We’ve all read the headlines: a trillion dollars in infrastructure spending, a repatriation holiday, corporate tax reform, Let’s Make America Great Again!
Tom Liguori
Sounds great for the country. Though what will be the affect on your company? Will there be winners and losers? Which will we be?
We are likely entering a period of stimulative spending and higher gross domestic product growth, though it will be accompanied by higher government deficits and interest rates. Stock markets are reaching all-time highs. Debt markets are pricing in interest-rate increases. It’s time to ask your management teams a few questions:
- How do we maximize the opportunities from these proposals?
- How do we minimize the risks?
- What is our action plan?
While today we do not know the final rules and regulations, they may have profound affects on our business. Let’s take a look at a few of these.
Higher interest rates. The period of historically low interest rates may be over. Changing interest rates affects interest expense, profitability, and cash flows. Tax reform proposals include the possible elimination of interest as a tax-deductible expense. That has significant long-term implications.
What can you do? Explore refinancing your current variable-rate debt with fixed rates. With equity markets strong, an equity or convertible debt placement should be part of your capital structure discussion. Higher interest rates and eliminating interest deductibility would affect your cost of capital. You need to reassess your capital structure, weighted average cost of capital, and investment hurdle rates. Each requires careful thought and planning.
Repatriation holiday. This is a slightly more complicated topic. Headlines imply a low tax rate of 10% to repatriate your offshore cash. Bringing the cash back to the U.S. presents significant opportunities for U.S. investment, acquisitions, and shareholder distributions.
The fine print of this proposal reveals more details. The “holiday” may be more of a mandatory tax than an optional holiday. Plus, the 10% tax is most likely on previously untaxed foreign profits, not just offshore cash.
That’s a huge difference. Many, if not most, companies have far higher offshore profits than offshore cash. The reason, presumably, is that offshore profits have been reinvested in the business, as they should be, leaving a smaller cash balance.
A company with $300 million in untaxed foreign profits, though with only $100 million in offshore cash, would have a tax due of $30 million, equal to 30% of its cash balance.
Understanding the potential tax expense and cash flows is important. It may be different than initially thought. Though once understood, the benefit of having cash available in the United States has enormous benefits. Domestic M&A opportunities are easier to fund, and with the tax handcuffs off, shareholder distribution policies need a careful relook.
Tax reform. This is an even more complicated subject, with potentially far-reaching positive and negative implications.
While the headline benefit of a corporate tax rate of 15% is extremely appealing and should provide many benefits, again we need to read the fine print of the Trump administration and House of Representatives proposals.
On the plus side, the fine print is a blueprint for a booming U.S. economy:
- 15% corporate tax rate.
- 0% tax rate on profits from goods manufactured in the United States.
- Low tax rate on intellectual property (IP) royalties.
- Full expensing in year one of capital expenditures made in the United States.
- Possibly a territorial system (no tax of offshore profits).
If we were starting anew, it would be a no brainer to say: Let’s develop our IP in the United States, license it offshore, manufacture in the U.S., and pay 0% tax!
For importers and companies that manufacture in low-cost offshore locations, however, there can be significant drawbacks and economic costs. For example, current tax proposals include a concept called “border adjusted.”
“Border adjusted” means there is no tax on profits from goods manufactured in the United States, and the cost of imported goods is not a tax-deductible expense. That’s right, the cost of imports is not a tax-deductible expense. Theoretically, as a result, a business that solely imports could be paying close to a 15% tax on its revenues.
The question is: Does the benefit of a 0% income tax in the United States outweigh the higher cost of manufacturing in the United States?
The chart below shows the affect of a “border adjusted” 15% tax rate on a firm that has outsourced its manufacturing to a low-cost Asia supplier. Since the firm must import its product, the cost of sales is not tax deductible and the amount of tax expense actually increases.
If the same firm moves its manufacturing back in the United States, it will enjoy the proposed 0% tax rate on U.S. manufactured goods though will likely pay higher costs in the U.S.
The challenge for management is, therefore, how do we change our operations and cost structure to be able to cost effectively manufacture in the United States and take advantage of a 0% tax rate? We do this by automating processes, reducing direct labor content, redesigning products, and streamlining overhead. Succeeding here provides an opportunity to benefit from tax reform as illustrated in the chart below.
There are many other implications. We need to assess the impact of border adjustability on our suppliers and customers. Throw on top of this proposed tariffs, and the topic is even more complex. Our entire way of thinking about supply chains may change.
How to Win
A winning strategy could start with repatriating our offshore cash. Then it can be used to repurchase shares and invest heavily in strategic M&A. Operationally, you can open a development center in the United States, license your IP to offshore subsidiaries, manufacture in the United States and take advantage of the 0% US tax rate.
The result: higher earnings and higher share price.
The new Trump administration has far-reaching proposals. The benefits may be huge to the U.S. economy and last for a long time. As with most far-reaching plans, the devil is in the details. There will be winners and losers. Each company may be affected differently. And there is always the possibility that little changes if consensus is hard to reach.
Regardless, strategic thinking at the board and executive management level is required now to capitalize on the benefits and minimize the risks. Asking the right questions today will facilitate having plans in place once proposals are finalized.
How much time do companies have? Let’s assume final details are available in the first quarter of 2017, the House and Senate vote in the summer, and implementation is effective in 2018. Companies have just about a year to think through their options and have a strategy in place.
Tom Liguori is CFO of Advanced Energy. He has been a public company finance chief for the past 15 years.
