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Equity Strategy Focus Point
Death and tax reform
Quantitative Analysis
29 January 2017 Corrected
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Deep dive on corporate tax reform
OK, maybe it’s not as inevitable as death and taxes, but some form of corporate tax
reform seems likely. It is a stated priority of President Trump and has widespread
Congressional support. We here focus on four components that could have big equity
implications. We assess the impacts at a market, sector, and industry level, and plan to
update and augment this work as more details come to light.
Potential near-term boost to EPS, long-term impact varies
Our 2018 S&P 500 EPS estimate of $137 already implies healthy two-year growth of +16%.
Tax reform in its entirety could add as much as $5-6 to near-term EPS, as benefits are frontloaded.
The sustained impact depends: under a 20% tax rate, the Blueprint would be
modestly accretive; under a 15% rate, this annual benefit could triple; but a 25% tax rate that
would appease the deficit hawks could shave $3.50 off of earnings each year. We also
estimate a one-time $8-9 charge to GAAP EPS associated with the repatriation tax (Table 1).
Cutting corporate tax rate could add $8 to EPS
Our starting point is the US statutory corporate tax rate. If it were lowered from 35% to
20% and the US moved to a territorial tax system (no longer taxing foreign profits), it
would boost S&P 500 EPS by an estimated 12% ($17 to 2018 EPS). We assume
companies would be able to retain half of the benefit ($8) and the remainder would be
passed on to customers or competed away. For instance, a lasting impact to Utilities'
profits is unlikely, as the benefit would be passed on via regulated pricing.
Repatriation: Buybacks could boost EPS by 3%
Both Trump and the Blueprint support a mandatory (as opposed to 2004's optional) tax
of overseas earnings of US firms’ subsidiaries at reduced rates. Non-Financials in the S&P
hold at least $1.2tn in overseas cash (mostly Tech and Health Care). If half was used for
buybacks, this could add 3% ($4) to S&P 500 EPS. A redux of 2004 where companies
used 80% of cash for buybacks may be less likely, in our view. For if repatriation is
accompanied by an end to interest expense deductions, companies may choose to pay
down debt over buybacks.
Border adjustment tax (BAT) hits EPS by $5-6
While Trump has described the BAT as being “too complicated,” White House press
secretary Spicer’s recent comments call into question his stance. This is a key
component of the Blueprint and would generate significant revenue. First-order impacts
could be significant, with border adjustments detracting $5-6 from 2018 EPS — nearly
80% of the drag comes from the consumer sectors. The second order impacts — product
pricing, pricing within the supply chain, exchange rates, foreign policy reactions, etc. —
while harder to quantify, are important to consider.
End to interest deductibility could detract 4% from EPS
We estimate that over time, the removal of the interest expense deduction would
detract about 4% from S&P 500 EPS. An increase in the cost of debt by an incremental
25% could have longer term ramifications for capital structures and funding..
Tax reform winners and losers
We include stock screens for potential beneficiaries and victims of tax cuts, repatriation
and interest deductibility changes, as well as industries most helped/hurt most by a BAT.
Note that the very fact that there are companies and industries that have the potential
to be very negatively impacted could call into question the likelihood of passage.
BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a
result, investors should be aware that the firm may have a conflict of interest that could affect the
objectivity of this report. Investors should consider this report as only a single factor in making
their investment decision.
