US tax reform is set to have profound implications for the US chemical sector – from profitability to capital investment, to mergers and acquisitions (M&A). The new US tax regime brings the corporate tax down from a top rate of 35%, to 21%, and also allows for full expensing of certain capital investments such as machinery and equipment through 2021.
“There is no question the tax reform act will benefit US headquartered chemical companies because the lower tax rate will directly increase after-tax profits. Each company will decide where they will use the extra earnings, whether it is greater dividends, stock repurchases, increases in wages, increased investment in their business or more acquisitions,” said Peter Young, president of investment bank Young & Partners.
In addition to the profitability boost that comes with lower taxes, there are more specific implications.
The ability for companies to expense 100% of certain capital expenditures (CAPEX) such as plant and equipment for the first five years (being phased down in the following five years) should spur quick investment decisions on major chemical projects in the US.
The US is now not only feedstock advantaged with shale gas, but also tax advantaged (or at least less tax disadvantaged). There’s a compelling argument for investing in major projects today – a lower tax rate on profits generated from those assets, and the five-year window of full deductibility of CAPEX.
Capital intensive commodity chemical companies are likely to focus more on internal rate of return (IRR) and after-tax return on assets (ROA) – “a recipe for tolerating lower margins across the next cycle and consequently taking on more projects”, noted Laurence Alexander, analyst at Jefferies. The full expensing of certain CAPEX also carries into M&A. “This also means that if you structure deals as asset sales, some or all of the non-goodwill portion of the purchase price can be deducted in the first year, providing real value to any buyer,” said Alex Khutorsky, partner at investment bank The Valence Group.
This deductibility could be one factor putting upward pressure on M&A multiples, as buyers would be able to pay more, said Khutorsky.
“The 100% expensing of CAPEX will be very stimulative, with benefits in particular for investment and asset purchases,” said Leland Harrs, managing director at investment bank Houlihan Lokey. “The tax reform is supportive of a strong M&A market, but you don’t need M&A to benefit,” he added.
The overall US tax reform also makes US assets more attractive to foreign buyers with “an economic incentive to buy US assets that wasn’t there before,” said Harrs. “It’s a tailwind, but we don’t see a wholesale rush to buy US assets.”
With attractive terms for repatriation of cash, US chemical companies should have a lot more funds available.
The new “deemed repatriation” tax provision makes all profits of US companies generated (and mostly thus held) overseas “deemed” to have been returned to the US and taxed one time at a 15.5% rate for cash and 8% for reinvested assets.
Companies bringing back cash to the US must pay tax immediately, while those that leave cash and reinvested assets abroad can pay the tax over eight years.
Future foreign profits would not be taxed in the US beyond what they are already taxed abroad, giving zero incentive to keep excess cash outside the US from a tax standpoint. Any future profit generated outside the US can now be repatriated at any time at no cost.
“The majority of US chemical companies with overseas operations will look seriously at repatriating their overseas cash. There are some provisions that create an incentive to do it now rather than later,” said Young of Young & Partners.
The range of options for companies opens up considerably. A company that would have wanted to make a large acquisition in the US, but was hindered by having a good portion of its cash held overseas, could now fund that deal if it so chooses.
The combination of US companies having lower corporate taxes, and the fact that they no longer have to pay US taxes on foreign profit “allows US companies to be much more competitive in the international M&A market”, noted the Valence Group’s Khutorsky.