Danger Ahead for Tax Loopholes
An interview with tax guru Robert Willens. Sizing up proposals that could affect REITs, AT&T and others.
When it comes to analyzing companies, taxes don't always command the same amount of attention from investors as, say, earnings growth or profit-margin trends. But taxes and tax policy, however dry and arcane, can have a profound impact on a company's financial outlook. How quickly a company can depreciate equipment it buys, whether it can repatriate cash cheaply, or even whether it's able to convert to a REIT (real-estate investment trust)—along with, of course, shutting down corporate-tax loopholes—are all hot topics in Congress right now.
For some perspective on those issues and others, Barron's spoke recently to Robert Willens, a well-regarded and very seasoned tax and accounting expert. Willens, 67, began his career in 1972 and eventually became a tax partner in the New York office of Peat, Marwick, Mitchell & Co., now KPMG. He then went on to spend 20 years at Lehman Brothers, which he left in January 2008 to start his own consultancy, Robert Willens LLC. Willens, whose consultancy caters primarily to hedge funds, focusing more on corporate tax than individual, also pens a daily newsletter called, what else, The Willens Report.
"The fear is that the IRS is attempting to make policy here, even though they don't usually do that." -- Bob Willens
Barron's: What's the latest as far as any tax reform coming out of Washington?
Willens: We are keeping an eye on the draft legislation, called the Tax Reform Act of 2014, which was put out in February by Dave Camp, chairman of the Committee on Ways and Means. He's a Republican congressman from Michigan. His proposal, which was several years in the making, would radically overhaul the tax code, even more so than the tax legislation we had in 1986. Camp's approach is to reduce tax rates, but broaden the tax base by eliminating many of the loopholes, to ensure the same level of revenue.
What in particular caught your eye?
The proposal has really caused a lot of anxiety in the investment community, particularly for people who invest in REITs. It doesn't seem these proposals will be enacted any time soon, but nevertheless they are a concern.
REITs pay out most of their taxable income to shareholders and therefore avoid corporate taxes. What does the proposal call for?
It would essentially terminate the ability of any company to convert to a REIT. There have been concerns that non-traditional companies have been qualifying for REIT status, perhaps inappropriately. But this proposal goes way beyond what is necessary to police the space. It would impose a "toll charge" on any C corporation that wanted to convert to a REIT—basically, the charge will be equivalent to the fair market value of all the company's assets, as if they had been sold. That would be a very large amount, and particularly onerous because it would be a gain realized without any cash to pay the tax on the gain.
What are a few examples of companies attempting to convert to REITs?
There are lot of companies, including Lamar Advertising [ticker: LAMR], Iron Mountain [IRM], Equinix [EQIX], and CBS Outdoor Americas [CBSO] [which just split from CBS on Friday], that have all requested rulings from the IRS to become REITs. Ordinarily, the IRS will issue a ruling within six to seven months after the request is made. But they have had their ruling requests at the IRS for more than a year. No doubt these companies are having dialogues with the IRS, but they haven't gotten rulings.
What are some of the key issues for these companies as they try to become REITs?
In the case of Iron Mountain, which handles record management and storage, one of the problems is that in order to be a REIT, you have to have real-estate assets, and you have to earn rents from real property. In Iron Mountain's case, in their warehouse they have these shelves they call racking, where they house documents. But there is some question as to whether that racking is a structural component of the building. If it is, then it is real estate. If it is not, then it is personal property.
For Lamar Advertising and Equinix, which operates data centers, it's hard to say what the issues are. It is clear, though, that Lamar has outdoor advertising displays, as does CBS Outdoor, which is attempting to convert its North and South American outdoor advertising business as a REIT. Those billboards are inherently permanent structures and, therefore, considered real estate. The fear is that the IRS is attempting to make policy here, even though they don't usually do that.
Another vehicle that investors looking for tax benefits have been turning to more often is master limited partnerships (MLPs), which, like REITs, pay out the bulk of their earnings to investors and forgo corporate taxes. Despite their similarities, does it look like we may see an increase in the number of companies becoming MLPs?
While the IRS is getting more restrictive on REITs and inversions, they are getting more expansive on MLPs, for some unknown reason. They are allowing a broader class of entity to convert to MLP status. Most MLPs are involved in the mineral and natural resource field, usually in exploration, development, processing, refining, marketing, and transportation of minerals or natural resources, including oil and gas. But over the last year, the IRS has been allowing companies that aren't directly engaged in those activities to become MLPs—companies that simply service companies that are engaged in those activities. We've seen an expansion in the number of companies eligible to be MLPs because the IRS has allowed companies whose activities are kind of peripheral to the main activities that MLPs were traditionally known for.
There's been a lot of talk about so-called inversions, in which a U.S. company changes its domicile to that of a country with lower taxes. First off, could you summarize how these transactions work?
It is simply a transaction in which a foreign company—sometimes newly created, sometimes an existing company—acquires the stock of a U.S. company. Typically, the foreign company pays for the stock, primarily with its own stock. Since the foreign company is inevitably smaller than the U.S. company it is acquiring, the result is that the U.S. shareholders acquire a majority ownership in the foreign company. Shares still typically trade on a U.S. exchange. The principal purpose of that—even though they will frequently tell you that there are many business goals that are achieved—is to reduce the tax burden. Income is shifted from the U.S. to the more benign foreign tax environments, typically Ireland, the Netherlands, Switzerland or the U.K.
