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Monthly Archives: October 2016

Halloween Is Not Just For Children – Time For Some Tax Loss Harvesting!

harvest2At this time of the year people living in the Northern Hemisphere are starting to prep their gardens for winter and if you live in the countryside many people are harvesting their summer crops.

In New England as the days get shorter and the temperatures drop families with young children will often visit one of their local farms and pick their own pumpkins for Halloween.
Just writing this brings back great memories of my children when they were young, but there also a different type of harvest that those of us near or in retirement should take part in – definitely not as fun but maybe of lasting value.

 

What I am referring to is tax loss harvesting. Uh, ah I just filed my taxes for last year and now you want me to focus on the dreaded “t” word again? Please allow me to explain. In my life travels I have never met anybody that does not think that they are paying too much in taxes and would love to lower their annual contribution to the government coffers (in a legal way of course).

One way of doing this which is pretty straightforward but often ignored is tax loss harvesting. Along with enjoying harvesting pumpkins with your children or grandchildren why not harvest your investment losses as well?

After all as we have shown in earlier writings (Leaving Money On The Table) proper tax management of investment portfolios can dramatically alter financial outcomes especially over long periods of time.

 

How does tax loss harvesting work? Tax loss harvesting is an approach to minimizing how much you pay to the government on the (hopefully) gains in your investment portfolio. What it involves is selling those investments where things did not pan out as expected and you incurred losses. You would then offset these losses with the gains that you hopefully have on other investments. A good background read on tax loss harvesting prepared by Fidelity Investments can be found here.

While everybody’s circumstances are different let us look at a simple example. Let’s say that at the beginning of the year the Mitchell’s bought a portfolio of Health Care stocks that unfortunately lost 20% of its value resulting in a loss of $10,000. They also luckily bought some energy stocks In January that currently exhibits $15,000 worth of gains.

The Mitchell’s are now worried about all the negative publicity surrounding oil surpluses and wish to sell their energy holdings. Doing so would trigger short-term capital gains on which they would have to pay taxes. On the other hand the Mitchell’s think that Health Care stocks will soon rebound after the US Presidential Elections turning their current paper losses into winnings.

But just like things do not always work out as expected, tax issues are never straight forward so in order to lower their overall tax bill they would have to sell both their health care and energy investments. Not really what they wanted to do, but a lower tax bill this year would come in handy to pay for that winter getaway vacation to Costa Rica.

However, what the Mitchell’s can do is go ahead with both sales, legally offset gains with losses and then buy an essentially “similar” investment in health care stocks. For example if they previously owned a basket of Pfizer, Mylan and Bristol Myers stock which they must now sell they could buy the S&P 500 Health Care Exchange Traded Fund (ticker XLV) as a replacement. From an IRS perspective that is a permissible transaction. So essentially they have maintained the same exposure to health care stocks but lowered their tax bill.

Assuming that the Mitchell’s are in the 25% marginal tax bracket they would owe $1,250 to the tax authorities using tax loss harvesting as opposed to owing $3,750 if they had sold their energy holdings and held on to the losing position in health care stocks. And their portfolio is still essentially positioned as they want with a bet that health care stocks will rebound post-election. They just turned lemons into lemonade and are able to save $2,500 in taxes which they can use to travel to their favorite winter spot on Tamarindo Beach in Costa Rica!

Effective tax management requires an integrated approach to portfolio construction and trading that recognizes the potential returns, risks and tax implications of a strategy

Simply reducing turnover or matching winning with losing positions once a year yields some gains but leaves a significant part of the potential tax alpha on the table.

Tax aware optimization techniques while complicated on the surface are commercially available but require customization to account for individual circumstances. In many instances such programs create voluntary losses to offset current investment gains and the more advanced applications encompass security positions across different asset classes.

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at http://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

 

Cutting US Corporate Tax Rates

taxpapers-1557352-639x852In this US electoral season the issue of corporate tax reform comes up frequently. Both parties seem to understand the competitive disadvantage in which US corporations find themselves often due to much more generous tax policies in other countries.

Where does the US stand in terms of corporate tax rates? KPMG, the large accounting firm, provides an excellent guide to Global Corporate Tax Rates . The current corporate tax rate for US domiciled companies is shown as 40% which is composed of the top federal rate of 35% plus applicable state and local authority taxes.  The KPMG guide is meant as a guide but clearly the ultimate corporate tax rate faced by companies is a function of many variables including importantly the location of foreign subsidiaries.

According to the KPMG data the US ranks highest in terms of corporate tax rates among major industrialized nations.  The global average in the KPMG sample is 23.6% with rates in OECD countries slightly higher at 24.8%.

In the last ten years there has been a race to the bottom in terms of corporate tax rates.  Countries have been lowering their tax rates as an incentive for companies to relocate to their jurisdictions.  In the KPMG sample we find seven countries with a zero corporate tax rate.  Some well-known tax locales with no corporate taxes include Bahamas, Bermuda, Guernsey and the Isle of Man.

What are the investment implications of lower US corporate taxes?  Lower corporate taxes would most likely make US domiciled companies more valuable as after-tax profitability would be enhanced.  By how much? To address this question we resort to using a simple discounted cash flow approach.

The basic idea behind using a discounted cash flow approach relies on using estimates of future cash flows to the company and discounting those cash flows back to the present by using the weighted cost of capital.

Our analysis is based on a discounted cash flow model built for a hypothetical company where the only two parameter inputs that we vary are the applicable corporate tax rate and the level of debt financing.  What do we learn from this exercise?

From a pure valuation perspective it is unambiguous that a lower corporate tax rate will result in greater gains for shareholders. Basically, the revenue foregone by tax authorities is now available to shareholders of the company.

But there is an offset in the valuation model via the discount factor of those now higher corporate cash flows.  Specifically, assuming the same capital structure, the cost of capital will increase as the tax advantages of debt financing are diminished.

Say corporate taxes go from 35% to 20%.  The after-tax cost of debt to the company yielding 5% goes from 3.25% to 4% (the calculation is (1-Tax rate)*Yield).  The net effect of lower corporate taxes is a higher weighted cost of capital (assuming no changes to the capital structure or risk profile of the business). A higher cost of capital implies lower a lower valuation assuming unchanged cash flows to equity holders.

The offsetting impact of a higher cost of capital in discounting cash flows is under most scenarios likely to be of lesser importance to the valuation of the firm compared to the value enhancing effect of higher after tax cash flows

Some of our conclusions:

  • A lower corporate tax rate will under most scenarios result in higher firm valuations
  • The effects of tax cuts are non-linear as the first few percentage points of tax cuts lead to proportionally higher rates of firm value appreciation
    • Going from a 35 to a 30% tax rate results in a greater increase in firm valuation than going from a 30 to a 25% tax rate
  • Firms using more debt financing will benefit from lower tax rates but less so compared to firms who do not use debt very much
    • Firms with low debt to equity in their capital structures will increase the most in value
    • This is due to the diminished value of the deductibility of interest expense and the increase in the weighted cost of capital
  • Companies in the Health Care and Technology sectors typically rely less on debt financing and will thus benefit the most from lower corporate taxes
  • Firms in industries with traditionally high levels of debt financing such as Telecom and Financials will benefit the least from a valuation perspective
  • Firms with significant tax loss carry-forwards will not be as enticing to merge with as the value of their tax credits are diminished under lower corporate tax rates
  • We don’t believe that foreign cash repatriation will instantaneously convince US corporations to invest more domestically

To access the full report click here!

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at http://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

 

 

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