September 27 Effective Date Indicates Congress Is All-In on Immediate Expensing, Creates Possible Rate Arbitrage

By Stuart E. Leblang, Geoffrey K. Verhoff, Amy S. Elliott, and Ryan Ellis

• Tax writers announced that they plan to give businesses the ability to immediately write off the cost of new investments in certain assets made after September 27, 2017.
• But the ability of Congress to enact a comprehensive tax reform bill is still very much in doubt. Are businesses prepared to take this promise to the bank and start making the kinds of investments lawmakers think will fuel economic growth? ^[1] 
• September 27 was the only effective date specified in the framework. Why include it? While tax writers may not have been aiming to encourage reliance and stimulate spending, they likely included the date to ensure that businesses that had been planning year-end investments would not delay that spending until 2018 to increase their chances of benefitting from possible tax reform. Such a delay would have slowed down the economy even though those businesses already had plans to invest.
• The question remains: If the broader tax reform effort fails, can a temporary expensing provision tied to September 27 be separately enacted?
• The effective date may also present a tax arbitrage opportunity for businesses willing to bet that comprehensive reform will pass in early 2018. If tax reform is enacted that lowers the top corporate rate from 35 percent to 20 percent effective in 2018 (as is the current thinking on the Hill), the benefit of the expensing provision is actually greater in 2017 (when it is worth 35 cents on the dollar) than in 2018 (when it will be worth only 20 cents on the dollar). It is unlikely Congress will decide to neutralize the benefit.
• There is precedent for retroactive effective dates that are tied to when tax changes were first announced at least when the tax changes involve cost recovery.
• While expensing does not generally result in an earnings per share (EPS) boost for publicly traded companies, it could create a sizable cash-flow benefit to firms in capital-intensive industries such as energy, telecommunications and transportation.

Tax writers in the House, Senate and the Trump administration issued a unified framework for tax reform September 27. On the business side, the plan would reduce the top corporate income tax rate from 35 percent to 20 percent; create a new 25 percent rate for pass-through business income; move to a territorial system of international taxation by exempting from taxation 100 percent of the dividends from (presumably active) earnings that a 10 percent foreign subsidiary makes to its U.S. parent company; impose a deemed repatriation tax on previously untaxed, accumulated foreign earnings at an unspecified rate paid out over several years; impose a minimum tax at an unspecified rate on the foreign (presumably passive) profits of U.S. multinational corporations; and adopt rules to similarly tax foreign-headquartered parent companies (presumably on their passive profits from U.S. consumption).²

But one of the more surprising details in the framework is the promise of unprecedented expensing for capital investments (excluding buildings). By announcing their intention to reduce the marginal tax rate on certain equity-financed investments to zero, tax writers are essentially giving businesses a green light to proceed as planned with their capital investment strategies. If they had not indicated that they plan to make the expensing provision effective immediately, some businesses may have chosen to put the brakes on their year-end spending with the thought that a three-month delay into 2018 could reap rewards if tax reform is successful.

It is unlikely the effective date was offered up with the intention of inciting businesses to go on a spending spree. And some of the benefit of the expensing provision will likely be tempered by the as-yet undeveloped limitations on interest deductibility. But if tax reform is ultimately successful, the math on expensing is hard to ignore. Assuming a 20 percent top corporate income tax rate, every $1 of qualified spending will reduce a business’s pre-tax income by $1, meaning that the after-tax cost of the expense just went down by 20 cents. That amounts to a 20 percent flash sale on computers and other equipment that might spur worker productivity.

That is not all. The current thinking on the Hill is that Congress is not prepared to enact a corporate income tax rate cut that is effective in 2017. If tax reform is successful, we could be looking at full expensing for businesses in the fourth quarter of 2017 when the top tax rate is 35 percent. In that case, a business owner who purchases a piece of business equipment on September 28 will likely end up better off than a business owner who waits until January 1. That possible future 20 cent benefit might actually be worth 35 cents until January 1. The arbitrage opportunity gets even sweeter if lawmakers decide to grandfather current interest expense tax treatment for debt financing incurred for capital investments in 2017.

