How Tax Law Changes Affect Investment Planning
Recent tax law changes provide an opportunity for rethinking investment planning. Consider how you might optimally structure investment in air and rail transportation equipment in today’s tax environment. Planning offers advantages when a solid understanding of the various ‘decision contexts’ that give rise to tax opportunities are understood. Efficiency is gained from integrating this strategy into the larger equipment investment, management, and residual remarketing picture.
The objective is to develop a ‘framework’ for thinking about how tax affects investment. Investment requires capital. Capital availability depends on the comparative profitability of financing alternatives. Financing alternatives are impacted by tax law. This upfront understanding is necessary since it oftentimes is costly to adjust investment structure and financing decisions once they are made.
Tax and Investment Planning for 2019
Effective planning requires consideration of the implications of investment on all parties. Everything being equal, and barring restrictions or limitations on income shifting, taxpayers would prefer to have income taxed at the lowest rate (or, not at all!). It is always desirable to defer paying tax as long as interest is not being charged on the tax liability. This approach requires a ‘global’ or ‘multilateral’ approach, rather than a ‘unilateral approach.
Consider both explicit and implicit taxes. Explicit taxes are the dollars paid directly to the taxing authority. Implicit taxes appear in the form of lower before tax rates of return on certain investments. In any planning effort, all cost should be considered. Tax represents only one of many. An example: the dollars you spend on tax planning are considered a tax-favored activity since for business that investment is generally tax deductible, while the payoffs (reductions in tax payable) are effectively tax-free. The higher your marginal tax rate, the higher the returns you will enjoy from your planning efforts.
Tax strategies involve the level of tax, relative rates across different activities, entity types, tax regimes, and structuring the use and economics of timing and payment of tax. Life would be simple if tax rules were unambiguous. But the tax rules are far from clear. Even if you could claim to have committed to memory the entire Internal Revenue Code, you would be able to resolve only a small degree of ambiguity in many of your investment structuring activities. Over the years taxpayers have displayed considerable ingenuity in attempts to manage this exposure.
Understanding The Impact of Tax
Understanding tax mechanics allows you to become a leader rather than a follower in business and investment activities. The rules of the game constantly change, and structuring alternatives have a real-world impact on investment returns. Are taxes ‘fair’? Of course, they are. They’re fair when someone else pays, and ‘not fair’ when you pay. That is why investment tax strategies have value!
Air and rail investment that combines efficient entity structuring with in-service equipment and experienced equipment management and remarketing have substantial value. Think ahead! Whether the Tax Cuts and Jobs Act remains in place will to a large extent be determined by the party in control of Congress. Taking advantage of opportunities now will ensure your investment is as protected as possible.
We’re rethinking air and rail investment. Contact RESIDCO.
Changing Legal Landscape
With a highly developed, liquid, and efficient secondary equipment market, strong corporate governance, and stable legal institutions, the U.S. has traditionally provided foreign investors with a stable and welcoming market. Prior to the recently passed Tax Cuts and Jobs Act (“TCJA”, the “Act”), there was a tendency to lend into the US and benefit from the tax rate arbitrage between the U.S. and foreign lending jurisdictions.
Now, with the passage of the pro-growth TCJA and reduction in regulatory hurdles, we can expect more foreign direct investment in the U.S. equipment leasing equity and debt financing markets.
With respect to inbound investment, the most groundbreaking changes under the Act include the lowering of the U.S. corporate tax rate to 21%, implementation of new NOL deduction and carryforward rules, new and more stringent interest expense deduction limitations, the denial of interest expense deductions from hybrid* transactions and entities, and the new base erosion and anti-abuse tax.
*Hybrid transaction structures are designed to create ‘stateless income’ through the manipulation of differences in the treatment of entities under the laws of different jurisdictions.
Equipment Investment
There are many different types and methods of investment, such as the direct acquisition of a capital asset or the purchase of an equipment leasing portfolio. Cross-border investment has been addressed by the Organization for Economic Co-operation and Development (OECD) through its Base Erosion and Profit Shifting (BEPS) legislation which is designed to address the practice of shifting profits and assets across borders to minimize overall global taxation.
The TCJA adds a new Base Erosion and Anti-Abuse Tax (“BEAT”) designed to provide a disincentive to ‘erode’ the U.S. tax base by making deductible payments (including interest and royalties) to foreign related parties. It’s largely aimed at inbound investment and its anti-base erosion provisions effectively apply a 10% minimum tax for taxable income adjusted for base erosion payments (but only for businesses where US gross receipts are greater than $500 Million, aggregated on a global group basis).
