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By Theo Francis 

A little more than a year on, companies are only just gearing up to put the 2017 tax overhaul to work.

For investors, that means it is time to keep a close watch on whether -- and how -- companies begin to adjust their operations to the new tax reality.

Much of the biggest change in the first year was on paper. First came the dramatic charges to earnings from accounting adjustments and big one-time tax bills. Then, as the Treasury Department and the Internal Revenue Service began issuing sheaves of guidance and new regulations to implement the tax law, companies calculated -- and sometimes recalculated -- the impact on their financial statements.

Many of the new tax rules remain in preliminary form. But the outlines are firm enough that companies are beginning to understand how they could reshape operations and refashion existing plans.

What remains unclear is just how they will take advantage of this new landscape. The changes are complex enough -- most of the rules governing international tax are wholly new, for example -- and interlocking enough that there are few rules of thumb: What works for one company may not for another.

Still, understanding some basics about the tax legislation can help investors evaluate new disclosures in the months and years ahead. Here is a closer look at some of those basics:

Foreign profits

The tax law's shift to a type of territorial tax system has the potential to pay off for multinational companies for years to come.

Under the former tax system, when companies committed to reinvesting foreign profits outside the U.S., they could avoid paying U.S. tax on the profits indefinitely. Now, new payments from foreign affiliates to U.S. parent companies should generally go untaxed by the U.S., with exceptions meant to discourage multinationals from artificially shifting profits to tax havens.

All told, companies over the next decade can expect to save $223.6 billion in the form of reduced taxes on foreign profits, according to congressional estimates. And that probably underestimates the value of other benefits to companies. With taxes on foreign income greatly reduced, executives say they will have readier access to their cash and more flexibility in how they spend it.

Through late September, U.S. companies shifted $571.3 billion to their U.S. operations from foreign subsidiaries, far more than in past years but still only a portion of the estimated more than $2 trillion they had accumulated overseas over the years. And the transfers slowed sharply during the year: By the third quarter, repatriations from foreign units fell below foreign profits -- meaning they were once again accumulating profits outside the U.S.

What remains less clear is where and how companies are going to spend it. So far, much appears to have gone to share buybacks. S&P 500 companies set three consecutive quarterly records for share repurchases, reaching $203.8 billion in the third quarter, according to S&P Dow Jones Indices. Dividends, too, set a record in 2018, at $456.3 billion.

How much companies plowed into capital expenditures is less clear. Most companies have been slow to tie new U.S. investment to the tax overhaul. Biotech firm Amgen Inc. said in early 2018 that it would spend three quarters of its five-year, $3.5 billion capital program in the U.S., up from 50% previously. Apple Inc. announced, to much fanfare, a $1 billion, 5,000-person Texas project as part of its earlier commitment to invest $30 billion and create 20,000 U.S. jobs over five years. Overall, federal data suggest, capital spending surged early in 2018 before slipping back to more typical growth trends.

Better access to foreign profits appears to also be affecting corporate borrowing demand, Bank of America Corp. Chief Financial Officer Paul Donofrio told investors early this year. "Tax reform has increased cash flow, and repatriation has also increased cash available for debt paydowns," he said in a mid-January conference call. He said the company's expectations for loan growth in the near term haven't changed.

Multinational companies previously borrowed heavily to pay dividends, buy back shares and invest in the U.S., because it was cheaper than using foreign profits and incurring U.S. taxes in the process.

Now, there are signs those companies are reducing their debt loads, freeing up yet more future income and cash for operations or returning capital to shareholders. Boilermaker A.O. Smith Corp. said in late October that it had repatriated almost $300 million, which went to repurchasing shares and paying down floating-rate debt.

The biggest winners remain those companies that had accumulated huge troves of cash parked overseas -- primarily tech and pharmaceutical firms, but also some large industrial, financial and consumer-products companies.

Lower rates for most

Most of the tax benefits for U.S. companies have remained right here at home.

Reducing the corporate tax rate to 21%, Congress estimated when the law was passed, would save companies $1.35 trillion in taxes through 2027 before considering tax breaks eliminated by the legislation. Companies stand to save an additional $40 billion over the decade thanks to the elimination of the corporate alternative minimum tax. The corporate AMT previously limited the degree to which many companies could reduce their domestic taxes with deductions and credits.

Those benefiting the most are domestic-focused companies and others that used to pay close to the old 35% statutory tax rate. Organic- and natural-foods distributor United Natural Foods Inc., which has been a big supplier to Amazon.com Inc.'s Whole Foods supermarket chain, said its effective tax rate for continuing operations declined to 16.6% in the quarter ended Oct. 27 from 41.8% a year earlier. Darden Restaurants Inc. reported an effective tax rate of 8.5% in the six months ended Nov. 25, down from 23.1% a year earlier, and said it expects a full-year tax rate of 10% to 11%. Mutual-fund firm T. Rowe Price Group Inc. recently said it expects its 2019 effective tax rate to be between 23.5% and 26.5%, down from closer to 34% before the tax overhaul.

Companies with hefty foreign operations -- and especially those depending more on income from intellectual property, or that shifted patents and profits to low-tax foreign havens -- have seen their tax bills shrink less, or even rise. Many tech and pharmaceutical giants fall into this category.

Accelerated depreciation

The new tax law gives companies a big break when they buy stuff. This break -- full and immediate depreciation for purchases -- applies to a variety of tangible assets, including factory equipment, machinery and vehicles acquired after late September 2017 and phasing out after 2022 for most purchases. Previously, such deductions were spread over longer time periods.

There is a twist: The accelerated depreciation applies not only to new assets, but to used assets as well. Still, don't expect a dramatic, direct impact on profits for publicly traded companies. From a financial-accounting perspective, companies have long had to book full deductions on equipment purchases upfront.

