The tax bill that President Donald Trump signed into law in December slashes corporate tax rates, so why are some companies announcing charges instead of benefits from the change?
Most of the big banks that have just reported fourth-quarter earnings, for example, unveiled multibillion-dollar charges or tax provisions, instead of announcing immediate gains from a lower rate.
That’s because the banks have deferred tax assets on their balance sheets, offsets that can be used to reduce future tax liabilities or to defer them. Many big banks suffered multibillion dollar losses during the financial crisis that created tax loss carryforwards that can help reduce their future tax bill. Basically, if you lose enough money one year, you can spread out the deduction of those losses over multiple years. Deferred tax assets can also be created when tax authorities recognize revenue or costs at different times than that of an accounting standard.
Deferred tax assets are worth less when the tax rate is changed, in this case lowered from 35% to 21%, a 40% cut.
That caused Citigroup Inc. C, +1.18% which has the largest deferred tax assets of any U.S. company, to announce a $22 billion non-cash charge for the fourth quarter that completely wiped out its profit.
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On the company’s earnings call, Chief Financial Officer John Gerspach spoke glowingly of the new tax law, which he said will help the economy and the bank and its clients over time.
Other companies that have to disclose the loss in value of these credits now include General Motors Co. GM, -1.62% American International Group Inc. AIG, +0.03% and Bank of America Corp. BAC, +0.76% as MarketWatch’s Francine McKenna has reported.
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On the other end of the spectrum are those companies that have deferred tax liabilities on their balance sheets, meaning they are facing an increase in taxes payable in the future. Those companies are enjoying a nice windfall now along with lower taxes going forward.
Deferred tax liabilities are formed when the real tax payment according to tax accounting is lower than the tax obligation based on financial accounting, as can happen with depreciating fixed assets.
Wells Fargo & Co WFC, +0.42% was the only big bank to see its fourth-quarter profit get a boost from writing down its deferred tax liabilities to reflect the new tax rate. The bank said its income of $6.15 billion, or $1.16 a share, benefited from a $3.35 billion one-time tax boost. Excluding that benefit, and other one-time items including the sale of an insurance unit and legal reserves, the bank had EPS of 97 cents.
Read also: Bank of America posts sturdy earnings, jockeys for position in ‘stronger America’
As earnings season kicks into high gear next week, investors can expect all companies to offer an update on how the tax law will impact their business. But companies that don’t use Dec. 31 as their year end will have to wait until fiscal 2019 to enjoy the full impact. That’s because they will have to use a blended old and new rate to calculate their taxable income.
Read now: Some companies have to wait for boost from lower tax rates
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Microsoft Corp. MSFT, -0.11% for example, has a fiscal year ended June 30. That means it will have a blended rate of 28%, based on six months at 35% and six months at 21%.
The Securities and Exchange Commission has already issued guidance on how companies should reflect the impact of the lower tax rates and other changes in their next filings. Companies are expected to take charges or record benefits based on a reasonable estimate, although that might be adjusted later. The SEC told companies that additional disclosures should accompany the announcement of any charges or credits, including any explanations for why the numbers might not yet be final.
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Bringing it home
Although the impact of tax cuts may reduce overall net earnings for the fourth quarter, it could lead many companies to raise, or give upbeat earnings guidance for 2018. In the weeks following passage of the tax bill, the average estimate of analysts surveyed by FactSet for S&P 500 SPX, +0.44% earnings per share increased 2.2% to $150.12 from $146.83, the largest increase during that time frame—Dec. 20 through Jan. 11—since FactSet began tracking earnings data in 1996.
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But more importantly, the one-time mandatory repatriation tax on cash held overseas, which will be levied whether the cash is repatriated or not, could actually help line investors pockets down the road, in more ways than one. The idea is that if companies have to pay taxes on that money anyway, then they might as well bring it home.
The repatriation tax will levy 15.5% of a company’s liquid overseas funds and 8% of its illiquid assets. The tax can be paid over eight years and aims to encourage companies with big cashpiles to bring it back and invest in the U.S.
Some companies, like Apple Inc. AAPL, -0.45% on Wednesday, have indicated they will bring a big chunk of the cash held overseas back to the U.S.
As BTIG analyst Walter Piecyk said, announcements, like Apple’s, make for “good politics,” but are usually short on details. In Apple’s case, Piecyk said he was directed to the upcoming 10-Q quarterly filing with the Securities and Exchange Commission, which is expected in early February.
Don’t miss: Apple didn’t say it was hiring 20,000 workers, nor bringing back all of its overseas cash.
Analyst Amit Daryanani at RBC Capital said he expects Apple will use “almost all” of the money it brings home for share repurchases and dividend payments to shareholders, instead of the capital investments that could accelerate job growth. He said the $30 billion Apple said it would spend on capital expenditures over the next five years was mostly built into previously provided capex guidance for 2018.
While Main Street may be left disappointed, Wall Street will likely rejoice.
Increasing dividends, or paying a special one-time dividend, puts cash directly into investors’ pockets, while share repurchases provide a couple of indirect benefits.
First, buybacks introduce demand to the marketplace, which helps sop up trading supply. Although actively buying a stock doesn’t guarantee the price will rise, at the very least it can reduce the negative effect of selling. More importantly, buybacks reduce the number of shares outstanding, which means the piece of each investor’s pie gets a little bigger—it’s just math.
Using Apple again as an example, the company said net income for the quarter through Sept. 30—the numerator—increased 18.9% from a year ago to $10.71 billion, but EPS increased 24.0% to $2.07 as the number of shares used in calculation—the denominator—declined 3.9% to 5.18 billion shares.
Even before the tax bill was passed, companies had stepped up their buyback announcements and a lot more are likely on the way.
“I expect a lot more announcements of rewards for shareholders,” William Lazonick, professor of economics at the University of Massachusetts Lowell and director of the Center for Industrial Competitiveness, told MarketWatch in December.