2018 saw major changes to the US tax code with significant implications for financial analysis, company valuation, and in particular financial modeling. The most important US tax changes include:
Headline fall in the federal tax rate from 35% to 21%
All financial forecasts will need to adjust for the impact on the effective tax rate. Free cash flow will rise for most firms, leverage ratios should improve faster. Deferred tax assets and liabilities on the balance sheet will also fall due to the lower tax rate. Tax loss carrybacks have been eliminated.
Moving towards a territorial approach to taxation
The move to a territorial approach is not at all complete, but the changes try and reduce the incentives for corporations to hold assets outside the USA. The reduction in the headline tax rate should go a long way to incentivize firms to repatriate assets.
A one-time repatriation tax for overseas assets ranging from 8% to 15.5%
This transition tax for assets held outside the US should incentivize firms to repatriate earnings – with a corresponding non-recurring tax charge. Depending on where the charge is located on the income statement, analysts will need to take care to calculate recurring EPS and a recurring effective tax rate for financial forecasts. The transition tax can be paid over a period of eight years.
A major increase in short-term deductions for capital expenditure until 2022
Initially, 100% of capex spend can be deducted against taxable income, the deduction rate drops after 2023 by 20% per year. For asset-intensive companies, the capex deduction is a major benefit. Where cash flow is very important e.g. in leverage finance models, the deduction must be modeled carefully and separately from the income statement.
BEAT (Base Erosion and Anti-avoidance Tax), which is similar to the OECD BEPS (Base Erosion and Profit Shifting) rules, limits the tax deductibility of interest to 30% of tax calculated EBITDA (changing to 30% of tax calculated EBIT from 2022)
BEAT is another important issue for leverage finance models – not just in the US though. Note if you haven’t been able to deduct all your interest in one year you can carry forward to future years. The interest tax shield must be modeled separately from the income statement, with carried forward deductions carefully calculated in financial forecasts.
Net operating losses can now be carried forward indefinitely, although they are limited to 80% of taxable income in any one year
The NOLs should be modeled carefully, and cash taxes calculated separately from tax expense on the income statement. For some companies, the value of their NOLs will fall due to the 90%/80% cap on usage and the lower future tax rates. So existing deferred tax assets related to NOLs could fall with corresponding implications for a company’s financial leverage ratios.
There are also additional limits on executive compensation and staff expenses
For most financial analysts these changes won’t have a material impact on a company’s financial statements.