FASB introduces new hedge accounting as tax reform looms and ATLG members focus on debt and investing.
As Congress struggles to repeal and replace the Affordable Care Act and tackle tax reform—a potential game-changer for many corporates—ATLG members got a briefing on what it is likely to look like and when it might arrive. In addition, Chatham Financial experts explained the pluses of FASB’s new hedge accounting and detailed hedging strategies related to debt issuance, and as always members exchanged practical knowledge on their current priorities. Here are three key takeaways from the group discussions:
1) Early Bird Gets Favorable Hedge Accounting Treatment. FASB plans to publish new hedge accounting guidance by late August, when companies can early adopt it for 2017 financial statements.
2) Don’t Bet on Radical Tax Reform. Time has run out for fundamental reform, and Republicans likely will settle for a lower corporate rate and other bits and pieces.
3) Long-term Cash Buckets Shrinking. The prospect for repatriation of permanently reinvested offshore cash is prompting corporates to shrink their longer-term cash investment bucket. Thus, while favorable rates of return are there for those firms willing to look far and wide, liquidity takes precedence.
Hedge Accounting Primer and Exposure Draft Update
On September 8, 2016, the FASB released an exposure draft on hedge accounting with the aim of making targeted improvements to guidance. Key goals are to facilitate greater success with achieving cash flow and fair value hedge-accounting treatment and to reduce the risk of restatement. Aaron Cowan, Chatham Financial’s global leader of corporate accounting advisory services, analyzed the proposal’s benefits and challenges and updated members on the most recent developments.
KEY TAKEAWAYS
1) Just around the corner. The FASB published its hedge accounting guidelines in August, at which point financial statement preparers were then able to adopt the language early if they choose; the amended standard otherwise must be adopted by January 1, 2019. While still challenging to comply with, it greatly facilitates obtaining hedge accounting treatment for both cash flow and fair value hedges. Formally drawing up policies under the new language is critical to avoid later second-guessing from higher ups. Auditors must be onboard before pulling the trigger on a transaction.
2) Better aligning accounting with economics and simplifying. The FASB recognized several areas where the accounting simply didn’t line up with the economics of a hedge, and the guidelines aim to narrow that gap. They also manage to simplify and streamline hedge accounting, to make it more accessible to financial-statement preparers. The new guidelines won’t be a walk in the park, but they take several steps in the right direction.
3) Better hedged-item benchmarks. Currently, only a limited number of benchmarks can be used to match the swap against the exposure at risk. Under the new standards, components of risk can be hedged if they are contractually specified. This raises three issues:
- Corporates will be able to switch benchmarks on which their loans are priced more easily.
- Commodity users will be big beneficiaries, because they’ll be able to contractually specify the key component to hedge and no longer have to include variable ancillary costs.
- But, to change benchmarks or contractually specify hedgeable components, longer-term contracts will need to be reopened and either side may be reluctant to do this without renegotiation of other terms and conditions that are no longer seen to be in their favor.
Capital Structure and Internal Lending Considerations
During their meeting, ATLG members discussed capital structure and internal lending changes, considering the implications with tax reform and the inflection point in monetary policy. Here are some of the key takeaways:
- Relieving pressure to issue US debt for synthetic repatriation. Bringing cash home through “repatriation and a territorial system just takes away the pressure [to issue debt domestically],” one member said.
- Rethinking the fixed-floating mix. Another member noted that research clearly indicates swapping fixed-rate debt to floating is beneficial most of the time, so why not consider floating for at least 25% or 30% of a company’s capital structure? “Our conclusion was to target 50% to 70% fixed and the rest floating,” he said.
- Advances on intercompany receivables can speed cash back. In response to a member question, a few members suggested the possibility of using advance payments on intercompany receivables to bring back overseas cash so it can be used sooner. In one case, a US entity effectively acts as a contract manufacturer for an off-shore sub, and that sub prepays for, say, a year’s worth of purchases to the US.
OUTLOOK
Qualifying for hedge accounting is still going to be work, and requiring the hedged component to be contractually specified to get hedge accounting is a tougher requirement than the International Accounting Standards Board’s less restrictive guidance. However, companies will have fewer obstacles to achieving hedge accounting and so be able to reduce volatility in their P&L. FASB has generously permitted early adoption, but several challenging steps must be taken to prepare.
Is Tax Reform Really Coming?
US MNC treasurers are undoubtedly focused on the potential for US tax reform under the Trump Administration. A tax expert from KPMG provided the group with an overview of the GOP tax reform “blueprint,” including the likelihood of a cash repatriation tax break, the border adjustment tax (BAT) and curbs on interest expense deductibility.
KEY TAKEAWAYS
1) High hopes, but it’s tough to plan in a vacuum. Hopes for tax reform are high because, for the first time since 2006, the Republican party controls the House, Senate and the White House simultaneously, and tax reform has long been a stated priority for them. KPMG noted that Republicans and many Democrats see further urgency for US tax reform because of:
- The fact that the US now has the highest statutory corporate rate in the OECD.
- GDP growth continues to lag behind historical averages, and the US manufacturing sector continues to decline.
