U.S. Tax Reform: More than Meets the Eye

1.
U.S. Tax Reform: More than Meets the Eye
Multiple challenges for Canadian companies. For all Canadian businesses with operations in the U.S., exporting
to the U.S. or competing in Canada with U.S. imports, the new U.S. tax law presents multiple challenges. The short
and long term consequences of the new law are difficult to evaluate as they may be challenged at the WTO, may be
subject to retaliation by foreign countries, and will undoubtedly incite tax arbitrage and opportunistic, yet unknown
behaviours on the part of both US and foreign corporations in order to minimize their US tax bill. Also, the IRS and
the Treasury department will have to issue guidelines and regulations to clarify some of the rules and minimize,
where possible, certain avoidance behaviours.
Moreover, the new tax law challenges the integrity of the U.S. tax system as it affects taxpayers and some sectors in
different ways often with no apparent policy justifications. Finally, the new tax law will affect most sectors, but the
impacts will vary greatly and it is thus likely to lead to significant restructuring and cross-border M&A activities and
asset reallocation.
The economic and corporate response is uncertain. Some independent estimates put the fiscal cost of the tax
reform at $1 trillion USD over the next ten years. However, this assumes a positive economic response to the tax
reform by allegedly favoring investment and growth. Yet, these economic feedback estimates vary widely as their
outcome is highly uncertain. Moreover, as corporations adjust their behaviour in response to the new tax rules to
minimize their tax burdens, and as trading partners adapt their own tax systems to regain their fiscal and export
competitive edge, U.S. fiscal revenues may turn out to have been overestimated.
As the U.S. tax reform was rushed through Congress at a record pace, many analysts fear that opportunistic
behaviours have not been taken into account in the analysis of the reform’s impacts, and could lead to a significant
deterioration of the US fiscal deficit. This in turn would have an impact on interest rates, affecting the cost of
borrowing, investment opportunities and the discounting of future cash flows.
Valuations will adjust differently across sectors. As the domestic federal corporate tax rate is lowered from 35%
to 21%, U.S. corporations that conduct most of their business domestically (thus pay most of their taxes in the U.S.)
will likely see their taxes improve more than those with operations abroad. All else equal, this will lead to improved
profitability and an appreciation of market value. These companies may increase dividends and buy-backs, further
improving valuations. Finally, the favorable tax outlook may increase their pace of investment and acquisitions. As a
result, the prospect of improved earnings growth could lead to an immediate appreciation of market value.
However, this will not be the case for all sectors. U.S. utilities, for instance, may see the benefits of lower taxes be
passed to consumers by regulators who usually specify allowable ROEs for these entities. Lower energy costs may
drive reduced opex for energy-intensive firms, and may attract investment to the U.S. U.S. REITS won’t benefit
directly from the lower corporate tax, but may see valuations increase as American REIT holders should be able to
use the new 20% deduction on pass-through income on REIT distributions to lower their tax bills. This will not benefit
the profitability of REITS themselves; hence their dividends, buybacks and investment plans may not be enhanced as
much as those of C-Corporations. In other sectors, the lower corporate tax rate will reduce the value of deferred tax
assets, forcing them to take one-off charges in Q4/17. For certain banks (otherwise mostly favored by lower tax rates,
less regulation and improved economic prospects), their Tier I capital ratios might fall as a result.

