Tax bill tossing and turning

E*TRADE Securities2

12/08/17

A pajama party it was not. The Senate floor stayed busy into the early hours last Saturday as lawmakers worked toward a sweeping tax reform. By the end of the session, a 51–49 vote advanced the bill to the reconciliation phase between the House and Senate versions. 

As is typically the case with major legislative initiatives, some have their doubts about the potential potency of the final version. For one, the nonpartisan Tax Policy Center estimates the bill would boost GDP by just 0.7% in 2018 and add $1.23 trillion to the federal deficit over 10 years.1

For market players, though, tax reform has been a dangled carrot. And it’s one that some believe could help keep the bull market intact for longer. This week, we take a look at what the tax bill could mean.

Companies eye tax breaks

The rundown

The proposed corporate tax rates have put many big companies on notice, especially multinationals. And the core of what could be the new tax code speaks directly to them:

  • Corporate rate cut. Companies with high US income and effective tax rates, including big financial firms, domestic manufacturers, retailers, and telecoms, stand to benefit with the top corporate rate cut from 35% to 20%. There’s been some noise that it could wind up at 22%. But either way, a cut could encourage companies to invest in more growth and spur development.
  • Repatriation incentive. Drug and biotech companies, as well as tech firms, are among those that keep significant earnings overseas. To get that money back to the US, the House and Senate plan to drop the 35% repatriation rate in favor of a territorial tax system that charges a one-time tax on profits (14% in the House’s bill and 14.5% in the Senate’s)—whether they’re repatriated or not. And leave companies’ future foreign profits largely untaxed.
  • Intellectual property transfer. It’s not just cash overseas. Intellectual property, including patents, trademarks, and copyrights, especially important for those firms specializing in digital and tech, has found a home abroad. The Senate bill hopes to entice earnings generated from intellectual property back to the US using a zero tax for three years, and a low 12.5% rate on future income thereafter. 

Kinks to work out

Know what a hypnic jerk is? It’s when a muscle twitch causes that feeling of falling while drifting off to sleep. Lawmakers and certain manufacturers, drug companies, utilities, and techs may have had a couple such twitches due to seesawing with the alternative minimum tax (AMT) in the last week between the House and the Senate.

The AMT keeps companies from using legal tax breaks to pay too little tax—it’s a guardrail. Most corporations pay the 35% tax rate, lowering their effective rates by claiming tax breaks along the way, and never get near the 20% AMT rate. The House’s version repealed the AMT. But in a surprise last-minute change, the Senate kept it. And because the Senate bill would also cut the regular corporate income tax rate to the same 20%, some tax pros say almost every US company could hit the AMT.2

That could actually lead to higher tax rates than companies currently enjoy, as tax breaks related to intellectual property, investments in new equipment, and the popular research and development tax credit would lose their effect. Silicon Valley is especially cognizant of the latter.

What to make of this

Some say the 20% AMT could actually be a simple “drafting error” (perhaps left in by some bleary eyes last Saturday).3 For investors, there’s a bigger lesson here: Tax reform is nowhere near done and dusted.

And there are not just equities to consider. The muni bond market may be in for a drop in issuance, after a last-minute debt rush to beat two types of bonds on the chopping block.4 The tax-exempt status for advance refunding bonds municipalities issue to secure low borrowing costs before retiring previously sold bonds has been eliminated. And the fate of private activity bonds that fund such public works as airports and hospitals is up in the air too.

Sleep may be at a premium for those trying to push this bill through. Should it become law, tax preparers could be losing the shuteye, as they’ll have to make sense of it all. It seems the market noted that too, as H&R Block’s shares rose 10% on Wednesday after CEO Jeffrey Jones said, “I’m convinced the value of H&R Block remains our ability to help".5 For investors, the market significance of this bill seems to creep into the light more every day. 

 

 

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1. “Analysis of the Tax Cuts and Jobs Act,” Tax Policy Center, 4 Dec. 2017. http://www.taxpolicycenter.org/feature/analysis-tax-cuts-and-jobs-act

2. “Chief Senate Tax Writers Prefer AMT Repeal: Tax Debate Update,” Bloomberg News, 5 Dec. 2017. https://www.bloomberg.com/news/articles/2017-12-05/brady-says-ending-corporate-amt-is-priority-tax-debate-update

3. Browning, Lynnley. “Senate Bill ‘Bombshell’ Could Raises Taxes on Tech,” Bloomberg, 5 Dec. 2017. https://www.bloomberg.com/news/articles/2017-12-05/trump-s-stock-forecast-fails-after-senate-tax-bill-s-bombshell

4. Platt, Eric and Rennison, Joe. “US municipal bond sales set to surge as curbs loom in tax reform,” Financial Times, 5 Dec. 2017. https://www.ft.com/content/71cbe636-d979-11e7-a039-c64b1c09b482

5. Minkoff, Yoel. “H&R Block rallies on changing tax code,” Seeking Alpha, 7 Dec. 2017. https://seekingalpha.com/news/3316828-h-and-r-block-rallies-changing-tax-code