Additionally, highly levered foreign-owned capital-intensive businesses will be impacted by the denial of interest and royalty deductions from “hybrid” transactions.
Invest Now
U.S. affiliates of majority foreign-owned firms produce more than a fifth of all U.S. goods exports. With the first major reform of the U.S. tax code in 30 years, the Act is extending U.S. domestic economic growth. Combined with a renewed focus on enabling businesses to operate with greater efficiency, “There has never been a better time to invest, grow, and create jobs in the United States.”
The scope of the implications of inbound investment changes, particularly in the context of inbound financing structures may cause many inbound financing structures to fail to qualify for the portfolio interest exemption (The ‘portfolio interest exemption’ allows a non-U.S. lender to avoid U.S. tax on U.S.-sourced interest income).
As a result, an understanding of individual fact patterns is necessary to determine the net effect of these reforms on specific foreign direct investment activity. Drawing conclusions remains a question of working through the rules on a fact-specific basis, making assumptions, and assessing the impacts. And, with the upcoming 2018 midterms might there be a shift in the balance of political power? Will tax reform survive in part or in whole?
For inbound capital equipment investment and management solutions, Call RESIDCO.
U.S. Economic Expansion
Revenues among the leading airline groups rose more than 10% last year and operating profits remain at historic highs. The economic indicators that make up the Conference Board Leading Economic Index were up .2% in May suggesting we may be approaching a ‘late growth stage’ of the current cycle. Most U.S. economic expansions have lasted more than three years, while recessions typically no more than 18 months. The current expansion started in June 2009 and will become the longest on record in July 2019 based on National Bureau of Economic Research figures that go back to the 1850s.
Growth in Aviation
The Aviation business continues to enjoy global traffic growth with 7% growth in RPK this year (well above the 20-year average of 5.5%) and cargo growth of 4%. We are in an expansionary period. But headwinds have begun to appear as inflation is near the Fed’s 2% target (expect a continued and gradual rising interest rate environment). Tariffs and trade negotiations are generating turbulence. The Asian markets are significant (Boeing has said China will need 5,730 single-aisle planes during the next two decades). Labor pressures, rising interest rates and jet fuel price volatility are all squeezing operating margins. And, on the horizon is a looming pilot shortage.
As we approach late stage growth in the current business cycle, industry operations have stabilized amid continuing strong passenger demand and the unbundling of ancillary ‘service’ revenues. Both have allowed carriers to cover climbing unit cost.
Aircraft Investment
In this environment investing in aircraft is a good business, even when financing aircraft to less than stellar credits, and even if we’re headed into what appears to be risky jurisdictions. Buffet’s Berkshire Hathaway manages a $200 Billion portfolio; he returned to investing in the aviation industry in 2016. Recently he has been increasing his investment in SWA and Delta, operators that have the best return on invested capital. Return on invested capital (profit margins multiplied by asset turns) measures how efficiently aircraft are used. While ROA is not the same as returns to shareholder/owners due to factors such as debt, accounting policies and taxes, operators who produce a good return on assets create value. Southwest is a good example. By flying just one type of aircraft (737s), built by a single manufacturer (Boeing), they control pilot and mechanic training and cut down overall cost.
With solid U.S. growth, few economists expect a recession in the near term. Interest rates remain low and inflation is just now touching the Fed’s 2% target. As fuel, labor, and interest rates rise, IATA is forecasting profits of the world’s biggest airlines will dip. Despite cost pressures, the airlines’ return on invested capital will top their cost of capital for the fourth consecutive year. Markets are global and a focus on network planning and efficient aircraft utilization is key.
Historic high returns (over 9% annually) and low volatility. Understand aviation investment’s key performance drivers. Want answers? Call RESIDCO.
Transportation plays a fundamental role in global market integration. The traffic flows of trading nations affect the structure and location of manufacturing facilities, the frequency of trips, distances travelled, transport modes, and equipment selected.
Aviation Traffic
Global air cargo traffic is up. The heads of air cargo surveyed by IATA remain positive in their outlook for air freight and expect continued growth in volume. They are especially bullish on the outlook for cargo yields. Despite increasing trade tensions, global trade is expected to accelerate in the third quarter of 2018. The DHL Global Trade Barometer, a new and unique indicator, confirms this robustness. Growth dynamics are primarily coming from global air.
