It’s no secret that US corporations face one of the highest statutory tax rates in the world.
So it’s a big deal when these companies are able to find ways to lower their effective tax rates.
One way some firms are able to do this is by taking advantage of tax credits, like the research & development (R&D) tax credit, which exist to encourage certain types of activities.
Morgan Stanley accounting expert Todd Castagno notes one tax credit that has gone largely overlooked during the first quarter.
“Congress is set to extend the R&D tax credit once again — possibly for good,” Castagno wrote on Friday. “This benefit is not yet reflected in YTD earnings.”
Castagno explains that if the Protecting Americans from Tax Hikes Act of 2015 is signed into law in its current form, not only would the R&D tax credit be extended, it would become permanent.
And this is a big deal, especially to R&D intensive companies like tech companies and health care companies.
“We estimate the credit reduces tax rates for R&D intensive firms by 300bps, on average,” Castagno said. “A 100bp reduction in tax rate results in a ~150bp increase in net income, so the impact can be material.”
So, why haven’t we heard more about this? Well, this can at least partially be explained by corporate accounting practices like the generally accepted accounting principles (GAAP). Here’s Castagno:
While many have viewed a 2015 extension as probable, US GAAP only permits recognition of tax credits enacted by current law. Therefore, benefits from any anticipated extension are not yet included in any fiscal or interim reporting period falling within the 2015 calendar year. The extension is expected to be signed into law by December 31st. Companies will then be able to report the benefit of the credit in their financial statements. Non-calendar year-end reporting firms will recognise the effect of the extension in their current fiscal year. For instance, upon extension, a firm with a September 2015 year-end will recognise benefits related to calendar year 2015 in their September 2016 fiscal year.
Even if this isn’t allowed on the books, nothing’s stopping executives and analysts from talking about this.
But Castagno sees little evidence that anyone is really considering this as a source of an upside surprise in earnings.
“From our survey of conference call transcripts, we find most management teams also exclude the benefit from guidance given the relative uncertainty of extension and legislative timing,” he said.
So if your interested in trading on tax law arbitrage, companies who invest heavily in R&D could be an interesting opportunity over the next few weeks.
“Note, a year ago the R&D tax credit was also retroactively reinstated for calendar year 2014,” Castagno said. “We observed some market participants were surprised by the earnings impact during the first earnings cycle of 2014.”
Companies that could come out winners include Citrix Systems, NVIDIA, Electronic Arts, Bristol-Myers Squibb, and Autodesk.