With a second 2017 interest-rate hike expected in June, businesses are beginning to assess the impact on their current and future debt. The cost of borrowing, however, will have a lesser impact on companies’ bottom lines than the potential boost from a sharp reduction in the U.S corporate tax rate.
The tax plan outlined by President Donald Trump proposes a 15% corporate rate, while others in Washington think a 20% rate might be more realistic. Either way, given the current 35% rate, the impact to companies’ net income after taxes (NIAT) would be substantial. Therefore, now is an ideal time to consider how a change in the tax rate could free up capital. For many organizations, a potential tax rate change could result in additional capital and borrowing capacity to drive growth.
The savings resulting from tax reform could be huge. Take the example of a hypothetical company with $100 million a year in revenue and a net income before taxes of $10 million. The company is currently in the 35% tax bracket. After taxes, net income drops to $6.5 million. With the tax rate at 20%, net income would increase to $8 million — an increase of 23.1% after tax and a $1.5 million boost. At a 15% rate, net income after tax would rise again, to $8.5 million, a 30.8% jump.
Tax cuts would also create additional borrowing capacity. The $1.5 million in additional income from a 15% tax cut would support nearly $11.3 million in borrowing capacity at an annual interest rate of 6% (amortized over 120 months based on a mortgage-style amortization). In the 15% scenario, the additional $2 million supports increased borrowing capacity of $15 million at an annual interest rate of 6% (using the same amortization).
Still, concerns about rising interest rates persist even though added interest costs would be minimal. In its most recent action, the Federal Reserve increased the federal funds rate by 25 basis points.
Assuming a company has a $10 million line of credit that is fully utilized for a 12-month period, the 25 bps change increases the interest paid by just $25,000, from $400,000 to $425,000. Even if interest rates went up a full 1% over the course of a year, that is only $100,000 more in interest paid—a small dent in the hypothetical NIAT savings outlined above. Despite interest rate hikes by the Fed, then, a reduction in taxes paid could free up substantial capital to support a business loan or make an acquisition.
Other Options Unclear
What has not been well-defined in the corporate tax proposal and could be a further boost for domestic businesses are:
- The tax rate and payment period for repatriation of foreign profits;
- How foreign profits will be taxed in the future; and
- How the immediate deduction for purchases of capital assets will be balanced against foregoing interest-expense deductions (if indeed these make it into any legislation).
Assuming a 10% tax on the repatriation of foreign profits is adopted and covers future foreign profits, any current and future repatriated earnings would provide for increased business investment in the United States and a major amplification for the domestic economy.
In addition, the ability to elect to immediately deduct the purchase of capital assets could drive future productivity increases by U.S. businesses. Gaining clarity on these elements of Trump’s tax plan is critical to accelerating the growth of the economy and business investment, which stalled in the first quarter. Uncertainty regarding tax reform has also reduced M&A activity to a near standstill.
Should these uncertainties about the tax plan become better defined, business activity and investment would increase — but by how much and how fast?
More capital and additional borrowing capacity would allow companies to increase returns to shareholders, undertake expansion or make acquisitions, invest in productivity-enhancing equipment and physical infrastructure, and hire additional staff. Of course, these are hypothetical scenarios and finance executives should consult with their tax planners to understand how policy changes could impact their organizations.
Finance executives should keep the forecasted increase in interest rates in mind when creating their strategic and tactical plans for 2017 and beyond, but also factor in how the actual rate hikes could be counterbalanced by a change in the corporate tax rate. If the corporate tax structure changes and the ambiguities regarding the details of the Trump plan are resolved, businesses will be well-positioned to increase their growth and profitability.
William Fink is chief lending officer and head of credit management at TD Bank.