Tax Cut Ripple Effect on Stocks
The tax bill passed at the end of last year handed a big tax cut to corporate America, lowering the top corporate tax rate to 21% from 35%. But it also caused some big surprises during fourth-quarter earnings season. If you’re still a little confused about what happened—and wondering what the bill’s impact will be in 2018—here’s a quick overview of its major effects.
Taxes on Foreign Earnings
Let’s start with one of the simpler provisions. The tax bill got rid of taxes on U.S. companies overseas’ earnings, going forward. But it imposed a one-time 15.5% tax on their offshore cash. That’s much lower than the 35% rate that companies previously had to pay to bring the offshore cash home, but it’s mandatory.
That means a big one-time windfall for the U.S. government, and some big one-time tax bills for U.S. companies. Apple (AAPL) alone will pay $38 billion in taxes on past foreign earnings.
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But because companies are now free to do whatever they want with their overseas cash, and the threat of the 35% repatriation tax is gone, this part of the tax bill was a positive for most companies.
Lower Corporate Tax Rate
This one’s also pretty simple. The tax bill lowered the top corporate tax rate to 21% from 35%. Companies that will pay lower taxes going forward adjusted their guidance accordingly, and earnings estimates for most companies went up.
The big, confusing side effect of the lower tax rate was its impact on deferred tax assets and liabilities on corporate balance sheets.
In the U.S., when a company has already paid taxes but winds up losing money (or overpays taxes in some other way), they don’t necessarily get those taxes back. Instead, they’re treated as a pre-payment toward future taxes. The pre-payment is reflected on the company’s balance sheet (a listing of their assets and liabilities) as an asset.
Conversely, companies that owe taxes can have a deferred tax liability on their balance sheet.
These days, most banks and financial institutions have big deferred tax assets on their balance sheets because they were unprofitable just a few years ago after the financial crisis.
Companies with high capital expenditures, like telecoms, are most likely to have deferred tax liabilities.
The asset or liability is calculated based on the company’s tax rate, so when the tax rate went down, the value of those assets and liabilities changed.
For example, American Express (AXP) saw its corporate tax rate fall to about 22% under the tax bill, which reduced the value of their deferred tax assets by about $600 million. That showed up as a $600 million charge on Amex’s fourth-quarter earnings, but it’s really just a change on paper.
The one-time charges meant a lot of investors were surprised to see their stocks reporting huge unexpected EPS losses in the fourth quarter, which then turned into solid gains when adjusted for one-time charges.
Other companies reported enormous earnings surprises, which again disappeared when adjusted. They included Verizon (VZ), whose un-adjusted GAAP earnings were about four times its adjusted EPS.
Corporations have emphasized that the long-term gains from the lower tax rate will more than outweigh the one-time accounting hits. KeyCorp (KEY), a regional bank based in Cleveland, recorded a $637-million-dollar one-time charge related to the tax bill, but will see its effective tax rate fall from 33% to about 18%—a big boost to earnings longer-term.
Dividends and Share Buybacks
Lastly, while not a direct effect of the tax bill, the legislation left companies with some extra cash lying around. Many are using it for share buybacks and dividends. BB&T Corp (BBT), which is in the Cabot Dividend Investor portfolio, announced a 4.5 cent special dividend funded by the tax cut last month, and the company hopes to make it a permanent addition to its dividend in the second quarter.
Many more companies are passing their tax cut savings on to shareholders through stock buybacks, which reduce the number of shares outstanding and support the stock price. American corporations announced $153.7 billion in buybacks last month, up from $59.9 billion in January, and well above the previous monthly record of $133 billion from April 2015.
The market correction undoubtedly played a role, since it made companies’ shares temporarily cheaper. But the tax cut was also a major factor.
Timothy Lutts heads one of America’s most respected independent investment advisory services. Each week, Tim personally picks the single best stock in his exclusive Cabot Stock of the Week advisory. Build your wealth and reduce your risk with the top stock each week for current market conditionsLearn More