Originally published on Forbes.com.
Citigroup is prepared for the large earnings hit, it will take from tax cuts, but other companies maybe not so much. It might seem improbable that [some companies will have a sharp drop in reported earnings the moment that President Trump signs the Tax Cuts and Jobs Act, but that is the way it works. The provision for income taxes that goes into the computation of net income under Generally Accepted Accounting Principles is only vaguely related to what companies actually pay. And the upcoming rate change will wreak havoc with corporate earnings.
Bill Can Have Big Immediate Effect On Corporate Earnings
If President Trump gets to sign a version of the Tax Cuts And Jobs Act that is some sort of amalgamation of the House and Senate versions, there will be an immediate substantial effect on current earnings of corporations. Companies carry on their books assets and liabilities that represent differences between the way taxable income and financial statement (GAAP) income is computed. If you write something off faster for tax purposes than book purposes, that creates a liability. If the write off is faster for book than tax it creates an asset. When rates change the assets and liabilities are recomputed at the new enacted rate and the change runs through the current period earnings.
The current GAAP rules about deferred taxes have been in effect since the early nineties. When was the last time there was a significant rate change while the current GAAP rules were in effect? That would be never. The rate dropped in two steps from 46% to 34% as a result of the Tax Reform Act of 1986, when GAAP rules were different. The rate moved up a point in 1993 and has been at 35% ever since.
So it may come as a surprise that some companies will have huge earnings increases or decreases, when deferred taxes are recomputed. But that’s not all folks. There is the matter of a deemed repatriation of earnings. The House version of the Tax Cuts and Jobs Act would tax the earnings accumulated overseas. The rate will be 14% if it is in cash or equivalents and 7% otherwise.
FASB Waiting For The Other Shoe To Drop
FASB is hanging fire on changes in required disclosures on income tax until they see how the bill shakes out. There is no indication that there will be any sort of a major rule change. Catherine Klimek, a FASB spokesperson, gave me the following statement.
To ensure our proposed improvements to income tax disclosures remain relevant, the FASB will consider the outcome of income tax reform legislation in Congress prior to finalizing a standard. At that time, the FASB also will act swiftly to provide guidance in the event that legislation results in a need for clarity or changes to our current guidance on income taxes.
I gathered that the phone is not ringing off the hook at FASB, as I thought it might be. Maybe the corporate tax departments have the situation under control or maybe they are asleep at the switch. We’ll see.
Deferred Tax Assets And Liabilities And The Rest Of The Story
When the Tax Cuts and Jobs Act was a mere framework, I collaborated with a couple of Bentley professors- Tracy Noga and Kristina Minnick – to get a notion on how big a deal this was. We were only looking at the timing differences. The S&P 100 showed companies with income pickups totaling over $200 billion and companies with net charges totaling over $80 billion.
The deemed repatriation will tilt things more to the loss side. Companies that planned to have foreign income deferred indefinitely did not set up a deferred tax liabilities for them. The House provision hits them with a 14% or 7% tax on income accumulated since 1986. The rate depends on whether the accumulated earnings are in the form of cash or equivalents, in which case the higher rate is used. Even though a company can elect to pay the tax over eight years, it hits earnings with no present value discount when the bill is signed.
The deemed repatriation is mitigated by foreign tax credit carryovers, which makes it difficult to get a handle on. If the foreign income was stashed in a country that charged 14% and the company kept good track of its foreign tax credit carryover, then there would be no charge. Since the JCT scores the proposed change at $293.4 billion, it seems unlikely that the charge will be wiped out by foreign tax credits.
Only considering timing differences, Citigroup is the biggest loser with an immediate negative adjustment likely to be over $10 billion just from the rate changes effect on its deferred tax assets (DTA). And then there is the $47 billion in accumulated foreign income. It is hard to put a tax number on that, since we don’t have the information as to how much would be subject to the 14% and we don’t know how much will be available in foreign tax credits.
How Much Will The Foreign Earnings Charge Be?
If a company was stashing income in a foreign country with a 14% tax rate, there should be no charge thanks to foreign tax credit carryovers. (That’s something of an oversimplification). Of course 14% is not that much of a bargain and companies with things like the Double Irish With A Dutch Sandwich could get close to zero. That is probably why the provision was scored at $293.4 billion. Also there will be the matter of checking and in some cases reconstructing foreign tax credits. I used to have this illusion that national firms would be on top of things like that. Then my firm was acquired by a national firm and we took at least a five year step backward in the quality of out electronic file maintenance. And for this exercise, you are talking about going back thirty years to reconstruct something that many people thought would never matter.
