What the U.S. Tech Sector Can Expect from a Corporate Tax Holiday
As part of a broader fiscal stimulus plan aimed at boosting economic growth, the White House has suggested creating a one-time corporate tax holiday that would encourage U.S. companies to bring cash held overseas back to the U.S. where it can be reinvested domestically. At the end of 2016, cash held by foreign subsidiaries of U.S. companies totaled an estimated $2.6 trillion, nearly 13 percent of the total value of the S&P 500 index.
U.S. tech sector may reap the most benefits
U.S. technology companies and their investors are positioned to benefit the most if such a deal were passed. As of Q3 2016, technology companies in the S&P 500 held $891 billion in cash and investments, up from $786 billion over the prior year. This growing cash hoard now represents just over 43 percent of the total cash and investments held by S&P 500 companies (excluding financials) and is nearly double the amount held by the next most cash-rich sector, healthcare. It’s no contest: If cash is king, the tech sector transcends royalty.
Yet it isn’t just the amount of cash held by tech companies, but also where that cash currently sits, that has many expecting an outsized windfall. The U.S. government taxes U.S. companies on all profits generated at approximately 35 percent regardless of where those profits are earned. However, taxes on foreign earnings can be deferred until they are returned (i.e., repatriated) to the U.S. parent company. Consequently, many American multinational companies have kept a substantial portion of their foreign earnings abroad to defer paying taxes on repatriated income. Over time, these untaxed foreign earnings accumulate as cash held by foreign subsidiaries, which, for U.S. tech companies, is where most of their cash and investments are currently stored.
Tax windfall would benefit some more than others
Consider that as of Q3 2016, just four U.S. tech giants — Apple, Microsoft, Alphabet and Cisco — held nearly $500 billion, or 25 percent of all cash and investments held by S&P 500 companies. Of the eight major U.S. tech companies listed in the following chart, cash and investments held by their foreign subsidiaries constituted 81 percent of their total cash assets, amounting to $540 billion held outside the U.S. Lowering the corporate tax rate on repatriated income from 35 percent to 10 percent could amount to a potential tax savings of $135 billion for these eight companies alone.
However, if such a tax holiday occurred, it’s possible that only a fraction of untaxed foreign earnings will be repatriated. Other than funding capital investments and ongoing working capital needs, having cash readily available abroad can serve strategic purposes, as was highlighted by Apple’s $1 billion strategic investment in Chinese ride-hailing service Didi Chuxing in May 2016.
How would the tech sector take advantage of a tax holiday?
If precedent from the 2004 Homeland Reinvestment Act is an accurate indication, U.S. companies might repatriate as much as 20 percent of their untaxed foreign earnings over the tax holiday window. For the eight tech companies above, this would amount to approximately $100 billion after accounting for a one-time 10 percent tax on repatriated income, representing a tax savings of nearly $30 billion compared to current tax levels.
A cash injection of this magnitude would certainly translate into shareholder value; judging from historical precedent, the majority of repatriated earnings would be returned to shareholders. But many of these companies have already returned much of these untaxed foreign earnings to shareholders: Apple, Microsoft, Oracle and Cisco have returned an average of 86 to 92 percent of their cash flow from operations, less capex, in dividends and buybacks over the last three years, despite more than half of their cash flows arising from foreign operations. Instead of repatriating foreign earnings, many of the largest tech companies have resorted to taking on larger debt loads to fund capital return programs. Thus, not all companies may be able to fund additional capital-return programs without risking their credit ratings.
Two examples help highlight this:
1. Apple has about $245 billion in cash and $87 billion in debt, yielding a net cash balance of $158 billion. Apple certainly might be encouraged to take advantage of a tax holiday by repatriating untaxed foreign earnings and putting that capital to work in the U.S.
2. Oracle, on the other hand, has about $58 billion in cash and $54 billion in debt. The company arguably has spent much of its cash already, and any tax break on repatriated income may have little impact on encouraging additional spending.
Could a tax holiday influence corporate strategy?
For companies with a comfortable net-cash position to take full advantage of a tax holiday, some might be incentivized to make additional investments toward both organic and inorganic growth objectives. Yet, as noted above, a one-time tax holiday is unlikely to be the only impetus for executing those initiatives because the largest tech companies already have access to cash held overseas through the bond markets.
As Tim Cook noted on Apple’s Q1 2017 earnings call, Apple doesn’t evaluate M&A opportunities, or presumably any investing activity, based on size but instead on the “strategic value” of the project itself. Similarly, Microsoft’s relatively paltry $26 billion U.S.-held cash store certainly didn’t prevent it from executing a $26.2 billion all-cash acquisition of LinkedIn, its largest all-cash acquisition to date. In many cases, these cash-rich companies already have access to the capital resources necessary to execute their corporate strategies, tax rates notwithstanding.
A rising tide lifts all boats
Whether the potential tax savings on repatriated income is allocated toward capital budgeting, strategic investments, M&A or, more likely, returned to shareholders in the form of dividends and share buybacks, the result would be positive for the U.S. economy and, in particular, the tech ecosystem as a whole. While it’s tempting to conclude that cash returned to investors would somehow be less value accretive to the economy, in reality, capital returned to investors only changes who makes the decision of where to reinvest it. Given the unprecedented level of value creation taking place in the innovation ecosystem, it certainly seems likely to ultimately benefit.
Additional reporting by Tim Lee, CFA and Daeyoung Choi, CFA from SVB Asset Management.
Source: S&P Capital IQ
STATE OF THE MARKETS 2017
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