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Major Tax and Reporting Changes Greet 2018

Changes In U.S. Law And Economy

The U.S. Economy has sustained 3% growth for two consecutive quarters. Prospects for continued growth in 2018 are strong, and there is likely to be an extra boost if tax reform is passed by Congress. Rising household wealth and job gains suggest the Federal Reserve will raise rates in December and several times in 2018. In this environment, growing air and rail transportation investment requires a strong origination team supported by a supply of competitively priced capital. Behind the business and economic analysis are the specifics of tax law, and financial reporting. How should you best prepare to manage the change expected in these areas in 2018?

The country has not rewritten its tax code since 1986. To promote economic, political, and business objectives, Congress is currently considering a major rewrite. The rewrite would achieve objectives in a ‘backhanded’ way, not through direct appropriations, but through a reduction in taxes payable. The recently passed House Bill suggests a reduction in the corporate tax rate from 35% to 20%. Existing tax law allows a deduction for business interest expense, reducing the after tax cost of borrowing. The House Bill would disallow business ‘net interest expense’ in excess of 30% of a firm’s EBITDA. Small business (with receipts less than $25 Million) would be exempted. Excess interest disallowed would be available for carryforward for five years. The House Bill would also allow the immediate expensing of the full cost of most assets with a tax life of less than 20 years. NOL rules would be altered with no carrybacks for 2018 or beyond allowed, while carryforwards would be limited to 90% of a corporation’s taxable income. If the Senate is able to pass a tax bill, the differences between the House and Senate versions would have to be ‘reconciled’ meaning provisions of a final bill remain in a state of flux. With passage, expect business transportation equipment investment to increase and drive economic growth.

Impact on Lease Investment

Financial accounting for lease investment is currently driven by the Financial Accounting Board’s Statement No. 13 (Accounting Standards Codification 840). The FASB’s new standard for Leases (ASC 842), represents the first comprehensive overhaul of lease accounting since FAS 13 was issued in 1976. The new standard was adopted in February 2016 as part of the FASB/IASB ‘Convergence Project’. It has an effective date of 2019 for public companies and 2020 for non-public companies. Since the SEC requires three years of comparative income statements for calendar year public companies and two years comparative balance sheet data, public companies are currently starting to capture 2017 lease data. Private companies should begin in that process 2018.

The new rules require balance sheet disclosure for all ‘lease contracts’ that identify a ‘specific asset’ and ‘transfer control’ of that asset to the lessee. The old FAS 13 ‘bright line’ tests for lease capitalization are officially gone, but technical ‘guidance’ in the new rules continues to allow consideration of the old FAS 13 tests to determine if a lease is to be treated as a ‘financing’. The most significant change is lessees will be required to recognize the ‘rights and obligations’ resulting from operating leases as assets and liabilities on their balance sheets[1]. The updates for financial reporting do not change the treatment of leases for income tax purposes. For book purposes an ‘operating’ lease, that would now be on the balance sheet as an asset and liability, will generate both deferred tax liabilities for the excess GAAP basis in the right of use asset and a deferred tax asset for the excess GAAP basis in the related lease liability. The new standard will generally result in accelerated expense recognition for those leases classified as ‘financing’ leases for book purposes while operating lease annual cost will be similar to the expense pattern under current operating lease accounting.

The tax and financial reporting changes are complex and can be expected to impact investment strategies. Change is the only constant. Managing change requires experienced advisors. Work with experience.

Work with RESIDCO.

 

 

 

[1] There are a few exceptions including leases shorter than 1 year (provided they do not include an option to purchase the underlying asset).

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The Big Picture

The most important decision an investor makes is the composition of his or her investment portfolio. That is what ultimately acts to determine the level and potential variability of returns. Research shows dissimilar asset classes act to increase returns while reducing risk. From an investment perspective, an aircraft or railcar under lease represents a stable and recurring monthly cash flow immune to short term swings in the market throughout the industry cycle. Real assets create real options, cash flow certainty, and economic value.