Airbus and Boeing support these growth conclusions, each having released their 20-year market forecasts at the Farnborough Air Show on July 17th. The demand numbers for single aisles, widebodies, and freighters are all up, based on passenger traffic growth and driven by expected aircraft retirements. The industry’s demand cycle shows no sign of slowing.
Rail Traffic
Rail traffic is up. Traffic on U.S. Class One carriers for the week ended July 7th totaled 485,193 carloads and intermodal units, up 8.6% from the same week in 2017. Carloads were up 5.4% while intermodal volume was up 12%. Nine of the ten carload commodity groups posted year over year increases, led by petroleum (21.4%), grain (17.7%), and nonmetallic minerals, including frac sand (up 7.1%).
Global Trade
Global trade remains potent even in the face of rising interest rates, oil prices, and potential tariff disruption. Second-quarter GDP increased 4.1% boosted by consumer spending and business investment. Investors and Nations pursue their own best interest and prosperity. Recent U.S. steel tariffs are an example[2]. Steel plays a critical role in building infrastructure and in national defense.
Chinese state-owned enterprises have willingly paid the price of economic inefficiency to accomplish political goals. In free market economies, private industry needs long-term confidence to invest. China’s government subsidies have led to global excess steel capacity, increased exports, depressed world prices and hollowed out other countries’ steel producing industrial bases. As long as it continues China is happy. When America no longer has the productive capacity, China will have won the war without firing a shot.
Some Americans are shocked the U.S. is moving to protect American productive capacity (or that the Administration does not believe in infinite American power). European leaders are shocked their free ride might come to an end. And China is shocked that the apparent self-liquidating superpower of the West might not be so self-liquidating after all.
The advantage lies with knowledgeable players who probe for opportunities, build on successful forays, and have an ability to shift flexibly as circumstances dictate. Success comes with leverage, market position, resources, and understanding. Traffic is robust. Contact RESIDCO today.
Rail freight transportation has grown over time with the expansion of the population and economic activity in the U.S. The markets are dynamic. Freight demand is driven primarily by the geographic distribution of the population and the level of economic activity (consumer spending and online ordering have made UPS the largest single rail customer). The U.S. freight rail system owns and operates more than 138,000 track miles and is the dominant mode by tons and ton-miles for shipments moved between 750 to 2,000 miles. Major categories of rail freight flow include:
Intermodal
Rail intermodal volume in 2017 was a record 13.7 million containers and trailers, accounting for 24% of total revenue for major U.S. railroads (and up 7% in the second quarter of this year compared to the same period last year). Intermodal has become the largest single source of U.S. freight rail revenue. Exports and imports count for about half of the U.S. intermodal traffic. Chicago and Los Angeles/Long Beach are the top U.S. metropolitan areas for intermodal volume. In these long-haul markets, double-stack trains are more cost-efficient and environmentally friendly than transportation by truck.
Coal
Coal volume has declined in recent years, but coal remains a crucial commodity for U.S. energy production (and for the railroads). In 2017 coal accounted for 32.2% of originated tonnage for the Class Ones, far more than any other commodity; 522.5 million tons of coal were loaded, up from 491.7 million tons in 2016 (coal shipments accounted for 14.8% of rail revenues in 2017, behind only intermodal).
Most coal is consumed at power plants with 70% delivered by rail. Different fuels dominate electric generation in different states; for example, in Indiana coal accounts for 72% of electrical power generation, while in California coal accounts for virtually none. The key to coal’s future lies in the demand for electricity. If natural gas exports result in an increase in gas prices, expect coal-based generation to be more competitive.
Crude Oil
Historically, pipelines transported the most crude oil. But crude oil production outpaced growth in pipeline capacity and railroads filled the gap. As crude oil output surged, so did crude oil carloads on U.S. railroads. Rail can serve nearly every refinery in the U.S. giving market participants the flexibility to shift product to different places in response to market needs and pricing opportunities. And, rail infrastructure can be expanded more quickly than pipelines.
Grain
The U.S. is the world’s largest grain producer (an average of 569 million tons per year from 2008 to 2017). As of the end of 2017, the North American grain car fleet consisted of nearly 283,000 railcars. Class One’s originated 1.46 million carloads (5.1% of all carloads, 144.1 million tons, or 8.9% of tonnage). The grain markets are complex and are influenced by weather, soil, consumer demand (both in the U.S. and for export), crop yields, competing grain exporting countries, exchange rates, government policy (think ethanol) and ocean freight rates.
