Some finance chiefs who think the federal corporate tax cuts that form the centerpiece of most tax reform proposals would be an unalloyed good for their companies would do well to think again.
True, the reduction in the current maximum federal tax rate for corporations from 35% to the 28% that President Obama has proposed or the even deeper cuts proposed by certain members of Congress would overwhelmingly benefit corporate America by putting cash at its disposal that would have gone to the Internal Revenue Service, advocates say.
(Companies that have the bulk of their operations in the United States, of course, stand to gain a lot more than multinationals that already pay lower rates because they do much of their business abroad.)
Rarely discussed in debates about tax reform, however, are the effects of corporate rate cuts on deferred tax assets (DTAs) and deferred tax liabilities (DTLs). And while most companies with such deferred tax balances would gain from diminished tax rates, some would be big-time losers, according to a study released in late February by the Georgia Tech Financial Analysis Lab.
“Everybody’s looking at tax reform as a big plus, and it is. But there are those who, if they’re not thinking about this, should be. Tax reform is not all good for some companies,” says Charles Mulford, a Georgia Tech accounting professor and director of the lab.
Hardest hit would be financial services companies, which tend to sock away huge reserves against future tax payments. Such DTAs would lose value if the tax rates are cut, in turn diminishing the value of the company’s shareholders’ equity, also known as its net worth.
For example, with a rate cut to 28%, Fannie Mae “would see its shareholders’ equity virtually wiped out with a tax rate change, reducing its deferred tax assets by $9.5 billion,” according to the Georgia Tech report.
Similarly, the Federal Home Loan Mortgage Corp. (Freddie Mac) would see a 35.4% decrease in its net worth on a $4.5 billion decrease in its DTAs. Orbitz Worldwide would see its debt ratios balloon, realizing a 334.8% increase in its liabilities-to-equity ratio with a $32 million decrease in deferred tax assets and a 77% drop in net worth.
Not only financial services would suffer from a 28% rate cut. Other companies with at least a 10% drop in shareholders’ equity include Avon Products, Tenet Healthcare, Vonage Holdings, Sirius XM Holdings, Strayer Education, Handy & Harman, Overstock.com, Delta Air Lines, Evercore Partners, and Brunswick Corporation.
The CFOs of such companies “need to think about rewriting debt covenants,” says Mulford. “If they have a covenant that requires a certain level of equity, they very potentially could be in violation.”
To be sure, the gains would outstrip the losses. Of the 809 U.S. companies with revenues greater than $500 million that report deferred tax balances that it studied, the Georgia Tech Lab estimated an overall net increase in shareholders’ equity of $104.2 billion if tax rates were to decline to 28%.
“Overall, U.S. companies win with tax reform. We see many more companies benefiting – and benefiting by larger dollar amounts – than the companies that are being hurt by this. So it definitely is skewed positive for U.S. corporations,” says Mulford.
But there would be a clear dividing line between winners and losers if the tax cut comes into being. Companies with DTLs, which would pay a lower rate in the future on those deferred tax bills, would “recognize a reduction in total liabilities and a corresponding increase in shareholders’ equity,” according to the report. “Companies with deferred tax assets will recognize a reduction in total assets and a corresponding reduction in shareholders’ equity.”
The difference between the two groups wasn’t even close. The researchers found that 548 companies with DTLs would realize a total estimated $142.4 billion rise in net worth, while 261 companies with DTAs would see a total estimated $38.2 billion decline.
Among those who stand to gain the most by a tax cut are companies in the cable and telecom, transportation, energy, and utilities industries – basically, “companies with big investments in capital assets,” according to Mulford.
Comcast, for instance, would have the deepest projected drop in its deferred liabilities, with a $6.3 billion decrease that would spawn a 12.5% boost in the cable company’s net worth. The railroad industry would also see hefty cuts in its deferred taxes, including BNSF Railway, with a $3.4 billion reduction in its DTLs and 7% jump in shareholders’ equity. Union Pacific would see a $2.8 billion cut and a 13.1% increase in shareholders’ equity.
Other companies in the top 10 in terms of decreases in their deferred liabilities would be Sprint Corp. ($2.8 billion), Exelon ($2.4 billion), Time Warner Cable ($2.4 billion), Southern Company ($2.1 billion), American Electric Power ($2.0 billion), Anadarko ($1.8 billion), and Consolidated Edison ($1.7 billion).
By far the largest amount of deferred tax liabilities for such companies is created by accelerated depreciation of fixed assets like plant and equipment, according to Mulford.
“Most companies will depreciate fixed assets on a straight line in their books. But on the tax return, they use accelerated depreciation, which enables them to write these capital assets off more quickly for tax purposes,” he said.
“Because you’re deducting it on the tax return now, in the future you will have higher taxable income because you won’t have the deduction” then, according to Mulford. Because their future liabilities are high, a tax cut will be quite valuable to such companies. (Tax payments are calculated on the basis of the tax rate in effect when the tax payments are due.)
Among companies that would see their deferred tax assets and future shareholders’ equity slashed would be banks (which set up reserves for loan losses), health care providers and insurance companies (which set up reserves for future insurance reimbursements), and restructuring reserves for companies that plan to go through a restructuring, according to Mulford.
All of those reserves are set up “for expenses for losses that are recorded on the books for which there are no tax deductions allowed until later, when things are settled up. The tax code doesn’t let you deduct [for losses] that are estimate[d],” he explained.