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Inbound Capital Equipment Investment

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.

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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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