Chemicals
Rail originated 2.1 million carloads of chemicals (7.4% of total carloads, third behind coal and intermodal). The vast majority of chemical traffic includes industrial chemicals, plastics, fertilizers, and other agricultural chemicals. The highest volume chemical carried by U.S. railroads is ethanol. Historically only coal and intermodal have provided more revenue to railroads than chemicals.
Investment in transportation equipment is made when earnings are robust enough to attract the capital needed to pay for it. With multiple opportunities available, you need to be alert to the risks and rewards of your decisions. To do that you’ll need the experience to evaluate current transportation facts.
Identifying alternatives, coping with uncertainty. For Rail Investment Opportunities Call RESIDCO.
Farnborough Airshow 2018 Showcases Robust Commercial Aircraft Demand
Farnborough Airshow 2018
The 2018 Farnborough Airshow is an aviation industry networking hub connecting over 1,500 exhibiting companies and 73,000 trade visitors. Held every two years, this year the Farnborough Airshow takes place between Monday, July 16, through Sunday, July 22.
As global GDP has grown, the demand for passenger and air cargo traffic has followed. Faster transit times for passenger and high-value cargo, higher density city pairs, global connectivity needs and rising affluence among the global middle class are all driving above-trend growth in load and utilization rates.
Airbus
Airbus agreed to acquire a majority stake in Bombardier Inc.’s C Series October last year and has rebranded the aircraft as Airbus 220. Just last Tuesday they announced an order for 60 A220-300s aircraft with JetBlue.
The A220 comes in two sizes (with a single type rating for pilots) and serves the 100 to 150 seat market segment. It’s primarily a composite airframe with flight control managed by an electronic interface (fly-by-wire, not mechanical), using Pratt & Whitney’s PW1500G, a geared turbofan engine (bypass ratio of 12:1), which delivers lower fuel burn per seat (The A220 offers 29% lower direct operating cost per seat compared to the E190, with fuel cost 40% lower and non-fuel cost 22% lower). It’s able to fly both high-frequency short missions and longer trips that include trans-continental U.S. flights.
Boeing
Boeing enjoyed $134.8 billion in net orders in 2017 from 71 customers and extended its backlog to a record 5,864 planes (approximately equal to 7 years of production).
Last week, Boeing announced a strategic partnership with Embraer to counter Airbus’ A220. Boeing is expected to take an 80% share in Embraer’s commercial airplane and services business, with Embraer owning the remaining 20%. The venture, which is subject to Brazilian lawmaker review, will position Boeing to serve the smaller single-aisle aircraft while giving Embraer access to Boeing’s sales network and ability to negotiate lower prices from suppliers.
China
Traffic varies by region, and according to the latest edition of IATA’s 20-year air passenger forecast, Asia-Pacific will be the biggest driver of growth with more than half of new passenger growth coming from the region. China is expected to overtake the US as the world’s largest aviation market around 2024. Boeing currently delivers approximately 70% of its aircraft to non-U.S. customers (with China accounting for 20% of Boeing’s order book).
Politically, China is a ‘collectivist’ society and dependent on central government management. President Xi Jinping envisions a globally competitive aerospace industry and reduced dependence on foreign aircraft makers. China’s two state-owned aircraft manufacturing groups (COMAC, and AVIC) have accelerated development through acquisitions of U.S. aircraft and avionics companies and partnerships with US companies. The price for access to Chinese markets has been required sharing of advanced technologies. This eliminates the need for Chinese investment and speeds their entry into global markets.
The size and future attractiveness of the Chinese market have led western business to invest in China. That investment is working to create a country competitor. Who will have leverage in U.S.-China trade disputes? Most of the planes targeted by recent Chinese tariffs appear to be older versions of the 737.
Yet if China were to cancel orders for newer Boeing aircraft it would be forced to turn to the second-hand market for aircraft (Airbus is booked and struggling to deliver). The result? Expect existing aircraft values to benefit.
Identifying competitive challenges and coping with political uncertainty. For competitive insights and Aviation economic analysis- Call RESIDCO.