Refer to important disclosures on page 26 to 27. 11706251
Timestamp: 29 January 2017 12:01AM EST
Equity and Quant Strategy
United States
Savita Subramanian
Equity & Quant Strategist
MLPF&S
+1 646 855 3878
savita.subramanian@baml.com
Dan Suzuki, CFA
Equity & Quant Strategist
MLPF&S
+1 646 855 2827
dan.suzuki@baml.com
Marc Pouey
Equity & Quant Strategist
MLPF&S
+1 646 855 1142
marc.pouey@baml.com
Alex Makedon
Equity & Quant Strategist
MLPF&S
+1 646 855 5982
alex.makedon@baml.com
Jill Carey Hall, CFA
Equity & Quant Strategist
MLPF&S
+1 646 855 3327
jill.carey@baml.com
Jimmy Bonilla
Equity & Quant Strategist
MLPF&S
+1 646 556 4179
jimmy.bonilla@baml.com
Table 1: Estimated impact of tax reform on S&P 500
2018 EPS
Tax policy 15% 20% 25%
Tax rate change 10.50 8.00 5.00
End int. deduct. – init. impact* -0.50 to -1.00 -0.50 to -1.50 -0.50 to -2.00
Border adjustments -4.00 -5.50 -6.50
Repatriation buybacks 4.00 4.00 4.00
Total init. Impact 9.50 to 10.00 5.00 to 6.00 0.50 to 2.00
End int. deduct. – recur. impact -3.50 -5.00 -6.00
Recurring impact 7.00 1.50 -3.50
One-time repat. tax -8.50 -8.50 -8.50
Source: BofAML US Equity & Quant Strategy, FactSet, Compustat, S&P
*Assumes end to interest deductibility only applies to new debt, where we estimate
70-90% of debt is long-term.
Note: For this exhibit, we assume that 100% of the cash is repatriated and 50%
of it is spent on buybacks. For different buyback assumptions, please see the
section on repatriation.
Contents
The costs and benefits of tax reform 3
Cutting the corporate tax rate 4
Repatriation 6
Border adjustment tax analysis 12
Closing loopholes 15
No interest tax shield 17
Tax reform screens 19
Related BofAML research on US tax reform 22
Methodology 24
2 Equity Strategy Focus Point | 29 January 2017
The costs and benefits of tax reform
2017 could be a watershed year from a tax reform perspective. Trump has continuously
stated that tax reform is a priority, and there is evidence of widespread support in
Congress. Tax reform could be enacted through reconciliation without the risk of being
filibustered, suggesting the timing could be imminent. Corporate tax reform could have
a significant impact on S&P 500 earnings, corporate behavior and capital markets. Much
has been written on the timing, funding and process by which corporate tax reform
could be enacted. In this report, we use House Speaker Paul Ryan’s Blueprint proposal as
a starting point in quantifying the impact of corporate tax reform on the S&P 500, with
some scenario analysis to account for differences included in the final bill (such as
Trump’s proposals). Our analysis is focused specifically on the impact of corporate tax
reform, however we recognize that there are many other factors that can impact the
sensitivity analysis (e.g. changes to household income tax rates, infrastructure spending,
etc.).
We estimate that the Blueprint proposal would initially boost S&P 500 EPS by $5-6,
assuming the end of interest expense deductions only applies to new debt, or is phased
in over time. But the devil is in the details. Over time, the loss of the interest tax shield
would be a significant drag on earnings as existing debt is refinanced. Additionally, the
corporate tax rate is critical in determining whether or not the tax reform policies end
up being accretive to earnings on a sustained basis. We estimate that at the 20% tax
rate, the Blueprint would be modestly accretive, the benefit would triple under Trump’s
proposed 15% tax rate, but at a higher 25% tax rate that would appease the deficit
hawks in Congress, the benefit would turn to a negative over time (Table 2). We also
estimate a one-time $8-9 charge to GAAP EPS that would be associated with the
discounted repatriation tax.
Table 2: Estimated impact of tax reform on S&P 500 2018 EPS
Tax policy 15% 20% 25%
Tax rate change 10.50 8.00 5.00
Ending interest deductibility – initial impact* -0.50 to -1.00 -0.50 to -1.50 -0.50 to -2.00
Border adjustments -4.00 -5.50 -6.50
Share count reduction from buybacks (50%) 4.00 4.00 4.00
Total initial impact 9.50 to 10.00 5.00 to 6.00 0.50 to 2.00
Ending interest deductibility – recurring impact -3.50 -5.00 -6.00
Recurring impact 7.00 1.50 -3.50
One-time repatriation tax (8.75%), GAAP
charge -8.50 -8.50 -8.50
Source: BofAML US Equity & Quant Strategy, FactSet, Compustat, S&P
*Assumes end to interest deductibility only applies to new debt, where we estimate 70-90% of debt is long-term.
Note: For this exhibit, we assume that 100% of the cash is repatriated and 50% of it is spent on buybacks. For different buyback
assumptions, please see the section on repatriation.
