Planning and modeling for the prospect of tax reform and its impact on capital structure, capital and cash forecasting is consuming large chunks of time for many NeuGroup peer group members lately. The uncertainty surrounding the content and timing of any type of tax reform requires treasury to develop scenarios and propose actions for various outcomes. Indeed, this has caused some CFOs to maintain a wait-and-see approach on reform-oriented planning. Still, the need for congressional Republicans to show legislative success before the midterm elections after their failure on health care reform may boost the odds of some kind of tax legislation passing. And although many details remain undefined, being proactive with no-regrets planning trumps being purely reactive.
Despite this, the political dysfunction in Washington points to a low chance of a well-thought-out, broad reform of the US tax code. On the positive side for corporates, elimination of interest deductibility is considered unlikely, as is the adoption of a border adjustment tax (“Hallelujah!” said one member). Policy makers are also still uncertain about the possibility of a split rate for repatriated cash (8.75% in the House “Better Way” Blueprint) and non-cash assets (3.75%). Staying liquid may be important because activist pressure means “time will be ticking really fast” to make good use of untrapped cash, experts warned especially for companies that lack credibility with activist investors.
NeuGroup Peer Research surveyed treasurer and assistant treasurer groups during the first half of 2017 on what preparation has occurred at their companies regarding potential tax reform and the repatriation of funds. The aggregated results from approximately 100 company responses and key takeaways from discussions with these NeuGroup members are summarized below.
Despite the questions about timing and content, planning for US tax reform is one of the top two priorities being addressed by members in 2017 H1 and scenario planning has (wisely) begun. Over half (52%) of members have prepared various scenarios for senior management regarding repatriation or tax reform, quantified after-tax proceeds with the tax group (36%), or mapped out potential uses of proceeds (36%). Only a small minority have changed their forecasting process or prepared scenarios for ratings agencies. Opportunities, members say, may include shifting more debt offshore (while having less onshore, with no impact to overall leverage), and using the additional liquidity in the US to accelerate tax-deductible uses of funds.
KEY TAKEAWAYS
- It’s time to put your tax playbook together. Although it may seem premature due to the lack of clarity on when and how tax reform will take place, lively meeting discussions throughout the first half led most members to conclude playbooks should be developed now—in collaboration with tax groups—for a wide range of scenarios. Treasurers should also lobby for senior level buy-in as soon as possible so action can be taken without unnecessary delay when the tax code changes. Much of the planning is opportunistic, or focused on what can be done if x happens or what value creation may be exercised regardless of whether x happens or not or if y happens instead.
Tax advisors presenting to members at one meeting encouraged “no-regrets” planning: taking actions to review or revise tax structures that will bring benefits no matter what form tax reform takes, or even if it does not come to pass at all. For example, this would include shifting out of offshore cash positions and making efforts to minimize existing profits subject to a transitional deemed repatriation tax by shifting liquidity to subs without earnings, harvesting foreign tax credits (FTCs) from subs in high-tax pools in case the FTCs are derailed by repatriation, or planning to accelerate interest deductions while you can.
The degree of planning and sophistication of the modeling may depend on the tax department’s connection with the CFO. “Our CFO was previously the tax guy,” one member noted, “so there has been a lot of debate about what we expect to happen and how to model the implications for shareholders.” It may also depend upon the board. As another member said: “Even though we know nothing, we have been modeling and continue to model, because the board wants to see what all the possibilities are.” It pays to make it a joint effort: “Our planning is a joint effort between treasury, tax, IR, FP&A and the business CFOs.” Some have been planning for a while: “Our tax group has been saying we will get tax reform in 2018 for five or six years, so we’ve been planning over that period for either getting tax reform in 2018 or changing how we view our capital structure anyway in 2018.”