That assumes Congress can deliver. Senator Ted Cruz (R-TX), told the FOX Business Network September 27 that while he thinks it will take a couple months to get consensus on tax reform in Congress, expensing is critical to the effort. “Immediate expensing is an enormous incentive for dollars spent here to create heavy manufacturing jobs, to create the kind of blue-collar jobs that have been the backbone of the American economy for decades,” Cruz said. ³ 

But what happens if Congress cannot pass comprehensive tax reform? What if the 35 percent top corporate income tax rate stays as-is? Will lawmakers have an obligation to ensure that the framework’s promise of immediate expensing for new investments in certain depreciable assets made after September 27 will nevertheless come to pass? (Recall that the House Republican blueprint on tax reform didn’t mention any specific dates.)

Including a specific effective date in the framework’s expensing provision may be a tell as to how critical tax reform’s success is to the Republican Party. But just because this is a “now or never” ⁴ moment, in the words of House Speaker Paul Ryan (R-WI), does not mean businesses should bet on it. Assuming expensing with an effective date of property acquired after September 27 will actually come to pass could cost them dearly if they are wrong.

Then again, Politico Playbook—which holds itself out as “the most reliable politics newsletter”—ran the following headline September 28: “Buzz: Congress could pass a small tax package this year.” As authors Anna Palmer, Jake Sherman and Daniel Lippman explained, “If Congress can’t squeeze through a big tax reform package this year, there’s already talk among some about passing a smaller package of tax cuts before the end of 2017. . . . This would be a way for Republicans to say they gave the tax relief they promised.”⁵

Such promises have been made before. As we reported in our February 8 memo, “Handicapping Potential Effective Dates for Tax Reform Based on Historical Precedent,” there is precedent for changing depreciation schedules retroactively. For example, the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010 (P.L. 111-312), which became law December 12, 2010, provided 100 percent expensing for certain property acquired after September 8, 2010, which was the date that President Obama made a speech proposing that “businesses should be allowed to write off all the investment they do in 2011.” ⁶ 

In the Economic Recovery Tax Act of 1981 (P.L. 97-34), Congress replaced the old depreciation system with an accelerated system for most non-real property acquired after December 31, 1980. The bill did not become law until August 31, 1981.

Although it is not yet clear how lawmakers plan to effect 5-year 100-percent expensing, they may decide to simply replace “50 percent” in the Section 168(k) bonus depreciation provision with “100 percent” as they did back in 2010. It is likely that the September 27 date in the framework will become the “acquired after” date for purposes of applying the provision. Congress may decide that its 5-year 100-percent expensing gift will apply to more property than is allowed under Section 168(k), which is generally limited to certain qualified property with a recovery period of 20 years or less. In the framework, the tax writers indicated that they wanted the provision to be available for all depreciable assets (no matter the length of their depreciable lives), with the exception of structures.

Researchers have found that even temporary provisions allowing for accelerated depreciation of business equipment increased investment by 10 percent a year between 2001 and 2004 and by nearly 17 percent a year between 2008 and 2010. The firms most responsive to accelerated depreciation were those that buy mostly long-duration capital and those that are not in a “tax-loss” position. ⁷ The Obama Treasury Department found that temporary 100 percent expensing reduced “the average cost of capital across all business investment from 7.18 percent to 1.68 percent.” ⁸ 

Capital-intensive industries such as energy, telecommunications and transportation stand to benefit the most from expensing. One oil company executive said on a February 1 earnings call that immediate expensing would be “extraordinarily positive” and that the company is “very supportive” of such a change in tax reform. ⁹ The CFO of energy holding company Vectren Corp. (NYSE: VVC), Susan Hardwick, said on a February 23 earnings call that immediate expensing “could positively impact our financing plan” in the longer term by freeing up more cash. Hardwick added that because Vectren has “very little parent company debt,” it is not concerned about the potential loss of interest deductibility. ¹⁰ 

But not all companies in capital-intensive industries are similarly situated. Tax reformers have acknowledged that they plan to pay for expensing in part by limiting the deductibility of business interest expense, and there are firms that are worried they may end up as net losers.