In the following pages, we focus on the following topics that have large implications for
US equity investors, but it is important to consider corporate tax reform holistically
rather than drawing major implications from each measure in isolation:
• Reducing the US corporate tax rate
• Repatriation - mandatory tax on overseas profits
• Border adjustment tax
• Removal of interest expense deduction
The government revenue associated with each of these is included in the table below.
Equity Strategy Focus Point | 29 January 2017 3
Table 3: Estimated 10-year* revenue impact from tax plans, $bn
Based on estimates from both the Tax Policy Center and Tax Foundation
House Plan Trump Plan
Corporate Tax Reform -890 to -1200 -1940 to -2630
Lower corporate tax rate (20% under House, 15% under Trump) -1800 to -1850 -2120 to -2350
Full capex expensing, interest expense no longer deductible (mandatory under
House, choice between two under Trump)** -450 to -1040 -320 to -590
Deemed repatriation of overseas earnings 140 to 190 150-200
Move to territorial tax system -90 to -160 n/a
Border adjustment 1070 to 1180 n/a
Changes to individual income/payroll taxes -980 to -2020 -2190 to -3730
Repeal estate/gift taxes -190 to -240 -170 to -240
Total (static) estimate -2420 to -3100 -4370 to -6150
*Tax Foundation assumes impact over 2016-2025 and Tax Policy Center assumes impact over 2016-2026
**Under House plan, Tax Foundation separately breaks out estimates for full capex expensing (-$2236) and disallowing interest deduction
on new loans (+$1194).
Note: estimates rounded to nearest ten billion, with range to incorporate estimates from both sources. Other elements to corporate tax
reform not itemized above include eliminating the AMT, repealing certain corporate tax deductions, etc.
Source: Urban-Brookings Tax Policy Center, Tax Foundation, BofA Merrill Lynch US Equity & US Quant Strategy (calculation of ranges)
From a sector and industry perspective there are haves and have-nots based on each
policy, but in aggregate most sectors have some puts and some takes based on tax
reform. The table below shows some relevant aggregate statistics by sector that inform
our subsequent analysis.
Table 4: Estimated overseas cash vs. last 12 month effective tax rate vs. COGS net exports by sector
Sector
Est. cash
overseas ($bn)
Overseas cash
% mkt cap
Effective tax
rate LTM
Net % imported vs
exported COGS
Discretionary 75 2.9% 28% -14%
Staples 68 3.2% 29% -13%
Energy 39 2.6% 21% -3%
Health Care 187 7.0% 23% -4%
Industrials 127 6.0% 26% 1%
Technology 647 14.9% 20% -9%
Materials 24 4.0% 23% 3%
Telecom 1 0.2% 29% 0%
Utilities 2 0.3% 28% 0%
S&P 500 ex. Financials & Real Estate 1,170 5.7% 25% -6%
Source: BofAML US Equity & Quant Strategy, FactSet, Bloomberg
Cutting the corporate tax rate
The best starting point for analyzing corporate tax reform is the US statutory corporate
tax rate, as this rate is critical in determining the impact of other proposed changes
(border adjustments, interest deductibility, etc.). If the tax rate were lowered from 35%
to 20% and the US moved to a territorial tax system (no longer taxing foreign profits),
all else equal, we estimate an initial boost to S&P 500 EPS of 12% ($17 to 2018 EPS).
However, over time, some of this benefit could be passed on to customers via lower
prices — for instance, it is unlikely that there will be any major long-lasting impact from
tax reform for Utilities sector profits, as any benefit/cost would likely be passed through
to customers when incorporated into each company's regulated pricing. The benefit
would also be offset by some of the other changes discussed in subsequent sections.
We assume that S&P 500 companies would be able to retain half of the benefit, or
roughly $8 of 2018E EPS. Below, we show the estimated EPS impacts on each sector
based on a tax rate of 20%.
