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How The Tax Cuts and Jobs Act Will Affect The Transportation Marketplace

Changing Tax Consequences

Whether you are an investor or a service provider, the Tax Cuts and Jobs Act (the “TCJA”) has changed the tax consequences for entities that compete in the transportation equipment lease finance marketplace. Investment stands on the marginal revenues and cost (including tax) it generates. The great news: TCJA reduces the after-tax cost of capital in our capital-intensive transportation sector.

The foundation of the TCJA was a reduction in the C-Corp tax rate from 35% to 21%. But such a one-sided decrease caused the competitive business playing field to severely tilt. For Equipment Leasing firms and service providers organized as Partnerships, Trusts, S Corporations, or Sole Proprietorships who are considered Pass-Through Entities (“PTEs”) TCJA created new complications with marginal benefit and an adverse tilt of the playing field.

You may recall prior to the subject TCJA and before considering capital gains tax, PTEs were subject to a 39.6% rate or an additional 4.6% over the 35% C-Corp rate. Therefore on $100 of income, the highest bracket PTE was subject to an additional $4.60 or a premium of 14% over the $35 a C-Corp would pay on identically derived income. Under the new TCJA, PTEs are subject to a reduced 37% rate or 16% over the new 21% rate for C-Corps.

Now on $100 of income, PTEs would pay an additional $16 or a premium which is 76% over the $21 a C-Corp will pay on identically derived income. PTEs would have lost the significant advantage over their C-Corp competitors if no additional relief was provided.

Section 199A

In the TCJA, Congress created a deduction for Qualified Business Income (“QBI”) of PTEs enacted under Section 199A and it is among the TCJA’s most complex components. On its surface, Section 199A allows owners of PTEs a deduction of 20% against income from their business. The intent was to reduce the effective top rate for PTEs from 39.6% under the old law to 29.6% under the new law (a new 37% top rate * a 20% deduction = 29.6%). With the 20% QBI deduction, PTEs might lessen their competitive disadvantage over C corporations ignoring capital gains.

But controversy and grey areas remain. The new Section 199A QBI deduction is not fully available to all PTEs. It is subject to both W2 and investment caps. Yet PTEs compete head to head in the leasing marketplace with C-Corps who are not subject to such limitations. PTEs now find themselves at a competitive disadvantage against their C-Corp counterparts who manage investment decisions to maximize after-tax cash to the corporation, not the individual investor. Individuals who have built successful businesses and created jobs as PTEs are faced with competing against this lower C-Corp tax rate without full access to the Section 199A deduction.

Aftermath

The TCJA has created competitive disadvantages. Air and rail investment alternatives have economic consequences and the tradeoffs between C-Corp and PTE equipment investment require clarification. Investors and service providers need clarity in order to make informed decisions regarding cash flow, entity structuring, and investment planning alternatives.

The significant wealth of private equity is invested through PTEs and into transportation equipment. These PTE investors must compete for capital. ‘Grey’ areas in the TCJA are subject to interpretation. There is a need to develop a solid understanding of decision alternatives that give rise to planning opportunities while understanding how to integrate that knowledge into the larger picture of after-tax investment decision making.

This is a call to action. If you are interested in the developing consequences of the TCJA on transportation equipment investment, please contact us. RESIDCO is leading an effort to gain regulatory clarifications, technical corrections and devising optimal entity structures to enhance the impact of the TCJA for transportation equipment investment.

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The State of the Aviation Industry in 2018

Demand in Aviation

Global passenger traffic is growing faster than expected. The International Air Transport Association (IATA) expects 6.0% revenue passenger kilometer (“RPK”) growth for the year, above the 5.5% long-term trend.

This level of RPK growth is indicative of the robust demand in the aviation sector. Rising fares coupled with continuing (but still relatively) low fuel cost and low-interest rates are expected. With tax reform, most agree this cyclical expansion will continue.

The industry’s net profit is expected to be $38.4 billion in 2018, an increase of 11% over record profits of 2017. With rising demand, carriers expect to grow capacity 3.4% in North America. It’s record profits, tax law changes and capital availability [1] that are allowing carriers to consider adding more efficient aircraft in important traffic lanes.

Operational Economics

While fuel remains relatively inexpensive (Brent crude is expected to average $62 a barrel this year, while West Texas Intermediate [the U.S. Standard] should average close to $59), newer technology aircraft are more fuel efficient. A transcontinental trip from New York to Los Angeles is 2,451 miles. Comparative fuel cost on that same trip? 757: $12,000, 737-800: $9,100, and 737MAX: $7,800.

Air carriers are balancing the economics of overhauling lower cost older aircraft (and refreshing interiors) while they wait for delivery of newer technology (better fuel, higher capacity, and distance) but more expensive units. It’s operational economics in competitive traffic lanes that drive aircraft selection. The aircraft finance market for new deliveries is more than $100 billion per year. The Boeing 737-700 has a list price of $75 million, the GE-90 engine that powers the Boeing 777 lists at $24 million each, while the A380 has a list price of almost $390 million U.S.

While improving financials are allowing North American carriers to consider fleet replacement, air carriers continue to operate units for their full life (25 to 30 years). United Airlines is mulling adding narrow-body jets to upgrade capacity on routes currently served by regional carriers (changes are pending an agreement with pilots’ unions).

New orders and the size of manufacturer’s backlogs are driving production rate increases. 2017 commercial jet aircraft deliveries were up 3% at 1617 units. Gross orders in 2017 increased to over 2,500 units (83% of which were for the Boeing 737 family and A320/1). These single-aisle aircraft have coast to coast non-stop range, are the industry workhorses, and are expected to remain so. The world’s commercial fleet which currently estimated at approximately 25,000 in-service aircraft is forecast to expand to 35,000 over the next decade.

The Future of Aviation Leasing and Investment

Operating lessor investors are providing the fleeting flexibility air carriers demand. The number of leasing companies is growing. In 2015 there were approximately 33 such companies with assets more than $1 billion and five with assets worth $10 billion. Today there are over 50 companies with assets in excess of $10 billion. Aviation investment is high profile and high reward, with attractive and stable returns. Nine years of a bull market, still growing and attracting new investment.

The future? Rising interest rates, higher fuel and operating cost, more competition, and more capacity. Investment success is based on aircraft type selection and an understanding of the strength of the user base. Lenders take credit risk, lessors residual risk.

While macro trends are important investing in aviation requires insight into aircraft type residual values and a team of aircraft finance and remarketing professionals. And, investors must ultimately be able to analyze and enforce contractual rights under transaction documents. Global economic growth continues. The air carrier industry is profitable.

With global economic growth continuing, aircraft type investment requires a long view of transaction analytics, including tax, accounting, legal, economic transaction pricing, and future residual values. For profit insight, call RESIDCO.

 

[1]: In 2017, nine ABS transactions were closed, the most since before the financial crisis.

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