For example, on a February 3 earnings call, the CEO of National Fuel Gas Co. (NYSE: NFG), Ronald Tanski, stated that “our initial analysis indicates that over the long-term, our cash flow would take a hit—a bigger hit by the elimination of the interest deduction than we could pick up through full expensing of capital expenditures.” ¹¹ Edison International’s (NYSE: EIX) CFO Maria Rigatti said on a February 21 earnings call that eliminating the deductibility of interest expense “would result in a permanent increase in customer rates,” although she added that the extent to which a customer rate increase might be mitigated by full expensing and a reduction in the top tax rate would depend on the ultimate details of tax reform legislation. ¹² 

As it looks like full repeal of the business interest expense deduction is off the table, the calculus for these firms may be changing. All the framework says on that point is that “the deduction for net interest expense incurred by C corporations will be partially limited,” adding that the treatment of interest paid by pass-throughs remains to be determined. We are hearing lawmakers are considering crafting either a haircut or a thin cap rule.

As we explained in our September 22 memo “Rate Reduction vs. Expensing: Tax Reform Could Cause EPS Roller Coaster for Listed Companies,” full expensing for all businesses should increase a firm’s cash flow. But that matters more to younger firms and firms that are not publicly traded. Nevertheless, there are a few established, public companies advocating for accelerated cost recovery. They include Comcast Corp. (NASDAQ: CMCSA), Phillips 66 (NYSE: PSX), Praxair Inc. (NYSE: PX) and Windstream Holdings Inc. (NASDAQ: WIN). ¹³ 

Should these companies start celebrating the potential full expensing effective date gift in the framework by changing their capital deployment strategies to make significant new investments in business assets right away? Or should they wait until it looks like tax reform actually stands a chance of getting passed in the House and Senate? Even if tax reform fails, do lawmakers now have an obligation to stand behind the framework’s promise of immediate expensing for business investments made after September 27 by providing such tax relief in a one-off bill given companies’ reliance interests? We shall see.

^{[1] http://mailchi.mp/press.speaker.gov/breaking-news-on-tax-reform?e=9214659c51}

^{[2] https://www.speaker.gov/sites/speaker.house.gov/files/Tax%20Framework.pdf provides that “the framework allows businesses to immediately write off (or ‘expense’) the cost of new investments in depreciable assets other than structures made after September 27, 2017, for at least five years.”}

^{[3] http://www.foxbusiness.com/markets/2017/09/27/ted-cruz-reagan-style-tax-cuts-will-spur-china-like-economic-growth.html}

^{[4] Edgerton, Anna, Ben Brody and Sahil Kapur, Sept. 27, 2017, “Trump’s Tax Plan With GOP Leaders Reaches ‘Now or Never Moment,’” Bloomberg Politics (https://www.bloomberg.com/news/articles/2017-09-27/trump-calls-20-corporate-tax-rate-in-plan-a-perfect-number-j83e69me).}

^{[5] http://www.politico.com/story/2017/09/28/playbook-gop-tax-reform-package-243243}

^{[6] Obama, President Barack, 2010, Remarks on the Economy – As Prepared for Delivery Wednesday, September 8th, 2010, in Cleveland, Ohio, 2010 TNT 174-24.}

^{[7] See Laurent Belsie’s write-up of research by Eric Zwick and James Mahon, “Tax Policy and Heterogeneous Investment Behavior” National Bureau of Economic Research Working Paper No. 21876, available at: http://www.nber.org/digest/mar16/w21876.html}

^{[8] https://www.treasury.gov/resource-center/tax-policy/Documents/Report-Temporary-100percent-Expensing-2010.pdf}

^{[9] https://seekingalpha.com/article/4041669-marathon-petroleums-mpc-ceo-gary-heminger-q4-2016-results-earnings-call-transcript?part=single}

^{[10] https://seekingalpha.com/article/4049254-vectrens-vvc-ceo-carl-chapman-q4-2016-results-earnings-call-transcript?part=single}

^{[11] https://seekingalpha.com/article/4042672-national-fuel-gas-nfg-ceo-ronald-tanski-q1-2017-results-earnings-call-transcript?part=single}

^{[12] https://seekingalpha.com/article/4048068-edison-international-eix-q4-2016-results-earnings-call-transcript?part=single}

^{[13] http://www.cranecoalition.org/membership/}