The Impact of Corporate Tax Reform on the Technology Sector
Excess cash on the balance sheets of technology companies was a topic that I first addressed in August 2013, and then again in December 2016 following the presidential election. While an enormous amount of research is involved in estimating the future earnings power and free cash flow generation of a business, excess cash on the balance sheet has also been a meaningful source of value at many companies within the technology sector over the past several years. Corporate tax reform is particularly relevant to the technology sector because of the magnitude of unrepatriated foreign earnings that technology companies have accumulated. The Tax Cuts and Jobs Act, which was signed into law on December 22, 2017, made changes to the U.S. corporate tax code that should provide clarity with respect to the timing of excess cash being available to be utilized anywhere in the world.
Worldwide v. Territorial Tax System
Previously, the U.S. had employed a worldwide tax system in which U.S.-based companies were subject to U.S. corporate income tax on profits generated anywhere in the world. Companies received a credit for taxes paid to foreign governments, but were still liable for the difference between the tax rate in the foreign jurisdiction and the U.S. corporate income tax rate. However, this tax on foreign profits did not have to be paid until the cash was repatriated to the U.S. As a result, many companies elected to leave foreign profits overseas and defer the U.S. tax liability rather than repatriate the foreign profits and pay the incremental tax.
The Tax Cuts and Jobs Act applies the concept of deemed repatriation to foreign profits that companies had previously left overseas. A 15.5% tax is applied to offshore cash and an 8% tax is applied to offshore non-cash assets. This tax liability that results from deemed repatriation of foreign profits is paid over eight years with 8% of the liability paid each year in years one through five, 15% paid in year six, 20% paid in year seven, and 25% paid in year eight. The ability to pay this deemed repatriation tax over eight years, with 60% of it paid in years six through eight, meaningfully reduces the present value of this tax liability relative to a scenario in which the tax would have to be paid immediately.
The deemed repatriation of these previously untaxed foreign profits allows this capital to now be utilized anywhere in the world and eliminates the motivation for companies to leave foreign profits overseas to avoid incremental taxation by the U.S. This should result in a reduction of excess cash sitting idly on the balance sheets of technology companies and an increase in capital deployed in the form of organic investments in the business, share repurchases, dividends, and/or acquisitions. Ideally, these previously unrepatriated foreign earnings will be invested with a focus on earning the highest possible returns on capital regardless of whether those opportunities are available in the U.S. or overseas.
Beginning in 2018, the U.S. will be utilizing a territorial tax system in which only profits generated within the U.S. will be taxed at U.S. corporate income tax rates. While there are a few exceptions, profits generated overseas will typically no longer be subject to taxation by the U.S. In addition to the benefit of lower overall effective tax rates, companies will now have the opportunity to more quickly reinvest future overseas profits anywhere in the world rather than letting that capital accumulate on the balance sheet in anticipation of a potential future U.S. tax holiday. It is worth noting that while large amounts of foreign profits did accumulate on the balance sheets of technology companies, the low interest rate environment made it quite inexpensive and rational for companies to issue debt that was implicitly collateralized by the overseas cash sitting on the balance sheet. As a result, these companies have generally had plenty of capital available for attractive investment opportunities. Nonetheless, a territorial tax system should simplify capital allocation decisions and increase the efficiency with which foreign profits are reinvested to benefit shareholders.
Lower Corporate Tax Rate
Another key provision of the Tax Cuts and Jobs Act is the creation of a single corporate federal income tax rate of 21% and elimination of the corporate alternative minimum tax (AMT). Previously, the top corporate federal income tax rate in the U.S. was 35%, which was among the highest of large, developed nations. Before and after the Tax Cuts and Jobs Act, state and local income taxes typically add a few percentage points to a company’s overall effective tax rate. As illustrated in a March 2017 report from the Congressional Budget Office1, many other G20 countries had significantly reduced their top statutory corporate income tax rates between 2003 and 2012 while U.S. corporate income tax rates remained essentially unchanged.
TOP STATUTORY CORPORATE INCOME TAX RATES IN G20 COUNTRIES, 2003 AND 2012 (%)
Source: Congressional Budget Office, using data from KPMG International and the Organisation for Economic Co-operation and Development.
Rates in Argentina, Australia, and Brazil were the same in 2003 and 2012.
G20 = Group of 20.
While the overall impact of the Tax Cuts and Jobs Act should be favorable for companies within the technology sector, there are a few provisions that may partially offset the benefits of a territorial rather than a worldwide tax system and a lower corporate income tax rate on profits generated within the U.S. A few notable items are:
- Interest Deductibility – For 2018 through 2021, deductibility of interest for tax purposes is limited to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA), and beginning in 2022 it is limited to 30% of earnings before interest and taxes (EBIT). While this is unlikely to impact any of Diamond Hill’s current technology holdings, it could contribute to slightly lower acquisition activity within the technology sector since acquisitions financed with large amounts of debt are somewhat less appealing when deductibility of interest is limited.
- Base Erosion Anti-Abuse Tax (BEAT) – To limit the tax benefits to U.S. companies from intellectual property located outside of the U.S., often in very low-tax countries, a minimum tax is calculated on a tax base that excludes the tax benefits of royalty payments on this intellectual property. To calculate this minimum tax, a 5% rate is applied in 2018, a 10% rate is applied from 2019 through 2025, and a 12.5% rate is applied beginning in 2026.
- Foreign Derived Intangible Income (FDII) – Foreign earnings generated from U.S.-based intangible assets will be taxed at a rate of 13.125% from 2018 through 2025 and at a rate of 16.406% beginning in 2026.
- Global Intangible Low-Taxed Income (GILTI) – For U.S. companies with foreign intangible assets, the U.S. applies a tax on profits above a 10% return on these assets. From 2018 through 2025 a 10.5% tax rate is applied, and beginning in 2026 a 13.125% tax rate is applied.
After years of uncertainty associated with the specific timeframe within which overseas cash might be repatriated, the Tax Cuts and Jobs Act should result in this cash being available to be utilized anywhere in the world, including in the United States. Cash and investments on the balance sheet remain a meaningful source of value at several current technology holdings. The table below illustrates the extent to which net cash and investments represent a source of value following U.S. corporate tax reform.
CASH AS A SOURCE OF VALUE
|(In $ millions, except share
and per share amounts)
|Cash & Investments||285,097||4,021||101,871||5,291||146,741|
|Short-term Tax Liability||n/a||(937)||(881)||(51)||(788)|
|Long-term Tax Liability||(42,261)||(651)||(13,242)||(584)||(33,236)|
|Net Cash & Investments||132,416||1.197||83,779||3,783||23,457|
|Diluted Shares Outstanding||5,158||384||704||595||7,799|
|Net Cash & Investments Per Share||$25.67||$3.12||$119.07||$6.36||$3.01|
|Stock Price as of 3/29/18||$167.78||$24.33||$1,037.14||$80.50||$91.27|
|Percentage of Stock in
Net Cash & Investments
As of March 31, 2018, Diamond Hill owned shares of Apple, Juniper, Alphabet, Cognizant, and Microsoft.
Originally published on April 17, 2018.
The views expressed are those of the research analyst as of April 2018, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.