By John Hintze
The tax reform bill introduces new elements for treasury to consider when managing cash globally, but rushing to make changes may be imprudent.
Not surprisingly, the new tax law that cuts the corporate tax rate and allows the repatriation of trapped cash will have a big impact on corporate treasury departments. It should set in motion a ramping up of M&A and push companies to start reconsidering funding strategies; it also introduces completely new elements for treasury to consider when managing cash globally.
A clear theme of recent NeuGroup meetings has been that treasurers must seek greater access to the board and insert their hands-on financial knowledge into C-suite decision-making. In the year ahead, they likely will have ample opportunity to do that on the M&A front, which has been very active in recent years and is expected to continue.
Tom Joyce, capital markets strategist at Deutsche Bank, noted that tax is one of several factors impacting corporate decisions to pursue M&A, and most if not all of those factors are aligned.
“Following four straight years of $3 trillion-plus in M&A, 2018 is likely to be another strong year, and now tax will be an important driver,” he said. Therefore, “companies will want to be in a position to be responsive to that.” He noted that M&A activity is highly correlated with equity performance, as equities continue to march higher, and also strengthening GDP, now occurring globally. Other factors include the cost of debt financing, now at historically low levels worldwide, and CEO and board confidence, which is understandably high, especially with the uncertainty of tax reform in the rearview mirror.
“So all the stars are aligned, and then layer on to that $3 trillion in overseas earnings, with maybe half of that not invested in hard assets, and it strongly suggests a continuation and even a pickup in the M&A cycle,” Mr. Joyce said.
On the tax front, Mr. Joyce noted three important points: US companies’ taxes on gains from selling US assets will be significantly lower; taxes on gains from selling non-US assets will be lower still; and US acquirers will be on a level playing field tax-wise with non-US buyers.
Another element to keep in mind, he said, is that the lower corporate rate also reduces the benefits of tax-advantaged M&A structures such as spinoffs. “There’ll still be spinoffs, but the relative attractiveness of those types of tax-advantaged structures is going to decline,” Mr. Joyce said.
There are a variety of ways tax reform will impact the treasury function. For example, while US multinational corporations (MNCs) may retain treasury decision-making in the US, many have established treasury centers in low-tax jurisdictions such as Ireland and Luxembourg to support significant overseas businesses and take advantage of lower tax rates. The new 21% corporate rate in the US, down from 35%, will give treasury departments more options in terms of where to locate their treasury centers.
Kathleen Dale, a principal in international tax at KPMG, said that on that issue treasury departments will have to weight the pluses and minuses, given that companies that have already established treasury centers overseas have sent significant staff to man them, so they comply with substance requirements of both US and non-US tax laws.
“So even though they may like the idea of bringing treasury functions back to the US, they may be constrained because they already have those people overseas,” she said, “But for those companies trying to determine whether to establish an overseas treasury center, the US becomes a viable option.”
There are also several provisions, including revenue raisers on the international front to pay for the lower overall corporate-tax rate, that treasury must consider. Ms. Dale noted that the mandatory one-time tax of 15.5% on income held as cash and cash equivalents and 8% on illiquid assets was put into place to transition to a territorial tax regime, in which US corporates are taxed only on earnings derived from their US operations.
“But the way the foreign provisions work, there’s actually a very small portion of overseas earnings that will be eligible for permanent deferral, and that’s because there are a couple of new tax provisions that will essentially impose a minimum tax on overseas income,” Ms. Dale said, pointing to provisions including the global intangible low-taxed income (GILTI) regime and the base erosion anti-avoidance tax (BEAT).
Another corporate-friendly provision is the ability to fully expense tangible property, plants and equipment, and to fund it the new law imposes limits on the amount of interest corporates can deduct.
“So treasurers will need to model out how the interest limitations will affect whether they use equity or debt to fund subsidiaries,” Ms. Dale said, explaining that under the new rules companies can take their full interest expense to the extent of their interest income, and anything in excess is limited to 30% of adjustable taxable income. “So companies no longer get a current deduction for the full amount of interest that is paid.”
According to Mr. Joyce, Deutsche Bank sees the combination of limited interest deductibility and the influx of repatriated cash reducing corporate debt issuance by upwards of 10%, especially by cash-rich pharmaceutical and technology companies, and he said less issuance should tighten bond spreads. However, he said, a sharp increase in debt-financed MA& may offset part or all of that decline. Mr. Joyce added that the bank foresees limited interest deductibility impacting mostly speculative-grade corporates, although a greater number of companies will be affected after 2021, when a lower debt-interest deduction threshold becomes effective.
“We could see more investment-grade companies doing foreign-bond deals to stay under the new [lower debt-interest deduction] threshold” which offers companies plenty of time to strategize how to deal with this change. — Tom Joyce
We could see more investment-grade companies doing foreign-bond deals to stay under the new threshold,” Mr. Joyce said, adding that a benefit is that companies will have plenty of time to strategize how to deal with this change.
In fact, rushing to decisions stemming from any number of the new law’s provisions may be imprudent. Ms. Dale said that treasurers should keep in mind today’s political volatility, and that components of the law could easily change.
“There are provisions of this law that our trading partners are very concerned about, so certain provisions may be challenged in the [World Trade Organization] and held up for a long time. And we also expect retaliation from other countries,” she said.
For example, the law reduces the 21% corporate rate to 10.5% for certain types of foreign-derived tangible income.
“[The law] is providing incentive for pharmaceuticals and technology companies—any companies with valuable brands or patents—to bring their intangible assets back to the US using a preferential rate,” Ms. Dale said. “Our trading partners will likely argue that it is an unfair trade subsidy that violates WTO rules.”
Another area for treasurers to consider is cash pooling structures. The interest earned or paid by these structures could be subjected to GILTI or other provisions, prompting the cost of funds to go up and raising the question of whether it makes more sense to do an external pool via a bank or an internal one. Tax, however, is only one factor to consider when adopting pooling structures. More importantly, Ms. Dale said, the IRS has recently proposed a rule allowing companies to recognize foreign-currency gains or losses on a mark-to-market basis, similar to financial reporting rules.
“So these rules will result in simpler measurement of FX gains and losses from lending transactions and the hedges of those positions,” she said. “And that’s big.”