- Tax reform would bring capital restructuring and M&A opportunities. In the event of tax reform, members see a sizable opportunity to rationalize the amount of debt on the balance sheet as well as increase capital return programs and boost inorganic or organic investments. Although Republicans and Democrats alike anticipate companies steering mandatory repatriated cash under tax reform to capex and new manufacturing jobs, a common expectation has been that much of the cash will go to share repurchases and dividends, with M&A a close third. A bank presenter at one peer group meeting suspects that “five years down the road, when companies no longer have trapped cash and can use overseas profits in their calculations to allocate resources, they’ll be able to think about their growth plans more holistically.”
Nevertheless, “the boon will be the accessibility of the cash,” said a treasurer whose company’s effective tax rate is already in the low 20% range. The company also may pay down debt with repatriation proceeds, using the “opportunity to have a meaningfulimpact on our balance sheet.” Another member said it would be impossible for his company not to pay a dividend if tax reformpasses. A treasurer whose company has been adding debt to thebalance sheet in recent years said tax reform was “causing us totake a step back and figure out where we want to land.” The treasurerof another large global company, one he described as a”huge taxpayer,” was unequivocal about the sizable windfall taxreform will bring: “It should be a huge win for us.”
- Safeguarding interest deductibility. Under the Houseblueprint, net interest expense would no longer be fullydeductible and instead would be carried forward. Comprehensivetax reform, or any tax reform at all, may create new economicsaround debt, so companies should consider havingprepayment penalties scrubbed out, if possible, via an “interestdeductibilityclause.” Changes to interest expense deductibilitywould have a significant enough impact that it is worth doingsome contingency planning for them. For example, it wouldmake sense to consider setting in-house banks up in jurisdictionswhere interest expense remains deductible. For cashpools, it would make sense to look at the net interest positionto maximize offsets and locate header accounts at entities inthe right jurisdictions, considering whether the net position ismore likely to be in deficit or surplus. Banks also might get creativewith ECR. Funding could also shift to entities in jurisdictionsallowing interest rate deductibility. However, treasurersshould note that many countries are considering curbs oninterest expense deductions under BEPS, which has proposedcapping it at 30%. The US proposal goes farther by proposingto eliminate it all together.
The good news is that it is very likely that existing debt wouldbe grandfathered and there would be some transitional relief,even though the proposal is short on specifics. A presentingbank at one of our recent peer group meetings spoke to seeingan acceleration in debt issuance so far this year, with rising ratesas one primary driver, but also because companies are trying toget on the right side of a grandfathering clause should taxreform limit interest expense deductions. Issuers are also goingfurther out the curve, issuing longer-term debt. Similarly, thebank has seen companies contributing to underfunded pensionsin the US to take advantage of the higher tax deductionbefore the corporate rate drops from the current 35%, “so theyget the benefit while they can, since they’ll have to make thecontribution at some point.” The bank suggested companiesshould scour their balance sheets for unrecognized losses thatthey can trigger before the corporate rate drops, when thoselosses would be less valuable from a tax perspective.
- Repatriation in some form is likely and if it comes,activists will come for your cash—fast. If repatriation isenacted, activists won’t delay gunning for the return of repatriatedcash to shareholders. They may, however, give you ashorter or longer window depending on what you say youmight do with proceeds, and if they believe in the positive outcomeof those plans. Members were advised to be sure todevelop a coherent message for investors, and perhaps highlightsignificant points with a portion of the investor base. Messagingshould provide confidence that (1) you have done duediligence on capital structure ratios that underpin your creditrating and (2) you have a coherent plan to mitigate the impactof repatriated earnings.
- A destination-based tax system for global competitiveness.At its root, the House blueprint is destination-basedtaxation in which the jurisdiction to tax is based on the destinationof goods and services, rather than the source of income orthe residence of the taxpayer. This is what results in the need fora border adjustment exempting exports and taxing imports.