The world’s economic growth has dropped from 4.9 percent a year from 1951 to 1973 to an average of 3.1 percent for the balance of the last century. And, since 2000, GDP growth in the U.S. has been persistently low, averaging 2 percent, with world economic growth similarly sluggish. What drives market expansion and economic growth? New technologies, productivity improvements, the ability to produce, the desire to buy, access to capital, demographics, and investment in education and capital equipment. Broad based economic growth ‘lifts all ships’ creating opportunities, raising living standards, expanding access to services and most importantly allowing each of us to chart our own future.

Sound volume growth prospects are a major reason to include commercial aircraft in your ‘real asset’ investment spectrum. International air traffic has been distinguished by high growth rates. Global air traffic (passenger) has grown at an annual average of 4% in the last decade (despite 9/11 and other external shocks)[1]. This growth reflects increased globalization and the international division of labor. Air transport cost has tended to fall as a result of increased competition, improved engine technologies, larger aircraft, and lower cost jet fuel. On the rail side, the roads are focused on the fundamentals of providing reliable service and controlling cost as crude oil and coal freight volumes have fallen (there are many examples of striving to solve investment challenges only to find efforts defeated by events occurring in a larger context).

Holding air and rail investment requires management by a specialist organization. Risk management is complex and depends on portfolio credit quality and desirability of individual aircraft and railcar types. It’s not merely a question of loan or lease to value, but the relative importance of the unit to the operator, which governs whether they are likely to continue to operate the collateral in bankruptcy. In weak markets, extending the period an airline or rail carrier continues to operate the aircraft or railcar provides a better result than selling into that weak market.

Today, fixed income yields are low and the volatility and dampened expectations in the equity markets argue that portfolio construction and manager selection are critical. The future is uncertain. How do you grow and protect value over an investment horizon’s duration? It comes down to two important investment related disciplines; managing risk, and managing volatility. With investment clarity and consistent focus ‘real asset’ managers do this well. Our firm has a history of excellence, expertise and ethics. Team with experienced investment managers. Call the air and rail transportation experts.

Call RESIDCO!

[1] Source, IATA.

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Handling the Cycle: It’s Not Luck

Government taxes to encourage (or discourage) a variety of economic activities. The rates set influence the market’s required before-tax rates of return for both individual and business investments from a social standpoint, taxes are designed to finance public projects, redistribute wealth, and provide basic services. Since self-interest is basic to human nature this creates private incentives to engage in tax planning. Such planning has long earned the blessing of the U.S. Courts.

When you invest, whether you are an individual, or a business owner, the taxing authority is your silent and ‘uninvited investment partner’. Effective planning involves more than being aware of current marginal rates; it requires an evaluation of the longer term results of your decisions, not just for yourself but for all participants. Each party and counter party has their own current and future marginal tax rates. These future expected after tax cash flows affect current actions and decisions. Understanding this concept is important since it directly influences the prices at which assets are traded now, and, what future pricing might be.

Naturally, most taxpayers pay no more tax than they believe they must. And they spend their time and money to arrange affairs to keep their tax bite as ‘painless’ as possible. Remember, money spent on tax planning is ‘tax deductible’, and the tax savings generated are ‘tax exempt’ because they reduce taxes payable.

Are increased taxes good policy? In 1997, Bill Clinton agreed to lower capital gains rates to 20% based on economic literature suggesting the lower rate would yield more tax revenue. It did. Yet Hillary has proposed to nearly double the top tax rate on long term capital gains to 43.4% from 23.8%. Under current tax policy, ‘capital gains’ are taxed as ‘ordinary income’ if an investor has held an asset for less than a year. After 365 days the current top long term gains rate of 20% applies (plus the 3.8% Obama Care surtax on ‘unearned’ income). Hillary has suggested a ‘sliding scale’ approach requiring ‘capital gains’ tax rates during the first two years holding period of 43.4%, year three, 39.8%, and 35.8% in year four. Investments would have to be held for more than six years to qualify for the current 23.8%[1].

