Part 1 of a 2-part series. Read Part 2.
There’s never enough cash to cover all investment options – but here in the U.S., options have recently expanded. At the end of last year, the U.S. Congress passed H.R. 1, otherwise known as the Tax Cuts and Jobs Act (TCJA). For U.S. companies, the upshot will likely be increased after-tax cash flows of between 10% and 20% – meaning more cash on hand for investment.
Here’s a quick roundup of the relevant areas of impact for U.S. corporations:
- Reduced corporate tax rate: The statutory rate has dropped from 35% to 21%. The corporate alternative minimum tax (AMT) will be eliminated as well.
- New (one-time) repatriation tax rate: The new law incentivizes corporations to bring offshore cash back home at a one-time tax rate of 15.5% – a significant reduction from the standard 35%.
- Immediate capital expensing: Corporations can now deduct 100% of the cost of “qualified property” acquired and placed in service after September 27, 2017, and before 2023.
- New rules on R&D expenditures: Software development costs will need to be recognized as R&D. Effective in 2022, R&D costs will be amortized over a five-year period domestically and 15 years overseas.
- Caps on interest deductions: Corporations can now deduct interest expenses of only 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA).
What are the strategic implications for corporations? Let’s take a look:
- Increased earnings: Companies in the S&P 500 should expect earnings per share to increase by as much as 16% in 2018. If overly high market valuations for some of these companies have been a concern recently, this increase in earnings should help bring balance-sheet fundamentals back into alignment with market value.
- Greater liquidity: Through a mixture of unlocked offshore cash and higher earnings, the new tax law will increase corporate liquidity to the tune of up to $4 trillion. In the past, larger companies have been able to borrow from their offshore cash. As dollars flow back into the U.S. economy, expect to see more investment.
- The benefits of immediate expensing: Also expected to further fuel investment will be the rule change toward immediate expensing – particularly for asset-heavy industries such as telecom, utilities, oil and gas, and mining. These companies can expect tax savings of up to three percent on total asset purchase prices.
- Higher deficits: Economists anticipate one overall impact of the new tax to be an increase in federal government deficits. Will this lead to revisions in the tax law, resulting in higher rates? Companies will be keeping an eye on the deficit and how legislators respond.
Where will the benefits be felt most?
I recently participated in a Webcast with Neetin Gulati, principal at the Boston Consulting Group. Neetin observed that companies will have $3 to $4 trillion in aggregate additional cash flow over the next few years as a result of the new tax law. He splits this figure into two major buckets.
The first will come from the repatriation of offshore cash – somewhere in the neighborhood of $1.5 to $2 trillion. But note that this bucket will be concentrated on the technology and healthcare industries, with the top 10 companies holding about 70% of the trapped cash. Because these companies have been able to borrow against this offshore cash for years, we can expect less than dramatic changes from this bucket alone.
More companies will benefit from the second bucket, which involves increased cash flow from the reduced tax rate, estimated at another $1.5 to $2 trillion. This will especially hold true for companies that previously have paid taxes at or close to the full statutory rate of 35%. Benefits will also be felt by industries with high domestic exposure such as telecom, retail, transportation, and banking.
How will your company respond?
The most important question, of course, is what will your company do with its increased after-tax cash? Some companies are buying back shares, paying down debt, or returning value to investors through increased dividends. Others are issuing employee bonuses – even if only on a one-time basis.
These approaches, however, are focused on short-term benefits. We believe that companies using the tax windfall to invest in growth stand the best chance of leading over the long term. Some companies are expanding operations; others are stepping up the game on the M&A front. Fewer are investing in innovation, focusing on their businesses’ future growth.
For SAP customers, the name of the game for long-term growth is digital transformation – harnessing emerging technology (e.g., Internet of Things, machine learning, Big Data analytics) in the service of new, innovative business models. Companies moving forward on this front – as SAP is doing itself – have a bright future attracting new customers on the lookout for convenience and affordability with increased personalization and better overall outcomes. You know, the kind of customers that stick around.
If you’re a CFO, think of it this way: three years from now, would you rather that you had bought back shares at a point in which valuations may be higher – or would you rather that you had invested back in the business with digital transformation?
If you choose digital transformation, then the next questions is: How do you move forward? To find out, stay tuned for Part 2 in this series.
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