Tax Reform In 2015 Can Impact Apple
Summary
Corporate tax reform is getting closer, repatriation of foreign profits is a possible outcome.
Reform may end the practice of deferment, meaning overseas cash hordes will no longer be part of common corporate practice.
Many large U.S. companies will have decisions on how to use funds that are no longer restrained.
Investors should consider the impact.
Tax reform has been a staple of political rhetoric for as long as I can remember. When campaigning, it seems every politician will highlight unfair or absurd consequences of the current tax system, and promises changes. However, reform has proven to be mostly talk with little action. Can it really be different this time?
While the two parties seem unlikely to agree on personal income tax reform soon, there is growing agreement regarding corporate tax reform. Incoming chairman of the Ways and Means Committee, Paul Ryan, R-WI, spoke in early December of splitting tax reform legislation to tackle corporate tax first. In his year-end press conference, President Obama said, based on his recent conversations with Republican leaders, he thought lawmakers could agree on tax reform.
How will tax reform affect Apple (NASDAQ:AAPL) especially with regard to the over $137 billion in accumulated offshore profits held? Apple is often the first example of offshore profits, because it holds the most of any U.S. company and because Apple’s overseas profits are growing the fastest. Tax reform may offer repatriation at lower tax rates or even force the repatriation of the restrained profits. In the case of Apple, many investors see only one use for most of the cash once repatriated – direct return to shareholders.
Possible changes in corporate tax include:
The maximum tax rate, which is currently at 35% although most companies pay a fraction of that rate. The U.S. maximum rate is above the rate for most countries. A reduction to 25 or 28% has been discussed. Currently the actual tax paid by corporations averages about 20%, so reduction of the maximum rate is expected in conjunction with some closing of tax loopholes.
Revision to the deferral rule, which allows U.S. companies that accrue profits to foreign locations to defer the U.S. tax on those profits while the funds are restrained. Prior to paying U.S. tax, restrained funds can be invested within the U.S., but cannot be returned to shareholders by dividends or share buybacks or to make investments in the company’s own business.
A repeat of the 2004 “tax holiday,” which provided a one-time 5.25% tax rate to repatriate foreign profits. In 2004, this provided a one year windfall in tax revenues, and U.S. firms returned $350 billion (about 44% of the tax deferred foreign cash held by U.S. corporations at that time). Unfortunately, the foreign profit “deferral” loophole remained in place and the 2004 tax holiday set the expectation of future holidays. This effectively encouraged multinational companies to take full advantage and build up restrained foreign cash. Recent years with historically low borrowing rates have given further incentive for multinationals to keep foreign profits restrained and borrow in the bond market to provide U.S. cash. Tax-deferred, overseas cash cannot be used as direct collateral for a bond issue, but the strong balance sheet of companies with billions of cash overseas allow excellent rates on bonds without specific collateral. Since interest payments on the bonds are tax-deductible, the after-tax interest rate corporations pay can be lower than the government treasury rate.
Earlier this month, Representative John Delaney, D-MD, introduced the “The Infrastructure and Global Tax Competitiveness Act.” The bill proposes repatriation of tax deferred foreign cash at 8.75% and provides the end of tax deferral. The bill includes a fallback option in the event of no further reform bill, setting tax on foreign profits on a sliding scale from 2 to 12.25% depending on the tax rate in the foreign country.
The overseas profits U.S. corporations hold in tax haven countries has increased steadily for decades and is now over 45% of the total overseas profits. The list of companies with the largest deferred balances covers many of the well-known U.S. blue chip corporations. Based on data from Bloomberg, the following table reports the six highest:
Company Offshore Profits (billions) Market Cap (billions) Offshore Profits per share
General Electric (NYSE:GE) $110. $257. $10.96
Microsoft (NASDAQ:MSFT) $76. $393. $9.22
Pfizer (NYSE:PFE) $69. $201. $10.95
Merck (NYSE:MRK) $57. $170. $20.00
Apple $137. $655. $23.40
IBM (NYSE:IBM) $52 $157. $52.57
Apple gets a lot of attention in this list because it has the most foreign assets under tax deferral, and because unlike the others Apple’s business operates with very low long-term debt. When the foreign funds repatriated to a company with a higher debt, restrictions can be expected regarding how the funds are spent to maintain the balance sheet and the investment rating. If Apple repatriated its overseas cash, we should expect a direct impact on shareholders. Apple has little corporate debt to pay down and a large cash flow to service it. As the giant in its industry, Apple has little opportunity to spend the money on large acquisitions. Apple would be expected to return a portion of the funds to shareholders in the form of increased share buybacks or dividends.
