The US tax code has just undergone its biggest overhaul in 30 years. The Tax Cuts and Jobs Act (TCJA), signed into law on the 22nd December 2017, is an extensive bill containing a multitude of changes to the US tax system.
1) MTR and ETR forecasts
The new federal tax rate is 21% (vs. 35% previously) and it is effective for financial years starting 1 January 2018. This change is expected to have two immediate consequences in financial models, ultimately also impacting valuation:
Marginal Tax Rate (MTR)
Any MTR forecasts which were previously based on 35% should be changed to 21%. Cost of capital calculations will be affected by this change. A lower MTR increases the post-tax cost of debt (due to the lower tax shield on interest expenses), resulting in a higher WACC, thus contributing to lift the cost of capital of US firms from their post-crisis lows. In DCF models, the WACC increase will result in lower Enterprise Values (EV) and Equity values.
Effective Tax Rate (ETR)
The ETR is the ratio between the tax expense and the pre-tax profit. ETR forecasts are often used in financial models to forecast tax expense, in order to derive net income. In DCF models, many practitioners use the forecast ETR to compute EBIT after-tax (aka NOPAT or EBIAT). As a result of the reduction in the federal tax rate, the ETR forecast for US firms for the year 2018 (and thereafter) must be adjusted downwards.
In financial models, the ETR reduction will cause an increase in forecast earnings and cash flows. Consequently, the EV and Equity values estimated by valuation models (multiples, DCF, DDM etc) will also increase. The ETR should not be affected by the changes in tax depreciation rules (described in section 4 below), since these are reflected in deferred tax without influencing the ETR.
2) One-off tax charge on foreign cash
The new tax bill imposes a one-off tax charge on the accumulated foreign earnings of all US corporations. Prior to the tax reform, US corporations with foreign operations were reluctant to repatriate their cash accumulated abroad, since doing so would have created a significant tax liability in the US. As a result, a substantial amount of corporate cash remained ‘trapped’ outside of the US. To resolve this issue, the tax reform has moved to a ‘territorial’ system of taxation which no longer taxes foreign income and which provides a 100% deduction on dividends received from foreign subsidiaries. As part of the transition to the new territorial regime, all US firms are subject to a one-off ‘deemed repatriation’ tax on their accumulated foreign earnings as of 31 December 2017.
The tax rates applied are: 15.5% of foreign earnings held as cash and cash equivalents and 8% on earnings held in other assets. The tax is payable whether a company intends to repatriate the earnings or not. Therefore, any US company with substantial foreign operations is likely to be hit by a significant tax charge in their 2017 financial year. Many US listed corporations have already made public announcements providing an estimate of the charge.
The tax charge on foreign cash should be treated as a non-recurring item in the analysis of earnings. When modeling cash flows, keep in mind that payment of the one-off tax can be spread over a period of eight years, thus limiting its impact on annual cash flows.
Valuation models should also be adjusted. In DCF models, we recommend to value the tax as a separate adjustment in the bridge between EV and Equity, rather than in the free cash flow forecast.
3) Re-measurement of deferred taxes
The reduction in the federal tax rate to 21% has required all US companies to re-measure their deferred tax assets (DTAs) and liabilities (DTLs). The technical reason for this is that US GAAP (as well as IFRS) requires valuing DTAs and DTLs using the ‘enacted’ tax rates (i.e. the rates officially set by law), so the measurement of deferred taxes on US earnings was previously based on a 35% federal tax rate (plus any other applicable taxes), but it must now be based on the new 21% rate. This has caused a reduction in the DTAs and DTLs reported on corporate balance sheets, which should be reflected in financial model forecasts.
To balance the reduction in deferred taxes, companies will report a one-off income or expense in their tax expense for the 2017 financial year. We expect corporations with a net DTL position (i.e. DTLs in excess of DTAs), such as many capital-intensive firms (e.g. telecoms, mining, automotive OEM’s etc.) to report a one-off tax income, whereas DTA-rich firms (e.g. due to accumulated net operating losses) should report a one-off tax expense. This charge does not have an immediate impact on cash flow. However, it is still important to forecast the DTAs and DTLs correctly, as they will affect cash flow in future years, when the deferred taxes reverse.
Finally, M&A models should be revised to reduce the tax rate used to create deferred tax assets and liabilities resulting from fair value adjustments on the net assets of US-based target companies at acquisition date.
4) Bonus tax depreciation
From 2018 to 2022, most types of capital expenditures will provide a 100% tax deduction in the year of purchase. In practice, this new rule removes the concept of depreciation in the calculation of US taxes for the next 5 years (although it does not have change the depreciation expense reported for GAAP purposes). Tax payments of asset-intensive firms are expected to fall significantly between 2018 and 2022 (for example, it is expected that US mining companies will pay tax as little as 7% of their profits in 2018). The new rule should not affect a company’s ETR, since this is based on the GAAP depreciation rather than the tax depreciation.
Capex forecasts will need to be revised to include any potential short-term increases due to the tax incentive provided by the new rules. Many commentators expect US companies to pull forward investment plans, without however necessarily changing the total amount of investment in the long-run.
Future tax cash flows may be significantly affected and modeling such changes in detail could be rather complicated. A simple modeling solution consists in modifying the forecast for deferred tax liabilities. The new rules will result in a substantial increase in the DTLs related to capital expenditures in the next 5 years. Increasing DTL forecasts in an integrated forecast model (where the forecast cash balance is computed in the cash flow statement) will cause cash flow to rise, thereby reflecting the lower tax payments resulting from the bonus tax depreciation.
The cash flow benefit of the new tax depreciation rules is entirely in the time value of money: the tax deduction is taken immediately, rather than being spread over a number of years. Therefore, the impact on corporate value should be limited. However, valuation models will also need to be adjusted to reflect any changes in investments plans made by corporations as a result of the new tax rules.
5) Limit to interest expense deductibility
The new bill introduces a significant limitation to the tax-deductibility of interest expense, which will have important consequences in the modeling of highly-levered companies and transactions, such as LBOs.
Interest expense in excess of 30% of EBITDA is no longer tax deductible. However, any interest in excess of the limitation can be carried forward indefinitely for future deduction (therefore creating a deferred tax asset). Starting in 2022, the calculation will be based on EBIT rather than EBITDA, thus further reducing the amount of interest being deductible.
All highly-leveraged US companies are likely to be affected significantly by these new rules and forecast financial models will therefore need to be modified accordingly. Models will need to include the 30% test, thus limiting the tax relief on interest. The DTA related to the excess interest deductions will also need to be computed and used to reduce tax payments in future years, when the interest bill falls below the 30% threshold.
6) NOL modeling
The new tax bill introduces significant changes to the utilisation of net operating losses (NOLs):
1. Carryforwards: losses incurred after 2017 can be carried forward indefinitely (previous losses are still subject to the 20-year limit);
2. Loss carrybacks have been abolished;
3. The utilization of losses incurred after 2017 is limited to 80% of pre-tax earnings. Therefore, loss utilization cannot completely wipe out a company’s annual tax bill.
NOL forecasts in financial models will need to be modified to reflect the three changes above.
The valuation of pre-existing accumulated losses will also need to be revised: as noted in section 3 above, US-based DTAs are now less valuable due to the drop in the federal tax rate.
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