January 22, 2018//-The new US tax law is expected to benefit businesses across America. Goldman Sachs’ Susie Scher, co-head of the Americas Financing Group in the Investment Banking Division, explains the implications and opportunities for corporate America.
The federal law lowers the corporate tax rate to 21% from 35% and, at the same time, puts a minimum tax on profits overseas, spurring some companies to repatriate “trapped” offshore cash to the US. What sectors of the economy are most affected?
Susie Scher: The impact on businesses will vary by sector and the tax profiles of the underlying businesses. Many domestically based companies will benefit from higher free cash flow associated with the reduction in the tax rate while US multinationals will get greater access to existing and future offshore earnings and cash flow.
The technology sector holds a significant amount of cash overseas, followed by large-cap pharmaceuticals and biotech firms, and mid-cap industrials and consumer products companies. Just last week, for example, Apple said it anticipates repatriation tax payments of approximately $38 billion and will ramp up spending in US jobs and capital spending.
How are companies thinking about using the excess cash?
SS: There’s currently a debate around capital allocation, but some generalities can be made. For companies that have not been capital constrained, their additional cash from tax reform will provide more flexibility for strategic investments or returning capital to shareholders. The decision between the two will be dependent upon the opportunities in the near to medium term.
Some opportunities will arise because of the new lower corporate capital gain tax which we expect will result in more companies deciding to sell non-core businesses. For other companies who have been capital constrained, we expect that many of them will strengthen their balance sheets.
How are companies thinking about the limitation on the deductibility of interest expense?
SS: Deducting interest expense has been a centerpiece of many companies’ financing strategy for decades. The new tax law does impose some limits on the amount of debt that can be deducted — interest expense of up to 30% of earnings before interest, taxes, depreciation and amortization is deductible through 2021.
But practically, most large-cap investment grade companies aren’t likely to be affected as their debt holdings are below that threshold. However, we could see certain high-yield issuers affected, in particular, starting in 2022, when deductibility of corporate debt becomes more restrictive.
So you could see some slight reduction of debt in the near term because of tax reform broadly writ, but we’re not predicting a huge drop in issuance.
For those companies that could be affected by potentially higher financing costs, are there any attractive alternatives?
SS: We expect that companies will evaluate their capital structures and look for opportunities to employ lower-cost financing structures, such as floating-rate debt and convertible bonds. Take, for example, a convertible bond, which is an interest-bearing bond that can convert into equity at a future date; in return, the bond has a lower coupon than plain-vanilla debt. Under the old tax law, a company that issued a bond with a 5% coupon would have typically paid the equivalent of 3% after taxes.
Under the new tax rules, the after-tax cost would now be closer to 4% and some companies may actually have to pay the full 5% if they are above certain limits on interest deductibility.
In such cases, those companies may opt for convertibles bonds as a financing alternative in part because the bonds’ lower interest expense would translate into higher earnings per share.
If I’m a CEO and considering financing in the bond market, I may be willing to give up some stock price appreciation, and I’d opt for a low coupon convertible bond, especially at today’s equity valuations.
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