Generally speaking, then, the tax base becomes domesticreceipts less domestic expenses plus net interest income (andperhaps other portfolio investment income). Territorial aspectswould result in big changes. The end to taxation of repatriatedforeign earnings would be a big relief to MNC treasuries, and itis probably the most likely of the proposed provisions to getenacted. To account for past offshore earnings that have beendeferred from US taxation under the existing tax regime, therewould be a deemed repatriation taxed at an effective rate of8.75% to the extent the funds are held in cash and cash equivalentsand 3.5% otherwise. Therefore, some MNCs have consideredshifting offshore cash out of cash and cash equivalentassets if they can. Payment of the tax would be spread out overeight years under the blueprint.
- Time is running out on comprehensive tax reform.There is a lot of wishful thinking out there about comprehensiveUS tax reform, and then there’s reality. Although it’s aRepublican priority, tax reform is competing with the attemptsto repeal the Affordable Care Act (ACA) and urgent issues suchas the 2018 budget and the debt ceiling. The fact that theHouse of Representatives hadn’t introduced a tax reform billbefore Congress went on recess in early August means taxreform is unlikely to be signed into law this year. Further, theHouse’s blueprint for tax reform, which would radically changethe US tax system to more of a consumption-based tax system,vastly reducing the tax on corporates’ global income, probably won’t happen at all. The greater likelihood is a more moderatelowering of the corporate tax rate (to around 25%), repatriation,and a move to a territorial-based tax system. Mandatoryrepatriation of corporate cash is one item likely to reach fruitionin 2017 or early 2018, before legislators start campaigning forNovember elections, because both Democrats and Republicansfavor it, if for different reasons.
OUTLOOK
For years, the Republicans have been calling for fundamentaltax reform, especially for corporate taxes. Their wish list tookshape a year ago, when Speaker of the House Paul Ryan andHouse Ways and Means Chairman Kevin Brady published theblueprint. One meeting presenter explained that the blueprintrests at one end of the spectrum in terms of fundamentalreform, while the middle—seemingly the direction of PresidentTrump’s page-long proposal—could include a rate reductioncoupled with eliminating some deductions, referred to as”broadening the base.” The other extreme would be simply”tinkering around the edges,” potentially including some formof cash repatriation, using part of the proceeds to invest ininfrastructure, and perhaps shifting to a territorial tax system.
The lack of an ACA repeal may present a hurdle to tax reformand other Republican initiatives. With Congress’s Augustrecently begun, it is unlikely there will be any major reform thisyear. And if a bill fails to get the president’s signature by the endof the first quarter of 2018, congressmen will be too busy campaigningfor midterm elections to pass major legislation. Onemeeting participant suggested a reform-lite bill could likely getthe president’s signature. Therefore, the most likely scenario isa signing ceremony in early 2018 but the package will likely beless transformative than hoped for; nor will it level the playingfield for US MNCs vis-à-vis their non-US peers. Although a primaryfocus for MNC treasurers is the potential for cash repatriationand what to do with the cash once it’s home, keeping tabson the big picture of proposed reform is still important. It maynot be all you want it to be. As one treasurer noted: “Everythingwe like is likely to be accompanied by something we don’t like.”
SURVEY SAMPLE
NeuGroup Peer Research surveyed treasurer and assistant treasurer groups in the NeuGroup Network on what preparation has occurred at their companies regarding potential tax reform and the repatriation of funds. The results help members identify common challenges for discussions at their meetings that generate solutions. The survey included members from the following groups: tMega, T30 LC, T30, Tech20, AT30 and ATLG.
ABOUT NEUGROUP PEER RESEARCH
NeuGroup Peer Research is the research division of the NeuGroup, with reports, data and analysis provided to members of the NeuGroup Network of knowledge exchange peer groups and to the subscribers of our flagship publication iTreasurer. NeuGroup Peer Research conducts research, surveys and other benchmarking across the NeuGroup Network, which includes more than 400 members across 18 active, invitationonly peer groups. Each report highlights what we have learned from this unique and exclusive access to survey data, trends and insights of world-leading treasury and finance professionals. This in-depth interaction has made NeuGroup, iTreasurer, and now NeuGroup Peer Research, trusted thought leaders and independent advocates for finance and treasury professionalsfor more than 20 years.