2. Economic Research and Strategy
Other tax rules must be considered in evaluating the impacts of tax reform on a company’s earnings: the accelerated
depreciation of assets, limits on interest expense deductibility, the taxation of income on a partially territorial rather
than a nominally worldwide basis, the repatriation tax that will vary depending on whether foreign assets are liquid or
not, and others.
Multiple moving parts to examine. There are three types of impacts worth analyzing: the mechanical impacts, such
as those illustrated above that directly follow from the new tax rules; the more tactical impacts which will be
determined by companies’ attempts to minimize their tax bills (likely involving behavior unforeseen by the legislator
that may ultimately cause tax receipts to fall further than expected, and an eventual response from the IRS and the
Treasury department); and the longer-term strategic impacts which include where companies will decide to invest,
locate, hire workers and book their profits.
There exists a debate as to whether reducing the tax rate to 21% (while making the U.S. corporate tax a partially
territorial tax system) will encourage corporations to locate in the U.S. The incentives still appear to favour foreign
locations now that there are no constraints on the repatriation of foreign profits.
The rising rate environment must be considered. On a macro note, tax cuts and other pro-growth measures are
likely to increase interest rates in 2018 (and beyond) which will increase the cost of debt for individuals, firms and
governments. Although we expect long-term rates to increase more than short term rates this year (hence the yield
curve to steepen), the higher cost of long-term financing may add risk (due to higher reliance on short-term debt) and
cost to heavily indebted businesses.
For highly leveraged U.S. businesses, higher debt costs may mean lower valuations. The lower differential between
their dividend rate and high rates on U.S. Treasuries may cause investors to require higher dividend yields causing
their equities to depreciate. However, even non-dividend paying businesses are interest rate sensitive. It can even be
argued that non-dividend paying corporations have longer “durations” than dividend paying businesses and should
thus be more sensitive to interest rate variations.
The impact of a stronger USD must also be considered in making earnings forecasts. As tax reform is leading
to upward revisions of U.S. economic growth, higher interest rates and foreign profit repatriation, the U.S. dollar is
likely to appreciate. For Canadian corporations (whether they have operations in the U.S., export to the U.S. or
compete in Canada with U.S. exporters), perhaps the most relevant elements of the reform are the features of its
new international tax regime, which has become a territorial system, meaning the profits of foreign subsidiaries of
U.S. corporations are no longer subject to U.S. corporate taxes, encouraging firms to locate in the lowest tax
jurisdiction.
The reduced tax could appear to favour a U.S. location at the expense of higher-taxed jurisdictions. However,
for as long as lower-taxed jurisdictions exist, incentives remain to locate there as opposed to the U.S. To avoid this
problem, the new tax law utilizes several mechanisms to favour firms with domestic operations and limit the use of
tax havens. However, many tax analysts claim the new rules still encourage U.S. firms to locate tangible assets and
jobs overseas. A border adjustment tax proposal was quickly abandoned on strong opposition and difficulties in
implementation. Yet, it was discreetly replaced by measures designed to achieve a similar outcome.
Now, U.S. export income benefits from lower taxes and rules limiting firms from using foreign affiliates to export their
IP and profits to low-tax jurisdictions. The financial and economic consequences of the new rules are difficult to
predict and many will be challenged by the WTO. Some will backfire and hurt the U.S. Treasury, rather than curb the
problems they were designed to solve. Countries may retaliate by lowering their corporate tax rates and/or imposing
similar constraints on U.S. exports in favour of their own exports. Even the IRS may join the fray in trying to inhibit the

3. Economic Research and Strategy
This document is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee
of Laurentian Bank Securities (LBS), a wholly owned subsidiary of the Laurentian Bank of Canada. The author has taken all usual and reasonable precautions to determine that the information contained in this document
has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze it are based on accepted practices and principles. However, the market forces underlying investment value
are subject to evolve suddenly and dramatically. Consequently, neither the author nor LBS can make any warranty as to the accuracy or completeness of information, analysis or views contained in this document or their
usefulness or suitability in any particular circumstance. You should not make any investment or undertake any portfolio assessment or other transaction on the basis of this document, but should first consult your
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behaviour of U.S. corporations to limit their tax avoidance strategies by clarifying certain definitions and implementing
guidelines to make it more difficult to circumvent the new rules.
A particularly relevant issue will be the opportunity for “roundtripping” of U.S. goods to take advantage of lower tax on
export-derived income. In this case, a U.S. corporation exports a good to take advantage of the lower tax on exports,
and reimports it into the U.S. at a higher price to further reduce its tax bill. The IRS may try to prevent this behaviour
by disqualifying exports of goods destined for final domestic consumption. However, with minimal transformation of
the goods abroad, the IRS would have a hard time arguing its case, let alone enforcing it.
Other attempts to minimize tax liabilities may arise. Expect more direct sales to consumers from foreign
corporations located in lower tax countries to avoid the 21% domestic corporate tax (for example, the Caterpillar case
which is now being examined) or to avoid the BEAT to the extent that it might otherwise apply. Other behaviours to
exploit the pass-through loophole are possible; both the fractioning and combination of existing businesses to take
advantage of the 20% deduction on pass-through income should be largely employed to arbitrage tax rate
differentials.
Changes to the M&A environment are not clear cut. As for M&A, there are no foregone conclusions emerging
from the new U.S. tax law. There are few strategic elements, besides the short-term mechanical impacts of the law
which can be exploited by corporations for now. M&A activities could involve the takeover of cross-border assets and
the movement of foreign assets into the U.S. to take advantage of favourable tax treatment. Firms outside the U.S.
could also move their operations to the U.S. to achieve this objective without merging with a U.S. entity.
However, as we have argued above, the new law still appears to favour the movement of assets and workers to low
tax jurisdictions. Moreover, in our opinion, due to WTO challenges and potential retaliation measures on the part of
trading partners, the likelihood of near-term wave of firm consolidation and asset reallocation is relatively small.
Finally, for as long as countries exist with lower rates than the U.S., the incentive will be to find legal ways to
circumvent the new constraints imposed by the new U.S. tax laws rather than the more complicated strategies of
moving physical assets.
Luc Vallée | Chief Strategist | valleel@vmbl.ca