The Future of Deferred Taxes

Corporate tax cuts could have major impacts on companies with large amounts of deferred taxes.

After disturbing a burrowing mouse in the 18th century, Scottish poet Robert Burns observed that the best-laid plans of mice and men often go awry. The year 2016 has proved the wisdom of Burns’ observation. Who could have predicted both Brexit and the election of Donald Trump? Perhaps even more surprisingly is that coupled with this wave of populism has been a continued rise in global stock markets. Even the Chicago Cubs won The World Series and the Cleveland Cavaliers the NBA Finals. If you have been complacent in your predictions or over-confident in your outlook then hopefully these surprises have forced some humility upon you.

The fact is, though, that despite often failing we cannot help but continue to handicap the likelihood of future outcomes. That includes struggling to read the tea leaves in an attempt to divine what policies President Trump will be pursuing. A few policies we do know – for example abandoning the Trans-Pacific Partnership (at least in its current form and probably altogether). Trump has stated, according to the Tax Policy Center, that he desires to enact broad tax reform during his Presidency that would see the statutory corporate rate drop from 35% to 15%, the reduction and/or elimination of most corporate deductions, a one-time tax on accumulated foreign earnings of 10% and the on-going taxing of all foreign earnings at the statutory tax rate.

Of course, should this plan be enacted, corporations with a large amount of overseas earnings could see a large accounting benefit from the immediate reduction of large deferred tax liabilities on overseas earnings; albeit at the expense of having to cough up the cash of the one-time 10% tax. But there is another class of companies that could see a large benefit from tax reform: companies who have large securities portfolios and have recorded deferred tax liabilities on unrealized gains.

Insurers typically fall within this category, however since income from fixed income investments often comes via interest payments and not appreciation in the value of the security it is particularly relevant for insurers that invest in common stocks. When an insurer receives a dividend payment they are able to record a dividends received deduction to limit the potential for the triple taxation of the income but this benefit does not extend to capital gains. Non-insurers would also benefit proportionately from this benefit if they also maintain a large investment portfolio.

While not exhaustive, the list below attempts to quantify what this benefit might be. If the statutory federal tax rate were to be lowered from 35% to 15%, then Berkshire Hathaway could receive a one-time benefit from the reduction of deferred taxes on its investment portfolio equal to about 3% of its market cap and legal newspaper and software provide Daily Journal Corporation could see double that benefit. While it is possible to get carried away in the impact of this benefit, it is also true that these benefits would not be completely immaterial. If the rate were to be lowered to 25%, then those hypothetical benefits would be half as large as they would at 15%.

Hypothetical benefits of deferred tax deductions for selected insurers and non-insurers.

While the ultimate rate paid by corporations could be higher than the proposed 15% rate, it is entirely possible that tax reform along the lines proposed could be enacted and if a decision is made to not introduce tax reform legislation on individual and corporate income at the same time (probably a wise decision) then corporate tax reform would almost certainly come before individual tax reform.

Your guess of the odds of such a scenario developing is as good as mine. But should it begin to develop, investors would be wise to look for companies who benefit along these lines or to focus on companies that currently pay close to the statutory tax rate and are not claiming large amounts of deductions. These companies would be heavily skewed to the small and mid-cap universe.

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