I tried calling what I considered the biggest losers last week and for the most part the people I spoke to did not know what the hell I was talking about. They said they would try to get somebody who know about such things and get back to me. Citigroup surprised me. A fellow whose job it is to handle press inquires said “Oh you’re talking about the DTAs.”
Citigroup Won’t Be Surprised
It turns out that Citigroup has been carefully managing its deferred tax assets and cautioning investors about the effect that a rate change would have. This is from Citigroup’s 10-K
While Citi may benefit on a prospective net income basis from any decrease in corporate tax rates, proposals being discussed currently—such as lowering the corporate tax rate or moving from a worldwide tax system to a territorial tax system—could result in a material decrease in the value of Citi’s DTAs, which would also result in a material reduction to Citi’s net income during the period in which the change is enacted. Citi’s regulatory capital could also be reduced if the decrease in the value of Citi’s DTAs exceeds certain levels (for additional information on the potential impact to Citi’s regulatory capital arising from U.S. corporate tax reform, see the notes to the tables regarding the components of Citi’s regulatory capital under both current (transitional) and Basel III full implementation in “Capital Resources” above). Given the number of uncertainties relating to the ultimate form any corporate tax reform may take, it is not possible to quantify the potential negative impact to Citi’s income or regulatory capital that could result from corporate tax reform.
Seeking Alpha covered the matter a year ago with Is Citgroup’s $45 Billion DTA At Risk Under President Trump?
The simple answer is yes, the DTA is clearly at risk.
Citigroup’s CFO John Gerspach brought the subject up last year anticipating a cut in the corporate rate to 28%
If federal corporate tax rates decline 20 percent under President-elect Donald Trump, Citigroup Inc (C.N) may have to take a $4 billion charge to profits to reflect lower values for its deferred tax assets, the bank’s chief financial officer said …..
So Citigroup is ready, but it is not clear that anybody else is. If President Trump does get a bill to sign with the big corporate rate cut and the deemed repatriation, analysts in the future will have to put an asterisk next to 2017 earnings when they are looking at trends. It will be interesting to see how shocked everybody is when the earnings reports come in.
I expected that the tax cut would have a favorable impact on Apple’s earnings to the tune of over nine billion dollars, but I was only thinking about its deferred tax liability. Apple has $232 billion in untaxed foreign earnings and will get hit with some percentage of that from the deemed repatriation, if the bill passes. Why did I look at Apple? Well its ticker AAPL is first in the alphabet. I will leave it to my readers to work their way through the rest of the S&P.
Other Coverage
I was beginning to think I was the only one noticing this, but it seems that coverage is picking up and there was some earlier coverage I missed.
Deloitte put out something called Preparing for Tax Reform last week.
Although the legislative process can be fluid in nature and taxpayers do not have certainty with respect to the final enacted version of the proposed bill, clients do have the ability to begin preparing. By taking inventory of existing temporary differences as well as other tax attributes and carryovers, taxpayers can position themselves to be able to efficiently respond to the enacted version in a timely manner.
If you know anybody who does tax provision work for a national firm, don’t expect to see much of them during the holiday season. The national firms will be loving this at it gives some opportunity for value billing $Kaching$Kaching$.
Murray Solomon and Anthony DiGiacinto mention deferred taxes and the deemed repatriation in How Tax Bills Could Impact Company Finances in CFO.
Scott Anderson had 100 Billion Reasons You Need To Understand How Tax Cuts Will Impact Deferred Taxes in Seeking Alpha back in February.
Andrew Barry had Trump Tax Cuts Would Be Huge for Warren Buffet in Barron’s last December. I had marked Berkshire Hathaway as the biggest winner with an income pickup of $33 billion, but the deemed repatriation will eat into that.
In March, Reuters had Fannie, Freddie may write down $21 billion due to U.S. tax cut: BMO.
David Cay Johnston discussed the issue in May on Investopedia.
There is more, but clearly the issue was not quite as obscure as I thought. Still it is a big deal and I don’t think corporate tax departments are quite prepared for it, but we will see.