Perhaps the biggest news of 2018 has to be the passage of the tax reform bill.
President Trump signed the Republican-led “Tax Cuts and Jobs Act” into law on December 22. And the bill has wide-sweeping implications for almost every sector of the economy. From college savings to itemized deductions, the newly passed bill changes how we’ve viewed taxes for what seems like decades.
But the biggest changes could be in the corporate sector.
Corporations get plenty of breaks in the new bill under the guise of growing the economy and creating jobs. While that element of the plan could be up for debate, the reality is that investors could be looking at a huge windfall. Thanks to new rules concerning the repatriation of overseas cash, the tax bill could have significant implications for dividends and buyback activity in the medium term. Already, we’ve begun to see some of the positives on this front.
The Problem with Being Multinational
It’s no secret that the world’s economy has become more interconnected over the years. You’re just as likely to drive a German car or have a Korean TV as you are an American one. But that fact works both ways. Plenty of American firms do robust business across the pond. However, for American companies, it poses an interesting and potentially costly problem.
Right now, U.S. firms pay tax on all their profits no matter where they are generated, and this can lead to double taxation. That’s a stark contrast to much of the world in that most other countries either allow for different rates based on trade deals or credits for international taxes paid.
To counteract this, U.S. firms are allowed to defer taxes on their foreign profits by keeping them overseas. It’s only until they decide to move that money back to the United States that they will then have to pay corporate taxes of 35% on these earnings.
So, naturally, many firms have been parking their cash overseas in order to avoid paying taxes on this money. And with many technology and healthcare firms realizing high margins/cash flows, the amount is truly staggering. According to an estimate by Goldman Sachs, American firms have an astonishing $3.1 trillion – that’s with a “T” – parked in cash and equivalents overseas. And that cash is pretty much just sitting there doing nothing, because if they touch it, it’s taxable.
Technology stock Apple (AAPL ) leads the pack with nearly $250 billion in cash held overseas. But AAPL is certainly not alone. Gilead Sciences (GILD ), Johnson & Johnson (JNJ ) and Google (GOOG) all have north of $30 billion each.
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The Tax Plan’s Big Break
But all of this cash might finally be coming back to U.S. shores, thanks to the recent changes to the tax code. The new law now provides some relief for U.S. corporations via a so-called repatriation holiday. This will allow companies to pay a one-time low tax rate on their overseas cash/profits. Under the new tax plan, firms will be charged 15.5% on cash and equivalents and 8% on non-cash and liquid assets such as equipment abroad that was paid for with foreign profits. This is a big drop from the previous 35% tax rate and the new 21% rate for corporate taxes.
The idea is that this lower rate should persuade firms to make the decision to bring this cash home and use it here in the United States for investment rather than have it just sit in an overseas checking account. And that seems to be holding true. Apple announced that it was bringing the vast majority of its cash hoard back from overseas, while Cisco Systems (CSCO ) has plans to repatriate ALL of its $67 billion.
Spending It on Dividends & Buybacks
However, despite brining a ton of cash back from overseas, it seems that many firms aren’t using it in the manner that it was originally intended. According to estimates by Morgan Stanley, only 13% of the cash will go into raises, bonuses and employee benefits. A similar small amount will go towards expansion efforts. Debt reduction, M&A activity and shareholder value creation will take up the bulk of the tax savings – with 43% going back to investors in the form of stock buybacks and dividends.
Already this year, Birinyi Associates estimates that U.S. companies have announced $171 billion worth of stock buybacks. And some of those announcements have been pretty hefty. Cisco alone raised its buyback by an extra $25 billion. While biotech giants Amgen (AMGN ) and AbbVie (ABBV ) boosted their programs by around $10 billion each. At the end of the day, analyst estimates have corporations buying back roughly $450 billion in shares this year.
And while buybacks are getting much of the attention from repatriated cash holdings, dividends are feeling the love as well. Like buybacks, dividends have gotten a shot in the arm as well, with plenty of double-digit jumps to payouts. For example, Mastercard (MA ) recently raised its payout by a whopping 25%. And that big jump is not an isolated case. All in all, early estimates suggest that dividends will increase by an average of 10.4% in 2018 because of tax reform and repatriated cash. That’s up from a 7.4% increase last year.
The most significant effect of bringing cash home will be higher dividends for you and me.
The Bottom Line
Thanks to previous tax schemes, U.S. firms have a ton of cash sitting overseas. But with tax reform now official, tapping that cash can be done at lower rates. That’s having a great effect on buyback and dividend activity. As more firms decide to repatriate their cash holdings, dividends and buybacks should continue to rise over the course of the year. Whether or not that will boost the economy is up for debate. But for investors, it’s a great thing.
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Disclosure: Author has a long position in GILD, CELG & V.