Sweeping changes to the US tax system are likely to be the centrepiece of domestic policy under President Donald Trump. The outcome remains uncertain, but if, as now seems very likely, the proposals being marshalled by Republicans in Congress become law, the effects on the corporate sector, and hence deal-making, could be far-reaching.
Already, hopes of tax cuts have underpinned a 25% rise in the S&P 500 index since Trump’s election — and it was already at a record high.
As the news about tax reform has twisted and turned, the stockmarket has reacted like a dog to a whistle. Smaller cap firms, with more revenues inside the US, are often deemed best placed to benefit from tax cuts.
Chief executives are not going to make decisions based on tax policy until the changes are law — and even then, they are likely to think carefully.
But tax can be a big contributor to M&A decisions — and is at least a consideration in every deal. The US has been hit by at least three waves of ‘inversions’ — US firms moving domiciles to lower tax countries. Each was eventually ended by the government, but not before a slew of firms had moved, often by acquiring a foreign company and making it the new parent.
In the last wave, Pfizer tried to merge first with AstraZeneca of the UK, and then Allergan — itself the result of an earlier inversion by US-based Allergan into Ireland.
No wonder the potential for tax-driven — or at least, tax-facilitated — M&A stemming from the US reforms is front and centre for investment bankers planning for 2018. Takeovers, of course, are the engine of much of the more dynamic activity in corporate capital markets.
“Everybody in the US — banks, private equity firms, corporates — is looking at this issue very carefully,” says Antonio Alvarez Cano, managing director in M&A at UBS in London. “It is a major event that is likely going to happen. The timing is still a bit uncertain — this will probably be implemented some time in the first quarter of 2018.”
Welcome home
Because the proposed reforms are multi-faceted, bankers are reluctant to make detailed predictions.
The US could leapfrog almost all major economies, from having one of the highest corporate tax rates, 35%, to one of the lowest: 20%. The UK at 19%, Singapore at 17% and Hong Kong at 16.5% are still lower.
Thomas Humphreys, co-chair of the tax department at law firm Morrison Foerster in New York, believes a cut in the tax rate would immediately change the perception of the US as a corporate domicile. “There are going to be some pretty big changes on the corporate side,” he says. “The US is trying to become more competitive through this tax reform as a place to form companies.”
Could this spawn inversions into the US? “You could see companies redomiciling to the US,” says Alvarez. “The inversion wave has clearly passed, and this could mean some of those companies go back to the US. Some of the inversions were also fairly artificial and the rules were very complicated, in terms of how you keep your offshore tax benefits. There was always some risk that US tax authorities would decide you were not meeting the rules anymore, or had not met them in the first place.”
Firms in Ireland or elsewhere with US roots might decide it is no longer worth the legal risk and move back.
The reform proposes sticks, as well as carrots. “You will see certain companies where the effective tax rate will go up — companies which have offshored a lot of their intellectual property,” says Humphreys. “That could affect technology and pharmaceutical companies.”
PricewaterhouseCoopers argued in February 2017 that a reversal of tax incentives to favour production in the US could lead some pharma companies to reconsider the structure of their global supply chains.
On the other hand, Ireland’s headline tax rate of 12.5% is still way below even a reformed US rate.
Companies that are historically European moving to the US is likely to be a slow and sporadic process, though lower tax would certainly remove one obstacle. “At the margin, if you were thinking about doing it, this should support your case, but will we see a significant impact? Maybe in the longer term, but not in the first year or two,” says Sam Losada, co-head of EMEA equity capital markets at Bank of America Merrill Lynch in London.
The most enticing proposal in the reform for capital markets is to end the arrangements that have led to companies hoarding cash, earned from foreign sales, outside the US — to avoid paying the tax due on these profits when they are repatriated.
Tech companies from Apple to Oracle are the biggest misers, and the total pile is estimated at $2tr.
Republicans want to stop taxing foreign profits. This might be dangerous for the US Treasury, creating an incentive to maximise profits outside the US, out of its reach. But a lower headline rate in the US ought to neutralise some of that pull.
Overseas cash piles will be taxed — but at low rates, probably about 14% for cash and 7% for hard assets. Because the tax will be levied whether the profits are repatriated or not, there will no longer be any reason to hide them offshore.
“We could see up to $400bn of the $1tr-plus of overseas cash being repatriated into the US. Those flows will be a driver for both the dollar and US rates in 2018,” says Losada.
Stewart Warther, equity and derivatives strategist at BNP Paribas in New York, says some companies may have started preparing for tax reform by holding back on various activities, such as share buy-back authorisations, until the changes become clear.
“M&A in the US is also only just up, year-on-year,” he says. “Companies are essentially in ‘wait and see mode’ with respect to what will happen, and the buy-backs declining are a particularly strong example of this.”
There is a widespread belief that when cash starts flowing back to the US, it will stimulate buy-backs and M&A. In 2018, says Losada, “US corporates may benefit from lower tax rates and higher cash levels; also, equity valuations are hovering at all time highs. These three dynamics happening at the same time could trigger strong M&A volumes. It would be conducive for ECM,” he adds, though he points out that typically, for M&A to trigger equity issuance, it needs to be transformative.
The first effects are likely to be in the US. Cash-rich US firms have had years to buy foreign assets. Now they have a chance to bring cash to the US and buy domestic firms, instead of having to borrow money.
The changes could also generate things to buy. “If the tax rates are lowered it could encourage some of the companies that have divisions or subsidiaries where they have significant capital gain to sell them,” says one banker. “If you are going to pay a lot of taxes on the capital gain, this discourages you from selling.”
Bankers in Europe do not expect an immediate windfall. “I haven’t yet found a significant angle to advocate cross-border M&A,” admits Losada.
But if there are willing sellers in the US, Europeans could bid for the assets.
The changes could also make it attractive for US firms to buy foreign ones. “If companies own stock in foreign corporations they can bring that dividend income back to the US tax-free,” says Humphreys — as long as they own at least a 10% stake. “That’s already started and we are already having conversations about that, which didn’t happen before.”
What happens if it fails?
If tax reform becomes law, its effects are likely to give US equity bulls enough legs to keep running through into 2019. Delay would be tolerable, but an outright failure to reach agreement in Congress would be likely to provoke a nasty sell-off.
Wiser investors are not counting their chickens. “There is a fair amount of scepticism that it actually gets done, and I don’t think that [reform] has been fully pulled into the markets,” says Mark Luschini, president at Janney Capital Management in Philadelphia. “But there is a better than a coin flip’s chance that it does get done. It may ultimately not quite be the fiscal kick that has been suggested.”
Many economists have criticised the plan, for adding $1tr to the Federal budget deficit in the next 10 years, and concentrating its bounty on shareholders — in other words, the rich. That could be bad for social cohesion and may not do much for consumer demand.
Cutting private individuals' ability to offset state and municipal taxes against federal ones will put fresh downward pressure on willingness to pay local taxes, which is likely to worsen the problem of poor infrastructure and city services caused by local authorities' want of money.
But Luschini speaks for many in the capital markets. “I think in general it is a positive — why wouldn’t it be, if it makes our corporations more competitive on a global basis?” he says. “It certainly should be a disproportionate help to smaller and mid-size companies, many of which are paying the 35% tax bracket.”
