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Tax Reform: An Investment Game Changer

The New Tax Law

The Tax Cuts and Jobs Act (the ‘Act’) will be an investment game changer. It is expected to pass Congress and be signed by the President. It will lower the corporate tax rate to 21% and provide for 100% immediate expensing of capital investment (but only for five years).

Currently, the U.S. tax regime employs a ‘worldwide’ system, meaning U.S. taxpayers owe U.S. tax on all their profits regardless of where those profits were earned. The new act will employ a ‘territorial’ system, meaning U.S. companies would owe U.S. tax only on what they earn here. Offshore profits would be subject to whatever tax is imposed by the country where the money is made, meaning you would just pay the local rate and be free to move your funds back to the U.S. Existing offshore profits will be ‘deemed’ to be repatriated and immediately taxed at 15.5%.

There will be a global ‘minimum’ tax of 10% (if you pay a lower rate in a foreign country you will have to remit the difference to the U.S. Treasury). Interest deductions will be limited to the sum of business interest income plus 30% of EBIT (no depreciation). And, since the Act taxes interest earned but limits the deduction for interest paid it has an ‘implicit’ tax on leverage. For those equipment lessors who are taxed as pass-through entities, a ‘deduction’ of 20% of ‘qualified business income’ subject to limitations and phaseouts is allowed.

How The Tax Act Will Impact Equipment Financing and Leasing

Lower tax rates, 100% write-offs, and limitations on the deductibility of interest all impact the economics of the equipment financing decision. If your firm is ‘EBIT’ taxable and has access to equipment investment funding, whether from internal cash flow, bank lines or from the capital markets the lease versus buy decision may change. But, lease financing will remain an attractive alternative in both the air and rail markets. It retains its risk transfer characteristics, term flexibility, and allows those air and rail carriers, who are not otherwise able, to fully utilize the tax benefits of ownership through lease pricing.

Investment managers now have the task of analyzing the Act and acting to improve competitive position. Tax planning and profit shifting is used to exploit gaps and mismatches in tax rules. Since investment platforms seek to maximize after tax returns the goal is to move profits to low-tax entities or jurisdictions where profits will be taxed at lower rates, and move expenses to where they will be relieved at higher rates. The Act’s switch to a ‘territorial’ system will require both air and rail operators and investors to review sourcing rules to determine where income is earned.

Aviation and Rail Investments

Aviation investment has delivered returns better than competing asset classes. Both domestic and international Aviation markets continue to show demand growth with historically high load factors and aircraft utilization rates. Rail carload and intermodal traffic for 2018 is expected to improve. Investors who understand equipment values and the business dynamics of their lessees will continue to support fleet growth in this new environment.

America is successful because of its geography, resources, political system, and decentralization of power. America is a magnet because of our freedoms and business environment. Strong businesses drive growth and create jobs. This legislation introduces the most pro-growth tax policy in decades. With passage investors will be faced with a new competitive landscape. Lease pricing and existing portfolio values will change.

Long term value decisions are best made based on the most probable compounding of after-tax net worth. Risks comes from not knowing what you are doing. Interested in discussing what actions you should take? Contact RESIDCO.

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2018: There is Room for Growth

Investing In Transportation

Transportation equipment investment is a long-term affair. It’s a complex business since investment risk and profit profiles change over an investment’s duration. At the macroeconomic level, the stage of the business cycle affects the value of everything, including leased air and rail equipment. When the economy is in recession, fewer people are flying, the values of aircraft are lower, industrial production suffers, and less rail traffic is moving. In an expanding economy more goods are being imported, produced and delivered.

2018 bodes well for Transportation Investment

The Global economic outlook is stable to improving and with tax reform the U.S. recovery will enjoy a second wind. Whether aircraft, engines, rail rolling stock or locomotives, market demand influence equipment values and lease rates.

Aviation fleet capacity is growing in order to serve expected future market conditions. Ultra-Low-Cost Carriers (“ULCC”) are expanding service, both domestically and internationally with a view to taking share from the legacy carriers. It’s a forward-looking industry, on the cutting edge of science and engineering, using many of the world’s most advanced materials, technologies, and manufacturing capabilities. Long-term investment decisions strongly impact an air carrier’s economic performance over the years an aircraft is in operation (and a lessor/investor’s residual profitability at lease termination).

The rail industry’s backlog for new railcars of 66,561 railcars implies approximately 6 quarters of future deliveries. On the aircraft side, Boeing’s website claims an order backlog of 5,744 units; while Airbus claims a backlog of 6,874 planes (that’s over 9 years of aircraft production at current production rates). Yet year to date rail carload traffic (other than intermodal) lags GDP growth. Coal loadings reached their highest monthly levels in August (since October 2015), and further improvement looks uncertain. Crude by rail has been a source of downward pressure and grain exports are slowing. The oversupply of locomotive power remains (an estimated 2500 units remain in storage). It’s only an active secondary market and the energies of creative portfolio managers that will unlock this transport capacity over the medium term. Otherwise, attrition and scrap are the only tools available.

How Leasing Companies Can Help

In these markets leasing companies play an important role, most obviously by providing immediately available equipment in contrast to the long lead times that result from OEM backlogs. Equipment acquired under an operating lease is a hybrid between an investment and a financing, offering ‘quiet enjoyment’ during the lease period in exchange for a rental payment. The risk the lessor carries is the lessee’s flexibility to abandon or purchase at the end of the lease period. Making informed investment decisions is challenging without extensive experience in the equipment markets, credit evaluation skills, an appreciation of changing tax and lease accounting rules, and an understanding of the complexities of multijurisdictional contract law and bankruptcy codes.

It’s a process involving strategy and planning for future market potential. Meeting the needs of unanticipated and uncertain future markets demands the business model go beyond the decision to acquire or dispose of equipment. Portfolio managers must be able to actively manage capacity through economic cycles. Research shows risk assessments range from ‘gut feel,’ to simple sensitivity analysis, to the application of more sophisticated techniques to judge the likelihood of potential outcomes and suggest alternative paths. Success requires uncovering insights about end-user needs. At the start of your investment, it’s not easy to take into account everything that can happen over the next 30 years.

What factors can be quantified? What really drives asset values? More information adds to the quality of your decision. Models do not make decisions. Experience does.

There is room for growth in 2018. To manage your investments confidently work with RESIDCO.

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