Amid Trump Tax Plan Windfall Lurk Some Early Losses
(Bloomberg Gadfly) -- Donald Trump's tax plan, if adopted, has been seen as an unmitigated windfall for corporate America. Cutting the corporate tax rate to 15 percent from its current effective rate of around 28 percent could generate nearly $2 trillion in additional income for the companies in the S&P 500 index alone over a decade.
But a surprising number of companies could be hurt at first. In all, because of an accounting quirk, the Trump corporate tax cut could erase as much as $210 billion from the bottom lines of companies in the S&P 500 in the first year.
Not all of those losses would be realized. Some of them would be offset by lower tax bills outside of the accounting adjustment. That would still leave a loss of about $50 billion more than they would save in the first year. Over time, the benefit from lower taxes would outstrip any initial accounting losses. The complicated equation and its effect on balance sheets could explain why investor enthusiasm for the plan hasn't been as robust as might be expected. And it could lead to some unintended consequences, like a potential flurry of asset sales.
The reason for the potential big losses has to do with tax-loss carry-forwards and the accounting for them. When a company loses money, it can use some of those losses to offset taxes it will have to pay in the future. Accountants see those tax credits as an asset, and companies have to note them on their balance sheets. They are typically called deferred tax assets, or DTAs, and they sit on balance sheets along with more real world assets, like cash or inventory or plants and equipment, contributing to the book value or net worth of a company.
The value of those DTAs can rise or, more likely, fall, with a company's future tax bill. A lower future tax bill means those tax credits, only a portion of which can be used each year, are worth less. And companies are forced to capitalize those deferred tax assets at the statutory rate, which is now 35 percent.
Here's the problem: A big drop in the corporate tax to 15 percent would diminish the value of those DTAs as well, by as much as 57 percent. Worse, while the benefit of the asset accrues over time, accounting rules force companies to realize any drop in the value of those assets immediately. The result is a big one time write-off. And when companies write down any asset, they are forced to take a charge to earnings as well.
A surprising number of companies have DTAs on their balance sheets. Of the S&P 500, 263 companies list deferred taxes as part of their assets. For most of them, the value of the tax asset is relatively small, less than $500 million for two-thirds of the group. But 60 companies have more than $1 billion in DTAs, and some companies much more than that.
Many of the big holders of DTAs are the financial firms that narrowly survived the financial crisis. Citigroup, for instance, has nearly $47 billion in DTAs, the most of any company in the S&P 500. Bank of America and AIG have $28 billion and $14 billion, respectively. Other large holders include General Motors at $35 billion, Ford at $10 billion and both Lockheed Martin and Johnson & Johnson at more than $6 billion.
Investors typically ignore one-time charges, so it's not clear how much these big write-downs will matter, but they could make earnings messy and perhaps even lead to some dealmaking.
If Citi, for instance, were to take the full write-down, that would create a one-time $20 billion loss. However, Citi says a good portion of its DTAs are foreign or state tax credits, which do not have to be written down. Last year, Citi's CFO John Gerspach said a reduction in the corporate tax rate to 25 percent would force the bank to take a $6 billion charge. By that math, Trump's proposed tax cut could cost the bank $12 billion.
That would cut Citi's expected pretax profit of nearly $23 billion for 2017 by more than half. Factor in the tax benefit, and Citi's earnings could drop to just more than $9 billion, or 35 percent less than what it is expected to earn this year. Of course, earnings would jump in 2018.
By the same calculations, GM's entire expected pretax profit of $10 billion in 2017 could be wiped out if Trump's tax plan were to be enacted this year.
The write-downs could matter more for banks than for other firms because they will impact book value. Investors typically value banks more on book value than earnings. What's more, regulators set capital requirements based on book value, though DTAs are mostly excluded from those regulatory capital requirements. Investors, too, have often been skeptical that banks could realize the full value of those tax assets.
As such, banks could rush to figure out a way to use up their DTAs before their value shrinks. One method would be to sell a division or assets that have appreciated in value and use the DTAs to offset any taxes on the gains. Some analysts have already been pushing for these deals. There doesn't appear to be any tax-plan-inspired bank deals yet -- perhaps signaling some skepticism about the proposal's prospects -- but the closer it becomes to being real the greater the likelihood companies laden with DTAs will be looking for a way to do something about them.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Stephen Gandel is a Bloomberg Gadfly columnist covering equity markets. He was previously a deputy digital editor for Fortune and the lead author on Time's economics blog The Curious Capitalist. His previous assignments included covering Wall Street in 1999, the housing market in 2005 and banks in 2008.
To contact the author of this story: Stephen Gandel in New York at email@example.com.