But from a cash perspective, it is a big change that can mean significantly less taxes paid in the wake of big purchases. It helped boost equipment sales early in 2018.

The tax break can also help corporate acquisitions, too, to the extent the acquisition involves tangible assets. For deals structured as asset purchases, buyers can get as much as a 21% discount on the cash purchase price thanks to the new depreciation rules. Acquiring a partnership is automatically treated as an asset purchase, while the same treatment can apply to acquiring other pass-through entities, such as S corporations or divisions of C corporations.

That has big implications for companies that acquire smaller local or regional competitors.

Stock acquisitions, such as when one public company acquires another, don't qualify. But acquiring a division of a public company can be structured as an asset purchase that qualifies for the immediate deduction. And note that regulated utilities don't get the new capital-expensing treatment; they gave it up to keep existing interest-deduction rules, which changed for most companies.

Vanishing breaks

Some existing tax breaks vanished or shrank sharply, including one for domestic manufacturers (saving the federal government $98 billion over 10 years) and one for pharmaceutical companies developing "orphan" drugs for rare conditions ($32.5 billion). Like-kind exchanges -- where two companies trade similar assets and postpone any tax impact -- are now limited to real-estate swaps (saving Uncle Sam $31 billion in forgone revenue). And some fringe-benefit deductions were scaled back ($41.2 billion).

Mostly, however, companies view these minuses as a small price for significantly lower tax rates and the new territorial tax system.

Interest deductions

For some companies, the change to interest-expense deductions can be substantial. Previously, companies could generally deduct the interest they paid each year. Now they may deduct no more each year than 30% of a figure similar to Ebitda, or earnings before interest, taxes, depreciation and amortization, plus the value of interest income. Surplus interest expense can be carried forward indefinitely, however, and no longer expires. Auto and other vehicle dealers have special rules, and real estate and regulated utilities generally aren't affected.

Many companies haven't been seriously affected by this change, but highly leveraged companies can feel a pinch. One analysis found that the health-care sector had the biggest proportion of public companies in 2016 with interest payments in excess of the threshold, at more than 75%, followed by energy, at about 70%, and business-equipment firms, at 45%. By contrast, about a third of chemical companies paid more interest than they could deduct under the new rules.

Starting in 2022, the interest-deduction limit is slated to get more strict and affect more companies.

The legislation also reined in the degree to which companies may use net operating losses to reduce future taxes -- and eliminated the ability to get retroactive refunds. That could make it tougher for companies to recover from unexpected downturns or other setbacks, bankruptcy experts say.

Guardrails

The U.S. will continue to tax some foreign earnings of U.S. companies.

Complex provisions attempt to prevent U.S. businesses from abusing the new tax law by artificially shifting income to ultra-low-tax havens overseas. Rules to implement these guardrails have been proposed, but still must be finalized. One, the base erosion and anti-abuse tax, or BEAT, applies to large companies with at least $500 million in gross receipts and significant cross-border transactions with related entities. For the provision to raise a company's taxes, at least 3% of a company's tax deductions must stem from cross-border payments to foreign affiliates. (The threshold is 2% for banks.)

Companies to which the BEAT applies must effectively calculate an alternative tax amount without deductions for cross-border payments -- then pay that new tax if it is higher than a modified version of their ordinary figure. Certain kinds of deductions aren't stripped out, including for cost of goods sold -- so a manufacturer doesn't trigger the additional tax solely because it imports parts from a foreign affiliate.

Although meant primarily to prevent companies from "stripping" U.S. profits by transferring them to foreign units without paying U.S. tax, the measure is snaring plenty of big service companies, including Western Union Co., Accenture PLC and Willis Towers Watson PLC.

The other primary guardrail, dubbed the global intangible low-taxed income tax, or Gilti, serves to set a floor on the tax companies pay on foreign income, whether to U.S. or foreign tax authorities. In effect, multinational companies that pay less than a minimum 10.5% to foreign jurisdictions on foreign income must make up the difference to the IRS. That minimum tax is applied to foreign income over a threshold based on the company's foreign tangible assets. The idea: Income over that threshold is more likely to be generated by patents, trademarks and other intellectual property easily stashed in low-tax havens.

Some companies have been struggling with Gilti and warning that its interactions with pre-existing tax laws mean they may pay the U.S. even though they are already paying substantial foreign taxes.

Investors can expect guardrails to mostly affect large companies that have successfully pushed their tax rates down by housing intellectual property in low-tax jurisdictions such as Ireland or Luxembourg. Foreign companies are particularly wary of the BEAT. Foreign banks, too, face exposure, although the rules put forward by the Treasury late last year provided a measure of relief.

The legislation's international provisions also offer a tax cut for U.S. companies that sell their goods or services overseas, generating what the law dubs foreign-derived intangible income. The provision provides a deduction for foreign sales of U.S.-produced goods and services above a threshold based on the company's tangible assets, effectively bringing tax on that income down to 13.125%.

Few companies have yet disclosed how they expect the provision to affect them, however, and the effective tax rate on such income rises to 16.4% in 2025. That, plus the risk of challenges from foreign countries calling the measure an unfair trade subsidy, leaves it unclear how likely companies are to change their operations to benefit from the provision.

Glassmaker Corning Inc. says its tax rate will rise to between 20% and 22%, from a core rate of about 17% in 2017, in part because of the international provisions.

Foreign companies are particularly wary of the BEAT. Swiss chemical manufacturer Clariant International Ltd. says it expects to pay millions more in taxes to the U.S. because of it, though the company also expects to benefit from the lower U.S. corporate tax rate.

Write to Theo Francis at theo.francis@wsj.com

(END) Dow Jones Newswires

February 15, 2019 08:14 ET (13:14 GMT)

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