- The OECD has developed base erosion and profit shifting (BEPS) recommendations putting effective rate pressures on US MNCs.
- The European Commission’s State Aid cases, which cast doubt on the predictability of the global tax system.
- The significant migration of business income into partnerships and other pass-throughs has eroded the US tax base along with corporate inversions.
Despite all this, US MNCs have no agreed-to proposal to plan against. And passage of any tax reform bill in the Senate will be complicated for both procedural and political reasons that don’t look to get any better.
2) The tax reform spectrum. KPMG pegged the chances of radical tax reform at 30% before the ongoing ACA repeal-and-replace debacle. Radical tax reform would factor in: 1. The GOP “Blueprint” that would eliminate interest-expense deductibility and move to a destination-based and territorial corporate tax system to pay for a drop in the corporate rate, from 35% to 20%. 2. The reconciliation process that must be revenue neutral or it will expire in 10 years. 3. President Trump’s agenda, highlighted in a one-page summary proposing dropping the corporate rate to 15%, eliminating unspecified tax breaks for “special interests” and moving to a territorial tax system, but not much else on the corporate side. It ignores revenue neutrality.
At the other end of the tax-reform spectrum would be tax-reform “lite,” which could bring together some milder components of the blueprint and Trump proposals, with a mandatory cash repatriation as one of the key elements.
Debt Issuance and Hedging Best Practice
Experts at Chatham Financial led members through explanations of the hedging strategies their clients are pursuing in conjunction with debt issuance in the current uncertain and supposedly rising interest rate environment.
- Floating-fixed swaps with embedded floors on loans. Most floors in term loans, typically between 75 and 100 basis points, have gone away. If a corporate does have a floor today, it’s probably at 0%. “There’s just generally more attention paid to rate risk than we’ve seen in the last few years,” said Chatham’s Amol Dhargalkar, Managing Director, Global Corporates Sector. Without a floor in the loan, there is more flexibility to pursue swaps with embedded floors to lock in a rate on a floating rate financing, which Chatham sees more corporates doing.
- Basis swaps. Basis swaps are another example of the flexibility the OTC derivative market provides to accomplish corporate goals. Corporates borrowing at three-month Libor can swap to one-month Libor to take advantage of an economic pick up. Basis swaps can also help hedge effectiveness by swapping to an index that is better to hedge.
- Swapping fixed-rate debt to floating. While it seems counterintuitive to swap to floating when the Fed is hiking rates, the uncertainty caused by the longer end of the curve can be reason to do so when swap rates encourage it—plus floating rates are still low by historical standards. Chatham recommends considering a swap that sets rates in arrears to ensure a higher guaranteed swap rate on the receiving end. The two big upsides to swapping some fixed to floating are the interest-rate pick up and the ability to adjust the company’s fixed/floating ratio. Only a few meeting participants acknowledged pursuing such swaps. It’s always cheaper to issue floating-rate debt, Amol said, with one caveat: Except in a rising rate environment.
OUTLOOK
Passage of the ACA repeal, which now seems unlikely, would give tax reform and other Republican initiatives a boost. However, as a tax reform bill has yet to be submitted to Congress, it probably will not become law this year. If a bill fails to find the president’s signature by the end of the first quarter, congressmen will be too busy campaigning for the 2018 election to pass major legislation. KPMG suggested a reform-lite bill is most likely to find the president’s signature..
Where to Invest Cash Now?
The potential for offshore cash repatriation, the anticipated upward-sloping yield curve and the potential focus on “America First” could dramatically change asset allocation considerations and risk correlations. On the heels of money-market reform and the shift out of prime funds, the “Trump impact” creates an interesting inflection point for cash investment. ATLG members exchanged ideas about where to invest cash in the low, even negative interest-rate environments.
KEY TAKEAWAYS
1) Look down under. Australian banks are paying favorable rates for deposits of USD—one member cited 1.38% for three-month deposits. Often the three-month tenor is based on a handshake deal: The bank will pay a decent if slightly lower rate for the generally sticky deposits, and in return, the corporate can withdraw the cash sooner if necessary.
2) Longer buckets shrink. Members spoke about dividing cash among short-term, medium-term and longer-term buckets. “Given the cash we have today, we would [normally] be allocating more to the longer-term bucket,” said one. “But in light of potential tax reform and repatriation, and since most cash is offshore, we wouldn’t want to add to the risk of having to repatriate.”
3) Relationship notice deposits. A new product from the big banks (mostly non US), a corporate gives the bank notice 31 days before the product matures whether it will roll the deposit or not, and it is rewarded if it does. “Every time you roll that deposit, you get two or three basis points more relative to Libor,” said one member.
4) The call of prime. The assistant treasurer at a pharmaceutical company said the company had fully transferred out of prime funds into government funds after new money market fund rules went into effect last fall, but recently it moved 100% back into prime. “We’re comfortable with the risk,” she said.
OUTLOOK
Central banks appear ready to raise short-term rates, at least marginally, but macroeconomic trends will probably hold longer-term rates down for the foreseeable future. No rich returns anytime soon.