Economists generally will agree that a system of competitive markets is remarkably efficient. Remember Ronald Reagan was elected in 1980 with his message that government is ‘the problem’ and economic freedom was ‘the answer’. The dominant lesson of the Great Depression and the Great Recession is that when Government overspends, overtaxes, and over regulates, economic freedom is suppressed and economic growth is impacted[2]. How is transportation investment best and ethically encouraged? Transportation asset Investors with a sound investment strategy hold diversified asset positions intended to weather volatility on the way to their longer-term objectives. Working with a firm that has a history of excellence, expertise and ethics produces results.

Call the air and rail transportation experts. Call RESIDCO!

[1] National Center for Policy Analysis, Hillary Clinton’s Capital Gains Tax Proposal, Brief Analysis No. 825, April 14, 2016 by Pamela Villarreal.

[2] WSJ, “Why This Recovery is So Lousy”, August 4, 2016, Phil Gramm and Michael Solon.

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Washington 2017

Times are changing! Expect a pro-growth business policy agenda in Washington (with little to no Congressional gridlock). Competitive tax rates. Less restriction on energy reserves, shale, oil and natural. Approval of the Keystone XL oil pipeline. A cut in regulatory red tape and an end to the ‘war on coal.’ A reform of Obamacare and a review of trade agreements. The objective? Benefit Americans and bring back jobs. Most economists now expect higher GDP, inflation, interest rates, and tax and regulatory relief, along with a stronger dollar in 2017.

In this environment, transportation equipment leasing equipment provides both an opportunity to invest and a source of cash. While it is affected by demand and supply changes, transaction activity and trends in the overall economy, it acts as a hedge against inflation since shorter term leases have the ability to reset rates, and inflated asset values are a source of leverage. Both Air and Rail investments operate in transparent markets with predictable cash flows, downside risk protection, and relative liquidity.

The rails transport the bulk of major products for industrial and personal use. This year a bumper grain crop and record soybeans (shipments are up 6.5% this year), with autos maintaining lofty levels are offsetting other commodity groups (coal, intermodal, and petroleum) which remain challenged. Expect rail fundamentals to improve with growth in the industrial economy.

Air operates in a global network. It generates strong cash on cash returns. Inefficient older engine technology is being replaced with new engine options which produce a 20% fuel efficient operating cost per seat improvement. Warren Buffet bought the Burlington Northern in 2009. Now he is investing in airlines. His Berkshire Hathaway SEC filings show the company has taken a stake in three of the four major U.S. airline companies[3] and an undisclosed stake in Southwest. Avolon is completing the acquisition of CIT’s aviation portfolio for $11 Billion. Airlines are issuing secured debt[4].

Transportation equipment investment means the ability to earn attractive profits. Exogenous shocks do occur. The solution is to invest in real assets where equipment valuation, utilization, rent levels and fundamentals are understood. Where are the tools and processes for making these investment decisions? Where is a reliable source of strategic insight? Build your portfolio with a team of experienced transportation equipment managers who are brilliant on the basics. A team that has practical tools and experience. A firm with a history of excellence, expertise and ethics.

Call the air and rail transportation experts. Call RESIDCO!

[1]The ability to pass legislation, ratify treaties, have Cabinet members and Supreme Court Judges approved comes with party control of both Houses and Administration. Will Republicans stay united?

[2] Renegotiate NAFTA? According to the treaty, any of the three signatories can withdraw from the agreement six months after notifying the other two parties.

[3] Deutsche Bank believes the sector will benefit from lower regulation under President-elect Donald Trump. The airlines contribute $1.5 trillion to the U.S. economy, and provide 10 million jobs, November 15, 2016, Investopedia.

[4] American issues $1.21 billion in EETCs to finance acquisition of 298 new aircraft with a book value of $1.66 Billion.

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