooked issue is that the value of the deferred tax losses that many companies had on their books—including tech (from the tech bubble burst), financial (from the housing collapse) and energy (due to the crash in oil prices)—are now likely worth less as they only offset a 21% tax rate instead of a 35% rate. This doesn’t mean you should look to sell companies that may apply to—but it is something to watch out for.
Similarly, the change to the way international earnings are taxed may seem somewhat negative initially to certain companies with large amounts of assets outside of the U.S., such as tech, but should end up being beneficial if things proceed as we think they will. Initially, according to guidance from the IRS, cash and liquid assets of American companies held overseas will be taxed at a 15.5% rate, while illiquid assets will face an 8% tax—and payments for both could be spread out if needed. That will result in a fairly large initial hit to some companies. But after that, companies can move money currently held overseas—and all future money earned overseas—to the U.S. tax-free. We believe this will result in a fair amount of money being brought back to the U.S. and at least some of that money will be used for capital expenditure purposes.
Additionally, the tax law also now allows capital expenditures to be expensed immediately instead spread out over a period of years—at least for the next five years. This should also incentivize companies to pursue more capital spending plans they may have been putting off, in our opinion. And we’re already seeing indications that companies are becoming more comfortable with the idea of adding to the expense side of the ledger, such as the jump in the New Orders component of the ISM Manufacturing Index and the capex plan question in the Empire State Manufacturing Survey. So while much of the tech sector may take an initial hit from the new tax law, ultimately we think it will be a net positive as they are able to bring cash back to the U.S. and benefit from an increase in other corporate spending on tech-related gear.
The consumer side of the tax law also has the potential to benefit tech companies as well as other consumer-related names due to the lower tax bill many Americans are going to have. There has been much discussion about whether the majority of Americans will indeed see a cut to their taxes, but according the research firm Strategas Research Partners, more than 80% of Americans are estimated to have a lower tax bill in 2018 than 2017. It stands to reason, at least to us, that some of that additional kept income will go toward spending.
But that doesn’t mean there aren’t some potential losers as a result of the tax changes. Among them is the potential for companies with a higher debt load to take a hit—such as the telecom group. According to the Wall Street Journal’s breakdown of the law, interest on debt above 30% of EBITDA (earnings before interest, taxes, depreciation and amortization) won’t be deductible for the next four years. After that, interest expenses above 30% of EBIT will no longer be deductible. In our view, that could hurt high-debt shareholders in two ways—first, the higher tax expense due to the lower deductibility, and second, the potential for equity stakes to be diluted as companies look to issue more equity instead of debt in order to finance their operations.
We believe the important thing to remember is that the tax situation of any given sector is typically a relatively small part of their overall picture so we urge caution in making any knee-jerk moves simply because of a tax law change.
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The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.
The Empire Manufacturing State Index is a regional, seasonally-adjusted index published by the Federal Reserve Bank of New York distributed to roughly 175 manufacturing executives and asks questions intended to gauge business conditions for New York manufacturers.
About the author:
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research