Transportation equipment investment is a long-term play. While the Conference Board’s index of leading economic indicators suggests the U.S. economy will enjoy solid growth through the end of this year, there are areas where headwinds and complexity exist.
China and America’s Trade
The Trump Administration imposed 25% tariffs on $50 billion of Chinese goods “that contain industrially significant technologies.” The purpose is to stop the forced transfer of U.S. technology (and mandatory joint ventures as a condition for doing business in China). China’s theft of intellectual property and their refusal to let American companies compete freely threatens millions of future American jobs.
China’s “Made in China 2025” plan is to make a China-dominated Eurasia an economic rival to the American dominated transatlantic trading area. The plan prioritizes ten sectors including Advanced Information Technology, Aerospace, Aeronautical Equipment, and Rail transport. But without a free domestic market, China’s production bears no relation to demand and is export driven. Its state-owned company contracts are simply the beginning of negotiations, and cyber warfare and technology theft are embedded in their state-controlled business model.
Evaluating the risk of engaging in a serious ‘Trade War’ and measuring its unintended impact on global economic activity, supply chains, and Air and Rail transportation equipment is critical.
Energy
Oil prices have risen 50% compared to last year. Given the difficult to predict political factors at play, the near-term outlook remains clouded [1]. The Saudis and Russians have indicated a willingness to increase output in response to the geopolitical risk to supply from Iran and Venezuela. Higher oil prices will help American shale producers and increase crude by rail shipments. More oil production means more natural gas. As a result, lower gas prices are expected to reduce domestic coal consumption 2% (to 756 short tons in 2018) as gas-fired plants increase generation of electricity (up to 34% while coal-fired generation falls to 28%).
Aircraft Engines
Spare engine values continue to increase to a point where engines could represent 90% of total aircraft value at 10 years of age if current inflation trends continue. With more than 30,000 in service with over 500 different air carriers, the CFM56-7B engine is the most popular high-bypass turbofan engine in the world. The Federal Aviation Administration has mandated ultrasonic inspection of its fan blade population due to the recent Southwest incident where a fan blade fractured in-flight. Similar problems with the Rolls-Royce Trent 1000 engine (which power Boeing’s 787 Dreamliner) are forcing air carriers to idle equipment.
Rail Investment
Improving economic activity is driving rail carload traffic. It is up 4.2% for the week ended June 9th from the same week a year ago. For the first 23 weeks, carloads are up 1.3% and intermodal units up 3.6%. Rail is continuing to benefit from tight trucking capacity. The percentage of the fleet in storage fell to 18.6% (306,500 railcars, of which tanks comprise 34% of total empty stored railcars).
Over the next four years, the Canadian Pacific (“CP”) is replacing its grain fleet with 6,000 new high capacity grain hopper cars (using National Steel’s shorter and lighter car design with a 15% greater cubic volume). The CP said it will be able to fit 147 of the new cars in an 8,500-foot train, a 44% increase in capacity. CSX has removed its boxcars from the nationwide Boxcar Pool (25,000 remain in the national pool managed by TTX). This has improved CSX service levels but has put an added strain on the shrinking fleet of boxcars which now total about 122,000 cars, down from 660,000 in 1971.
Reality is noisy. To extract transportation investment signals from the noise, get smart. Call RESIDCO.
A Growing American Economy
The U.S. economy is heading into the second half of 2018 with strong momentum. Nonfarm payrolls are beating expectations. Manufacturing and construction indexes are accelerating. Economists are expecting growth through the end of the year between 3.6% and 4.8%. Economic activity, passenger, and both domestic and global air and rail freight traffic flows are growing.
The expected value of our economy is in the direction of its activities, the processes and politics that enable those activities, and the ensuing progress in technology and productive efficiency of its participants. It’s driven by expectations of the future.
While there are many software programs that take into account cost, accounting, tax, and cash flow considerations, these programs may not say anything about the future ‘risk’ of current investment. Risk tools allow originators, investors, and portfolio managers to adjust investment and portfolio structure by testing transaction exposure under different scenarios. Enterprise business intelligence tools keep investment strategy on course and allow it to react to changes.
Recognizing that market volatility often will limit any plan’s short-term usefulness it is important to take a long-term view and look to the underlying direction of economic activity, inflation, and political policy backdrop. The goal is to transform current investment opportunities into revenues that contribute the most to your long-term bottom line.
