How Tax Reform Gives Savvy Investors An Edge

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Posted: Jan 22, 2018 9:56 AM
How Tax Reform Gives Savvy Investors An Edge

We are about to see the new earnings reports for some of the largest public companies in the market.

Because of the new corporate income tax laws signed into law in December, companies are scurrying to account for the changes making last year’s faith and optimism become reality. It promises to be quite a show.

Before the hype starts, here is a primer on what you are about to see unfold. I will provide several observations and an easily (hopefully) digestible explanation. 

Hang on until the end and you will walk away a little wiser than your friends who may be chasing the frenzy.

Corporate income tax changes are both “right now” and prospective.

This is difficult to grasp at first, but it will make sense. When you and I think about income tax expense, we think about the nasty check we scribble out or the withholding from our paycheck. Whether paid in a check or withheld from your pay, it is an issue right now

But in reality, most all of you have future income tax obligations that you intuitively know about, but do not write down on a personal financial statement, and you do not calculate routinely (or ever). Take for example your traditional IRA that is hopefully growing. Alongside your IRA sits an invisible future obligation to pay income tax. It is a deferred income tax expense. So using some easy math, assume your IRA balance is $500,000, and you project you will be in the 10% bracket. You have a deferred income tax expense of $50,000 ($500,000 * 10%). It is invisible, and you deal with it each year piece by piece as distributions from the IRA are taxed, so it does exist. Transferring this mentality to the corporate side, these “invisible” deferred income tax expenses may not be invisible. They must be calculated and recorded in the financial statements. These deferred amounts arise, not from IRA accounts, but differences between what an asset is worth for accounting purposes vs. income tax purposes. Many of these differences stem from fixed asset carrying values substantially different because of differing depreciation methods.

Using our previous example with your IRA, if you currently have a deferred income tax expense of $50,000 at a 10% rate, you “theoretically” benefit if your rate drops to, say, 8%. Your new deferred income tax expense is $40,000 ($500,000 * 8%). Because your tax rate dropped, you have an economic gain of $10,000, ($50,000 previous deferred income tax expense vs. $40,000 now at the new rate). If you were an accrual basis corporation, you are required to add $10,000 to your profit and loss statement as a reduction of a deferred income tax liability. Imagine this on a $100s of millions scale, and you see what is about to come trucking through the 2017 earnings season for each company.

The immediate impact will vary across companies and industries.

Using the concept above, these reductions of deferred tax liabilities cause an increasein reported current earnings. The opposite is also true. If you have a future deduction you may use on a future tax return (called a deferred tax asset), these are now worth less in the future because of the new low rate and the new rules. The reductions of these deferred tax assets reduce earnings right now, just like a reduction in deferred tax liabilities increase earnings right now.

Therefore companies recording more deferred tax assets than deferred tax liabilities (you could say a net deferred tax asset) will have an overall reduction of earnings as a result of the new low rate. Said another way, some companies will lower their tax rate and have an associated tax expense. Seems backwards, doesn’t it?

The effects of the new territorial system will take longer to incorporate.

In general terms, there are two categories of tax systems for corporations: a worldwide system and territorial system. The US had a worldwide system until December. The new legislation moves us into a new territorial system. Under a territorial system, (generally) only profits earned in the US will be taxed in the US. Profits earned in say, Ireland, will be taxed in Ireland at 12.5% and returned to the US, if needed. In some ways this is old hat. Under the old worldwide system, there were still ways to earn profits overseas and not pay income tax until they were returned to the US. But the tax upon return was 35% or more. (No wonder they were held off shore). Now in the new world, when a company elects to bring the old profits back, they will enjoy a new 8% rate (could be higher, depending on how it is done). So current earnings will feel some of this because if management decides to do this, the income tax expense is a “right now” reduction of earnings. Meanwhile, the more beneficial territorial effects will be felt over time as companies use this system and continue to restructure operations to make their footprint as tax efficient as possible.

Analysts have been pricing this in for a while, so lower your expectations.

I am a guy that believes the market prices in all known information in relatively short order. The framework of this new system, plus the promise by Republicans, has been public for a while now. So some of the stock price increases we have enjoyed over the past 12 months have been a combination of a predication of future earnings under the new rules plus some speculation. How much exactly of each is impossible to know. But it is safe to say now the rubber is about to meet the road, and analysts and market makers have some certainty in the new system and rates. The movement this quarter may increase stock prices in some companies and leave others relatively unchanged because the accounting is simply catching up to estimates already priced into the market. The opposite is also true: some stock prices may fall since the benefits priced in earlier may prove to be a non-reality.

Changes in income tax rates and switching systems do little to immediately impact the underlying economic engine of the business.

Even though I am a CPA, and I try hard to reduce taxes for my clients, I believe income tax planning is not really a value added exercise. At best, it only retains value created by my client’s labor or their investment activities. Hear me out, keeping more of what you earn or more of your yield is great, but in reality it is the hard work and investment gains that created the value, the tax reduction just allowed more of the value to accrete to the owner and compound in the future. In many ways, this is semantics because you could argue I added value to the owner (since he/she would have had to pay the tax and retain less…I digress). 

It stands to reason that if a company ends up with a larger than normal tax expense reported in 2017 earnings while accounting for the huge changes, it has not changed the fundamentals of the business. This immediate tax movement is an accounting exercise, not an immediate change in the business. This may yield attractive buying opportunities for active managers as the unwary get out of good companies too soon.

What is attractive are the companies reinvesting the freed up earnings into new assets, increased wages, hiring, and planning to become more competitive globally over a long-term horizon. That, my friend, is value added. So maybe I am wrong, and tax planning does add value?

As you can see, large legislative changes like this have a deep echo in a public company’s financial statements and reported earnings, and the accounting rules require companies to report the impact now. A working knowledge of the truth behind the earnings will give savvy long-term investors an edge over any short-term irrational exuberance we may see.