4 Equity Strategy Focus Point | 29 January 2017
Chart 1: Sector EPS estimated impact from 20% rate
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Financials
Discretionary
Telecom
Staples
Industrials
Health Care
Energy
Materials
Info Tech
Real Estate
2%
4%
8%
10%
10%
14%
12%
12%
16%
18%
Source: BofAML US Equity & Quant Strategy, FactSet, S&P
While the effective tax rate of the S&P 500 is generally about 28% (currently closer to
25% due to the recent commodity recession), we estimate that the tax rate for the S&P
500’s domestic operations is much higher at roughly 33% — although this includes
state and local taxes. If all companies with tax rates above the proposed new tax rate of
20% were to drop to 20%, and no companies provisioned for US taxes on foreign
profits, we estimate the domestic effective tax rate for the S&P 500 would fall in line
with its foreign tax rate of roughly 19%. This would represent a 9ppt decrease in the
current S&P 500 tax rate and a 12% increase in EPS. We show the sensitivity to S&P
500 EPS to different assumed tax rates in the chart below, but we reiterate that these
estimates exaggerate the actual impact on profits, as a significant portion of these
benefits would likely be passed on to consumers via lower prices. We assume that in
aggregate, roughly half of the gains from the lower tax rate would be retained (i.e. half
of the amounts shown in the sensitivity analysis in Chart 2).
Table 5: Impact of 20% domestic corporate tax rate
Sector Current tax rate New tax rate Change
Discretionary 30% 19% -12ppt
Staples 29% 20% -9ppt
Energy 41% 32% -9ppt
Financials 33% 21% -11ppt
Health Care 25% 16% -9ppt
Industrials 32% 23% -9ppt
Info Tech 18% 14% -4ppt
Materials 28% 23% -5ppt
Real Estate 9% 7% -2ppt
Telecom 29% 20% -9ppt
Utilities 32% 20% -12ppt
S&P 500 28% 19% -9ppt
Source: BofAML US Equity & Quant Strategy, FactSet, S&P
* Current tax rates may differ from other sources, as this analysis is based on companies’ 5-yr median
fiscal year domestic and foreign tax data from annual filings.
Chart 2: Benefit to 2018 S&P 500 EPS from lower tax rates
20%
15%
10%
5%
0%
$10.50 $8.00
15% 20% 25%
New Corporate Tax Rate
Estimated impact on 2018 EPS
$5.00
Source: BofAML US Equity & Quant Strategy
Note: Our base case assumes that half of the benefit would be passed on to customers, competed
away or offset by other changes to the tax code. Thus, we would expect the uplift to our EPS forecast
to be roughly half the calculated benefit from simply lowering the corporate tax rate.
The market is beginning to price in the benefits of tax cuts , but we may still be in the
early days – note that potential beneficiaries of fiscal stimulus (i.e. infrastructure
spending) have seen an 18% multiple re-rating but de minimis fundamental support,
whereas potential beneficiaries of lower corporate tax rates have seen performance
driven nearly equivalently by multiples and earnings.
Equity Strategy Focus Point | 29 January 2017 5
Chart 3: Decomposition of performance of 1) S&P 500 stocks exposed to fiscal stimulus* and 2) top
50 S&P 500 stocks with the highest L12M effective tax rates, vs. rest of S&P 500 (1/31/16-1/23/17)
25%
20%
15%
10%
5%
20%
2%
18%
15%
7%
19%
11%
8% 8%
15%
6%
9%
0%
Stimulus Beneficiaries
S&P 500 ex-Stimulus
Beneficiaries
High Effective Tax Rate
List
Chg in PE Chg in EPS Performance
S&P 500 ex-High Eff Tax
Rate List
*Stocks identified by BofAML analysts as stimulus beneficiaries in 150 stocks with exposure to the Fiscal Stimulus theme 21 Aug. 2016
Source: FactSet, BofA Merrill Lynch US Equity & US Quant Strategy
Potential beneficiaries: See Table 19 at the end of this report for a screen of
domestically-oriented companies with high effective tax rates which could
potentially benefit from a lower corporate tax rate.
Repatriation
Repatriation likely under both Blueprint and Trump plans
Mandatory tax on overseas profits of 8.75% under Blueprint, 10% under Trump
The US currently operates under a tax system in which the domestic earnings of US
corporates are taxed at the federal US corporate rate (35%) and any overseas earnings
that are repatriated are taxed at this rate less a credit for foreign taxes paid on those
same earnings. Many multinationals’ foreign earnings thus remain parked offshore,
allowing corporations to avoid the tax hit associated with bringing them back to the US.
