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Equity Perspectives

Giving companies a "tax holiday" could help if it overcomes stiff opposition. But most of the financing should still come from municipal bonds and more participation by the private sector. 

 

In Brief

  • Led by technology, health care and consumer discretionary companies, S&P 500 companies parked a record $2.1 trillion in earnings abroad, and there's at least $690 billion of overseas cash, according to Credit Suisse estimates.
  • Aside from the fiscal impact on the U.S. government, investors should be concerned about such practices because companies might have less financial flexibility (and their tax liabilities might be greater) than their balance sheets would indicate.
  • In an attempt to pay for massive, long-deferred infrastructure improvements, Congress has  considered a “tax holiday” that would allow companies to repatriate overseas profits at lower tax rate.
  • With or without a tax holiday, tax-free municipal bonds likely will continue to play a critical role.  Whether Congress can expand tax-exempt financing for public-private partnerships is another matter.

 

Like it or not, U.S. companies are stashing a ridiculous amount of earnings and cash overseas.

According to Credit Suisse accounting analyst David Zion, earnings parked overseas by the S&P 500 companies hit a new peak in 2014 reaching $2.1 trillion, and there's at least $690 billion of overseas cash.

“Since the last repatriation holiday in 2005 (the American Jobs Creation Act), it's grown at a compound annual rate of 19%,” Zion said. “That impressive growth rate is due to some combination of companies doing more foreign business, profit shifting to low tax countries and companies keeping more earnings overseas to reinvest there or with hopes of another repatriation holiday.” 1

Why, then, has the pace of U.S. firms' overseas earnings recently slowed? (See Chart 1.) One possible rationale is that companies may have needed to repatriate some of the funds back to the U.S. to buy back stock or pay dividends. Or, as some analysts have suggested, they are finding it harder to defend the claim that the earnings are "indefinitely reinvested" overseas (especially when it is simply plowed into cash).

“Another explanation is that foreign profits have dropped (which they have over the last few years as you can see in Chart 2),” Zion said. “And that could be due to a slowdown in business overseas, or a stronger dollar or maybe companies have scaled back on the shifting of profits to the lowest tax country they can find.”

Why should investors care about cash and earnings parked overseas?

Zion offers three simple reasons: 1) companies might have less financial flexibility than the balance sheet leads you to believe; 2) balance sheets might not be as healthy as they appear, especially after factoring in the off-balance sheet tax liability associated with the earnings parked overseas, which First Boston estimates is $533 billion for the S&P 500 companies; and 3) earnings quality concerns, i.e., if companies need the cash in the U.S. to return to shareholders or to support the domestic business that could call into question the sustainability of the tax rate.

“Taxes are a black box for investors and the disclosures leave a lot to the imagination,” Zion added. “Take the earnings parked overseas (see Table 1), there's so much more we'd like to know that would be helpful in figuring out the potential tax implications associated with these couple trillion dollars. For example, what's the potential tax hit if earnings were repatriated back to the U.S. which as we highlighted most companies don't disclose (even though it's required, but there's an out). It would also be nice to know the amount of foreign tax credits that are available to the company if it were ever to repatriate.”2

For all the rhetoric among Presidential contenders, bipartisan support for repatriation of an as-yet unspecified portion of overseas earnings has resurfaced recently, albeit in the form of a three-month extension of current highway funding. While the tax rate on repatriated earnings presumably would be lower than the current corporate income tax rate of 15-35%, such a measure could run into opposition from proponents of a more comprehensive corporate tax reform package.3  

Some of that opposition can also be traced back to the last tax holiday in 2004, when more than 800 firms repatriated $362 billion at just 5.25% in tax. But a large portion of those repatriated profits was used for dividends and stock buybacks, according to some studies.4

Whether Congress can muster enough support for stepped up infrastructure investment remains to be seen. “It is hard in this partisan and charged political environment to expect much from Washington that will draw out these funds, not a tax holiday much less tax reform,” said Milton Ezrati, Lord Abbett Partner, Senior Economist and Market Strategist.

Case in point: Congress’s recent decision to kick the can down the road with a three-month extension of the Highway Trust Fund before it was about to expire, despite predictions of much greater shortfalls in the years by 2025.  (See Chart 2.)