Risks To Global Growth
Over the past year, global growth has been supported by still relatively low-interest rates, central bank balance sheets, and larger government deficits. But the trend toward nationalism (and economic protectionism) increases the risk of trade tensions, deglobalization, and moderating growth.
Some risks are judged acceptable because of their returns (others may be judged too large to be compensated for). An example: credit risk is the uncertainty about the lessee’s ability to make rental payments. Such risk might be managed with structured rent streams (front-loaded, back-loaded, or level payments).
To manage credit risk, you need four pieces of information: the ‘probability of default’, how that probability changes over your investment horizon, the expected recovery in the event of a default, and an estimate of the variability of each of the previous three. Although you seldom can time the market successfully you can improve your returns by knowing where you are in the business cycle. Given that we are nine years into the current expansion we might suggest there is a relationship between the state of the business cycle and credit risk.
Analytics in Investment
Understanding investment behavior with better information allows you to prepare for success. Advanced analytics are keeping planes flying more than 16 hours a day, helping to spread operating cost. Aircraft manufacturers like Bombardier, Boeing and Airbus are using “AI” (Artificial Intelligence) to scan reams of data in order to monitor their planes in flight. So-called health monitoring on planes such as Bombardier’s C Series allows data to be analyzed more quickly and accurately, enabling preventative actions to be immediately conveyed to airlines.
AI could eventually be used on all systems of aircraft, including brakes, generators, valves, engines, and avionics to extend the life of parts, minimize maintenance disruptions and offer huge savings to operators.
Best results are created with access to a wide range of perspectives. Bill Gates once said, “Once you embrace unpleasant news not as a negative, but as evidence of a need for change, you aren’t defeated by it, you’re learning from it.” Predictive analytics monitors trends and prioritizes investment using data, experience, research, and insight. True value lies in your ability to make reliable predictions.
Leverage our insight in translating raw data into meaningful and useful investment alternatives.
Call RESDICO.
Global Economic Forecast
Investment forecasts are driven by models built on expected levels of economic activity. Shifting international dynamics and the impact of the U.S. Administration’s economic policies are driving changes.
While oil prices remained below $50 for most of 2017, recent volatility reminds us there is uncertainty as to their future direction. OPEC has raised its oil supply forecast based on US output growth. The U.S. is expected to be producing a record 10.5 million barrels a day according to preliminary weekly data from the Energy Information Administration (quickly approaching top producer Russia, which pumps about 11 million barrels daily).
Apart from the U.S., global economic growth is open to impacts from U.S. trade policy and sanctions on Russia and Iran. OPEC, along with Russia has been limiting output since January 2017, in order to drain a glut of oil that caused a historic price crash. The decision to exit the Iranian nuclear deal will mean the U.S. will restore wide-ranging sanctions on Iran, OPEC’s third-largest producer.
This and the movement of the U.S. Embassy to Jerusalem are likely to cause turmoil in the Middle East which will act to support crude pricing. Brent crude oil spot prices averaged $72 per barrel in April, an increase from March, and the first time monthly Brent crude has averaged more than $70/barrel since November 2014 (West Texas Intermediate crude is expected to average $5/barrel lower in both 2018 and 2019).
Transportation Investments Remain Promising
The U.S. and World economies are the basis for longer-term growth for both aviation and rail. The FAA baseline forecast for U.S. air carrier passenger growth over the next 20 years averages 1.9%. This baseline forecast assumes economic growth remains solid as both consumer and business spending expand (the recent Tax Cuts and Jobs Act acting as a near-term stimulus for both).
Compared to the baseline, optimistic cases are marked by more favorable business environments and lower fuel prices. Pessimistic cases are characterized by weakened consumer confidence, higher energy pricing, and higher interest rates which lead to a contraction in the commercial real estate and curtailed investment and spending. Will rising oil prices, rising interest rates, and an international shock lead to a stock market that falls sharply and an end to our long-running expansion?
Rail investment
For Rail, volume growth is continuing. Both petroleum and coal car loadings are improving. Total U.S. rail traffic for the first four months of 2018 has risen 3.2% year-over-year, is a shade below where it was in 2015, but otherwise is higher than it’s been in the last 10 years. The number of railcars in storage continues to decrease (but an oversupply remains which continues to impact demand and suppress pricing). The industry reported quarterly orders of 10,000 railcars for only the second time since the second quarter of 2015. While challenging, the North American railcar markets are improving.