What are a few examples?
Actavis [ACT] recently completed one inversion, and they are on the verge of doing a second one with the acquisition of Forest Laboratories [FRX]. Other examples of companies doing inversions include Eaton [ETN] and Perrigo [PRGO]. Chiquita Brands International [CQB] just announced one.
Will there be more of these transactions?
Absolutely. But I'm often asked why everybody doesn't do this, because you are guaranteed to reduce your tax rate dramatically and help the bottom line. There is some reluctance because the transactions tend to get covered in the press not very charitably, and there is fear of some reputational risk.
How do inversions affect investors?
Inversions complicate things for investors. First and foremost, the exchange of their stock in the U.S. company for stock in the foreign acquirer is taxable. And going forward, any dividends are from a foreign corporation, which complicates matters.
Do you expect the U.S. government to crack down on companies performing these inversions, which has cost billions in lost federal tax revenue?
You would think so. There have been periods of inactivity in this area and periods of great activity. The first inversion was in 1994 for a company called Helen of Troy, now domiciled in Bermuda. Since then there have been three waves of inversion transactions; we are now in the third wave. The last time Congress got involved was in 2003, and while they did create some impediments, they weren't sufficient in deterring companies from doing these transactions.
What's happening now?
A few weeks ago, when President Obama laid out his budget, it included proposals dealing specifically with inversions. In the budget, the president refers disparagingly to inversions—how they have very little, if any, business purpose and that they are done almost exclusively for tax-avoidance reasons. It also says there is no reason why these companies should be able to reduce their tax rate so easily by shifting income to more friendly foreign tax environments. Those proposals, if enacted, would almost certainly stop inversions.
What's the chance of that happening?
There is little chance of the proposals passing in their current form. But by becoming part of the conversation, it increases the possibility of their being enacted down the road, perhaps in a different, though no less punitive, form.
There are many U.S. companies with a lot of cash parked abroad, thanks to their overseas operations. But they're reluctant to spend that cash in the U.S. because of the tax bill it will incur. What do you expect on this front?
It's hard to say. U.S. companies had a one-year option in 2004 or 2005 that allowed them to repatriate earnings at a very low tax rate. The problem was that the companies, for the privilege of repatriating those earnings, were supposed to use repatriated cash to build plants, hire workers, and invest in research and development, and advertising. The only things they weren't allowed to do were to repurchase stock, pay special dividends, or pay executive compensation.
How did that turn out?
Studies showed there wasn't any incremental R&D spending, and there weren't a lot of incremental advertising or marketing expenditures. But there was a huge ramp-up in stock repurchases and dividends. So the program got a very bad name, and it clearly didn't accomplish what it was supposed to.
So companies spent the cash on exactly what they were explicitly told not to.
The problem was that money is fungible, or interchangeable. The funds that were repatriated were used for things like R&D, but the repatriated funds freed up money that was used to pay dividends and buy back stock.
There have been a lot of attempts to have another tax holiday for repatriated cash, and the proposals have been accompanied by very strong enforcement mechanisms to ensure that if a company didn't have an increase in its plant and equipment investment or R&D expenditures, it would have to pay taxes on the repatriated cash at the higher rate. But I don't expect we are going to see that, at least not anytime soon. So companies are left to their own devices, and they have to try to come up with their own techniques to repatriate the earnings tax efficiently. But that's very difficult to do nowadays.
What other tax matters are you keeping an eye on, particularly pertaining to investing?
The tax extenders bill has a better chance of passing this year. This bill extends the provisions in the tax law that have to be re-enacted continuously, usually every two years. The reason these provisions aren't a permanent part of the tax law is because of budget accounting—if they were permanent, the budget deficit would look worse than it is.
Which extenders are you most interested in?
Bonus depreciation, which was enacted in 2008 and has been extended several times. It allows companies that invest in capital goods to deduct, in the year they purchased the equipment, 50% of the cost of the equipment. For a company like AT&T [T], it is incredibly important and has reduced their cash tax rate dramatically.
So it accelerates depreciation on capital goods?
It goes beyond that. We already have accelerated depreciation. This is bonus depreciation, on top of the accelerated depreciation. When you combine bonus and accelerated depreciation, you wind up allowing a company to deduct about 70% or 75% of the cost of plant and equipment in the year of purchase. So they get to recover almost the entire outlay through tax deductions. AT&T has been a big beneficiary, and the expiration of bonus depreciation would clearly increase AT&T's cash tax payments this year, relative to prior years, and contribute towards a decline in cash from operations. But with this extenders bill in limbo, analysts that follow AT&T are getting quite concerned that their cash taxes will be higher this year. There have been some rumors about AT&T perhaps doing an inversion transaction with Vodafone [VOD]. But as a practical matter, I don't think they can. For such an iconic company to do an inversion would not be looked upon very favorably.
Do you expect that there will be meaningful federal tax reform anytime soon?
It is hard to imagine that, given how hard it is for the various factions in Congress to ever agree on anything. Tax reform is a fairly major undertaking, and presumably a lot of people's oxes would be gored if there were a comprehensive tax-reform effort. So I have a hard time believing that Congress could arrive at the kind of compromises they would have to reach to come up with anything meaningful.