Both Trump and the House (under Ryan) have proposed a mandatory tax of overseas
earnings of US firms’ foreign subsidiaries at reduced rates, such that this cash can be
brought back and put to work in the US. This differs from the 2004 repatriation tax
holiday, which was optional.
Under the Blueprint, accumulated overseas earnings will be subject to a transition tax of
8.75% 1 (for those held in cash/cash equivalents) or 3.5% (for all other holdings), with
companies able to pay the tax liability over an eight-year period. This would be part of
broader tax reform, where a proposed territorial tax system would exempt companies’
foreign income from US taxes and prevent future buildup of overseas profits as
companies would be free to bring them home. Trump’s plan calls for a one-time deemed
repatriation of overseas corporate profits at a 10% tax rate.
Table 6: Blueprint vs. Trump tax plans for taxing offshore earnings of US firms’ foreign subsidiaries
Plan
Tax rate on accumulated overseas earnings
Blueprint
8.75% for cash/cash equivalents, 3.5% of all other holdings
Trump tax plan 10%
Source: donaldjtrump.com, abetterway.speaker.gov
The Tax Policy Center estimates that a repatriation tax holiday would generate
approximately $150bn in tax receipts under Trump’s plan (over 10 years) and $140bn
1
Note: The effective tax rates of 8.75% and 3.5% under the Blueprint are based on an allowable deduction of 75% (for
deferred earnings held in cash/liquid assets) or 90% (for the non-cash portion), with the remainder taxed at the US
corporate tax rate, i.e. 35%(1-75%) = 8.75% and 35%(1-90%) = 3.5%. This methodology was proposed by Dave Camp’s
(former chairman of the House Committee on Ways and Means) Tax Reform Act of 2014.
6 Equity Strategy Focus Point | 29 January 2017
under the Blueprint (over eight years). The Tax Foundation similarly estimates that a
repatriation act could drive spending amounting to $185-200bn in revenues through
2025, which could help fund infrastructure/defense spending.
S&P 500 companies could bring back over $1tn – mostly in Tech & Health Care
Our FX team has written that US corporates in aggregate (including Financials) hold
~$2tn in cash overseas, and their work suggests that nearly half is concentrated within
20 companies. Similarly, as we discuss below, half of the repatriated cash following the
2004 Homeland Investment Act came from just 15 companies, predominantly in Pharma
and Tech. Our own analysis of the S&P 500 (based on filings and estimates from our
analysts) suggests that non-Financials in the S&P hold approximately $1.2tn overseas,
nearly three-quarters of which is in Tech and Health Care (Chart 4).
Chart 4: Estimated overseas cash as a % of mkt. cap by sector for the S&P 500 (excludes Financials
and Real Estate)
Overseas cash as a % of market cap
16%
14%
12%
10%
8%
6%
4%
2%
0%
Tech
Health Care
Industrials
S&P 500 ex. Fins. &
Real Estate*
Materials
Staples
Cons. Disc.
Energy
Utilities
Telecom
Note: Overseas cash based on company disclosures where available, BofAML analyst estimates, and BofAML US Equity & Quant Strategy
estimates using overseas sales as a guide where the former two were not available. For some companies, analyst estimates are for total
accumulated overseas profits (which may not all be in cash). *S&P ex. Fins. & Real Estate cash is as a % of total S&P 500 market cap
Source: Bloomberg, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy, BofA Merrill Lynch Global Research
Repatriation in context: a look back at 2004
The last repatriation holiday in the US was the Homeland Investment Act (HIA) of 2004
(part of the American Jobs Creation Act), which allowed for a one-time repatriation of
foreign earnings by US multinationals at a reduced effective tax rate of 5.25% (vs. the
statutory 35% rate), based on an allowable exemption of 85% of foreign earnings from
US taxes (35% x [1-85%] = 5.25%). This deduction could be claimed in the tax year
beginning before or after the passage date in Oct. 2004. Approximately $300bn was
repatriated, according to the Bureau of Economic Analysis (BEA)’s U.S. International
Transactions Accounts Data, vs. an average of $60bn over the prior five years. The IRS
estimates 2 that 843 US companies took advantage of the act.