Aviation investment
The Aviation industry consolidated with three major mergers in the last five years*. The bankruptcy of Republic Airlines in February 2016 is a reminder that the resulting financial pressures on regional carriers have not abated. But buried in United’s fleet plan for 2018 is the addition of 40 Bombardier CRJ200s and one Embraer ERJ-145 resulting in a net increase of 38 small regional jets in its feeder fleet. With crude oil pricing increasing, will carriers act to remove older less fuel-efficient aircraft? And, how will the U.S. act to engage with the rest of the global economy?
Industry knowledge, experience, and analysis allows us to adjust for unexpected variances in key variables. RESDICO has the investment insights that produce results. Contact us today!
*The top six, American, Delta, United, Southwest plus Alaska/Virgin and JetBlue account for more than 85% of U.S. airline industry capacity and traffic.
Investment in air and rail assets involves complex disciplines.
These include financing, legal, bankruptcy, jurisdictional analysis, documentation skills, insurance knowledge, residual collateral value expertise, tax structuring, accounting (under the new lease accounting rules), and an understanding of the after-tax cash economics of loan vs. tax lease pricing.
Secured lending is a credit risk and collateral value game. Lease finance is the preferred option, deriving value from the tax benefits the lessor passes to aircraft and rail equipment end-users. These tax benefits take the form of lower rents, flexible terms, early buyout options, upgrades, and the equipment maintenance and remarketing skills the lessor provides.
The Tax Cuts and Jobs Act and Impact on Transport Investment
The Tax Cuts and Jobs Act (TCJA) changed aircraft and rail equipment investment economics. It will change end-user equipment procurement strategies.
C Corporation tax rates have been permanently reduced to 21%, and the corporate AMT eliminated. Non-corporate pass-through entities access to a 20% ‘Qualified Business Income’ deduction is subject to various inequitable limitations and to sunset at the end of 2025.
The Act’s swift passage left application of many of its provisions unclear. As a result, technical corrections through legislative action or regulatory guidance will be required. Some of the significant provisions that affect both C Corps and pass through entities include the following:
100% Expensing
100% Bonus Depreciation is available when equipment is placed in service: 7-year MACRS for aircraft or rail equipment used predominantly in the United States, 12-year straight line for aircraft or rail equipment used predominantly outside the United States.
If the equipment is eligible for 7-year MACRS, the TCJA will permit U.S. taxpayers to elect the higher 100% bonus depreciation (or fully expense the acquisition). Access to bonus depreciation phases down for property placed in service after December 31, 2023, by 20% every year thereafter until it disappears completely in 2027. A significant change allows bonus depreciation for used equipment if the property is ‘new to you’ (note that bonus depreciation would not be available to purchases from related parties).
Ultimately, this full expensing combined with the new interest expensing limitations (see below) will make leasing more attractive.
Sale-leaseback
For example, consider a sale-leaseback. The TCJA will allow the lessor in a sale-leaseback to claim full expensing even though the user of the equipment remains the same. That means end users who have acquired and depreciated air or rail equipment will be able to enter into a sale-leaseback with a third-party lessor and continue to use the same equipment.
The sale proceeds could be used to reduce outstanding debt eliminating interest expensing limitations described below. Each pass-through entity or corporation (including members of a consolidated group) can make their own depreciation election for property placed in service, in each year, by each asset class (disregarded entities or trusts are not allowed separate elections).
However, such depreciation elections will apply to all assets in each class. That means if an entity makes a certain election for rolling stock, that election will also apply to commercial aircraft since both are in the same depreciation class.
Interest Limitation
The TCJA changed financing economics by including a limit on the current deductibility of interest expense. Section 163(j) limits the deduction of “Net Interest Expense” to 30% of the taxpayer’s EBIT (starting in 2018) or tax EBITDA starting in 2022, with any interest expense disallowed carried forward indefinitely. Eliminating a current deduction for 100% of interest translates into higher financing cost. Asset-based Bank Lenders will not be as impacted as non-bank lessors. Non-bank lessors may have to use Section 467 rent structuring to create ‘deemed’ interest income for tax purposes.
The Tax Cuts and Jobs Act provisions will require technical corrections. RESIDCO is leading a pass-through entity interest group that will explore investment alternatives and advocate for private non-corporate owned lease finance investment.
The goal? Level the competitive playing field!
RESIDCO’s size and wholesale capability is a competitive advantage. We respond quickly and creatively to ever-changing market conditions.
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