Tax reform was crafted to grow the economy and create jobs. Whatever side of the aisle you’re on, you can’t deny that after 30 years of “around the edges” tax changes, this massive reform will make an impact on U.S. business, shareholders, employees and tax revenue.
From the perspective of business, some of the most important changes include the following:
- C Corporation taxation reduces from a high of 35% to a 21% flat rate.
- Conversion from worldwide to territorial tax system incents approximately $2.6 billion of U.S. cash held overseas to be repatriated back to the U.S.
- New and used capital equipment can be 100% expensed after purchase, with the inclusion of accelerated depreciation on used equipment - a new concept.
The implications of the reduced tax percentage and repatriation of cash are that U.S. based companies will have a major improvement in both cash balances and cash flow available for investment. The low growth disincentives of U.S. high taxation and tight regulatory environment of the post-financial crisis had delayed capital investment by U.S. businesses for many years. With tax reform, the “doubt dam” of business ownership should greatly reduce, resulting in increasing levels of capital investment, higher wages for employees, and improved dividends for shareholders.
Limited interest expense deductions drive leasing benefits
Simplification measures on the corporate taxation side also include the limitation of interest expense deductions for tax purposes. Leverage is favored by the private equity industry as it provides greater equity returns when revenue and EBITDA improve over time, plus, private equity owners believe leverage puts more discipline on management. Under the new regulations, business owners can only deduct up to 30% of the annual EBITDA. In 2021, it becomes even more restrictive as the 30% cap is just on EBIT – the “DA” no longer counts.
Another nuance of the one-time 100% depreciation expense is that it has a sunset of five years. In 2023, a company will only be allowed to bonus depreciation at 80%; it then scales back 20% each year thereafter.
In the near term, lightly levered companies requiring capital equipment addition will get the benefits of 100% same year depreciation. The effect of the EBITDA interest expense cap and reduction of bonus depreciation will have a long-term impact on the party that takes on the risk of equipment acquisition.
Predictions are for higher capital equipment spending and increased equipment leasing
We have already seen political, logistic and economic conditions that contributed to on-shoring manufacturing back to the U.S. Tax reform will release the hold companies have had on purchasing new capital assets. The one-time cash creation from repatriating offshore dollars and major tax rate reduction will spur on equipment acquisition. New technology will be even more attractive as businesses look for ways to increase efficiencies and profitability. Automation, robots and geometric growth in computing storage needs will require capital investment. And, we will see further growth of the “use” vs. “own” approach to capital equipment.
Equipment leasing has been relevant in the U.S. economy for many decades. Eight of 10 companies still lease vs. own capital equipment, with leasing a $1 trillion financial sector in the U.S.* With tax reform, the risks and rewards of ownership will slowly migrate from operating companies to asset investors/owners who specialize in equipment rental and leasing.
As long as one has a true lease structure for tax purposes (ignoring “operating” and GAAP treatments) and the depreciation is given to the lessor, a company that leases its equipment can still deduct the FULL rental payment for tax purposes. Companies that have higher amounts of leverage and are giving up valuable interest expense tax shield due to the 30% cap can, in essence, reclaim a portion of the lost value when entering into a true lease. The company does trade the benefit of the one-time 100% depreciation for more “smoothed” expensing via the lease payment. Levered companies can recover some of the lost benefits of capped interest expense deduction via leasing capital equipment.
As domestic equipment needs grow and incentives for ownership dissipate for companies, skilled and well-capitalized equipment lessors will fill the equipment ownership role. Just as Uber and Lyft have changed the modes of transportation and car ownership, 2018 tax reform has now set the capital equipment user versus owner paradigm into motion.
Written for the 6th Annual ACG Chicago Middle Market Manufacturing Investment Conference
*ELFA – Equipment Leasing and Finance Association