Despite HIA’s intent; most repatriated cash was spent on buybacks/dividends
Despite the U.S. Treasury Department’s guidelines that repatriated earnings should be
spent on capital investment, R&D, M&A, and other pro-growth uses such as hiring, this
was not ultimately the result: the National Bureau of Economic Research (NBER)
estimates 3 that $0.92 of every $1.00 brought back was used to return cash to
shareholders ($0.79 for buybacks and $0.15 for dividends) 4 , and that repatriation
ultimately did not lead to a pick-up in capex, employment or R&D. In fact, a 2011 report
by US Senate Permanent Subcommittee on Investigations 5 found that the top 15
2
Redmiles, Melissa: “The One Time Received Dividend Deduction”, https://www.irs.gov/pub/irssoi/08codivdeductbul.pdf
3
Dhammika Dharmapala, C. Fritz Foley, and Kristin J. Forbes: “Watch What I Do, Not What I Say: The Unintended
Consequences of the Homeland Investment Act”, NBER Working Paper No. 15023, June 2009,
http://www.nber.org/papers/w15023.pdf.
4 The $0.79 for buybacks and $0.15 for dividends does not sum to the $0.92 cash return figure due to the
NBER’s calculation methodology.
5
United States Senate Permanent Subcommittee on Investigations: “Repatriating Offshore Funds: 2004 Tax Windfall
for Select Multinationals”, Majority Staff Report, October 11, 2011
Equity Strategy Focus Point | 29 January 2017 7
repatriating companies—which accounted for 52% of the total repatriated amount—
actually reduced their US workforce and decreased their R&D spending following the
repatriation act. The authors of the NBER study point out that cash is fungible, and
firms were able to bypass the guidelines on how repatriated cash should be used.
Table 7 shows the top 15 repatriating companies following the HIA, and IRS estimates
for the proportion of repatriated cash by industry are in Table 8.
Table 7: Top 15 repatriating companies based on the 2004 HIA
Company
Repatriated Amount ($bn)
Pfizer 35.5
Merck 15.9
Hewlett Packard 14.5
Johnson & Johnson 10.7
IBM 9.5
Schering-Plough 9.4
Bristol Myers 9.0
Eli Lilly 8.0
DuPont 7.7
Pepsi Co, Inc. 7.4
Intel 6.2
Coca-Cola 6.1
Altria 6.0
Procter & Gamble 5.8
Oracle 3.1
Source: Data provided by corporations in response to U.S. Senate Permanent Subcommittee on
Investigations survey
Table 8: Corporations Repatriating Dividends Under IRC Section 965,
Selected Items, by Selected Major and Minor Industry of the Parent
Corporation, Tax Years 2004-2006
Industry
% of Repatriated Cash Dividends
Pharmaceutical and medicine manufacturing 29%
Computer and electronic equipment manufacturing 19%
Other manufacturing 8%
Food manufacturing 6%
Other chemical manufacturing 5%
Information (including software publishers) 4%
Finance, insurance, real estate, rental and leasing 4%
Transportation equipment manufacturing 3%
Management of companies and enterprises 3%
All other industries 2%
Paper manufacturing 2%
Machinery manufacturing 2%
Electrical equipt, appliance & component manufacturing 2%
Other services 2%
Basic chemical manufacturing 2%
Fabricated metal product manufacturing 1%
Retail trade 1%
Wholesale trade, nonduarable goods 1%
Wholesale trade, durable goods 1%
Profiessional, scientific and technical services 1%
Transportation and warehousing 0%
Plastics and rubber products manufacturing 0%
Primary metal manufacturing 0%
Note: all figures are IRS estimates
Source: IRS (https://www.irs.gov/pub/irs-soi/08codivdeductbul.pdf)
Our data for the S&P 500 similarly suggests that share repurchases saw the biggest
pick-up in terms of cash use from when the HIA was passed in October 2004 through
the end of 2006. Buybacks jumped over 200% over this period, where they went from
12% of operating cash flows to 33% of operating cash flow by the end of 2006.
Chart 5: Capex, dividends, buybacks and M&A for the S&P 500 ex-Financials: increase from
10/31/2004-12/31/2006 and % of Operating Cash Flow during both dates
60%
250%
% of Operating cash Flow
50%
40%
30%