 

Chart 1. S&P 500 Earnings Stashed Abroad Have Piled Up Since the Last Tax Break
Earnings parked overseas, 2001-2014, S&P 500

Source: Calcbench, Company data, Credit Suisse estimates

 

Table 1. S&P Earnings Parked Overseas Have Nearly Quintupled Over the Last 10 Years
S&P 5001 earnings kept abroad by sector, 2005-2015

1 Excludes REITs and companies domiciled outside the U.S.
Source: Calcbench, Company data, Credit Suisse estimates

 

Chart 2. Stopgap Measures Fail to Deal With Long-Term Challenges
Congressional Budget Office projects for cumulative shortfall in the highway account and transit account

Notes: 2015 numbers not included because the shortfall was less than $500 million. The trust fund can not legally incur negative balances.
Source: Congressional Budget Office, CNBC

 

America’s Infrastructure Gets a D+
Unfortunately, deterioration of the nation’s infrastructure is part of a much larger problem. In its most recent report card, the American Society of Civil Engineers (ASCE) gave America’s infrastructure (defined as roads, ports, bridges, tunnels, dams, aviation, rail networks, transit, water, hazardous waste and solid waste facilities) a D+. According to the World Economic Forum, the U.S. ranked 12th globally for infrastructure in 2014, down from seventh place in 2003.

As of the ASCE’s last evaluation in 2013, America’s bridges scored C+, even though one in nine was rated structurally deficient. Dams, aviation, and roads were each given a D, while levees were given a D-.

"Our infrastructure systems are failing to keep pace with the current and expanding needs, and investment in infrastructure is faltering," the ASCE report said.

ASCE estimates it could cost a $3.6 trillion to upgrade America’s infrastructure by 2020. Complicating that challenge is Washington’s long-standing reliance on a gas tax to pay for transportation needs. The federal gas tax has not been raised since 1993, but fuel economy has improved dramatically since then.

“There is some talk that oil price declines have made room for a gasoline tax hike,” said Ezrati. “But otherwise, infrastructure spending will remain hostage to the many other demands already straining federal, state, and local budgets.”

Wrestling with Payment Options
Should Congress give corporations another chance to repatriate earnings and cash currently in offshore accounts to help pay for infrastructure construction and repairs?

Whatever additional funding the federal government can provide, tax-free municipal bonds likely will continue to play a critical role. Between 2003 and 2012 (the latest data available), for example, counties, states and other localities invested $3.2 trillion in infrastructure through long-term tax-exempt municipal bonds, 2.5 times more than the federal investment.5  

The other, and more recent financing model, is the public-private partnership (P3) model, an officially sanctioned approach of many other Western developed countries, including Canada, Australia and much of Europe.

In the state of New York, construction of a new Tappan Zee Bridge and a recently announced overhaul of the obsolete LaGuardia Airport may involve some aspects of the P3 model. But the P3 market has been slow to develop in the face of the significant municipal versus private financing cost differential, said Chris Hamel, head of U.S. Municipal Finance at RBC Capital Markets.6

As a result, federal policymakers are exploring ways tax exempt financing for state and local government might be combined with the P3 model to achieve the benefits of both approaches. One possibility is a new class of tax-exempt debt that facilitates greater private involvement in public infrastructure projects and helps lower overall costs.

Take, for example, recently introduced legislation sponsored by Senators Ron Wyden, D-Ore., and John Hoeven, R-N.D., that would expand tax-exempt private activity bonds and create a new infrastructure tax credit, giving states significant flexibility to pursue infrastructure projects that are badly needed across the country.

The Move America program would create Move America Bonds, to expand tax-exempt financing for public-private partnerships, and Move America Credits, to leverage additional private equity investment at a lower cost for states. Through cheaper and more flexible access to debt and equity, Move America would attempt to give states the tools they need to expand investment in roads, bridges, ports, rail, and airports.7

Skeptics, however, may point to Boston’s “Big Dig,” which turned into the most expensive highway project in the United States and was plagued by escalating costs, scheduling overruns, leaks, design flaws, charges of poor execution and use of substandard materials, criminal arrests, and one death.

 “For many years there have been discussions about creating more public/private partnerships and privatizing infrastructure that might be more effectively managed by private entities,” said Daniel S. Solender, CFA, Lord Abbett Partner & Director. “So far, there have been a range of results from the projects that have occurred partially because sometimes private involvement happens when a government needs cash so it might not have been the most opportune times to get the best prices.” 

“The deals created more than ten years ago were in the early stages of these types of arrangements and were not as successful as new ones,” added Solender, the lead Portfolio Manager responsible for overseeing Lord Abbett’s municipal bond investment products. “Recently there have been several toll road projects that have involved public/private partnerships around the country, and Pennsylvania recently brought a municipal bond deal to partially finance a public/private partnership to maintain bridges around the state. If bonds are structured appropriately, there is a lot of demand for these deals even though they are often in the lower investment grade tiers due a range of reasons including construction risk and uncertainty regarding user projections.”

No matter how the 2016 Presidential campaign shapes up, look for more discussion of such financing options between now and Election Day.

--Reported by Steve Govoni

 

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