WORLDVIEW: Tax reform could trip up high-growth US tech sector

Last year’s US tax overhaul was widely seen as positive for American companies – it lowered the corporate tax rate and created an opportunity for US companies to repatriate overseas profits (which some shareholders are hoping to see distributed as cash dividends). However, some analysts are worried that tax reform may actually turn out to be negative for at least one key US sector, namely the powerful, high-growth technology sector. There are two reasons for the concern. The first issue is a problem of relativity. According to S&P Global, the tech sector has historically paid a relatively low tax rate compared to other industries in the US (see chart). That means that tech stocks will benefit less from the fall in the US corporate tax rate than other stocks (which pay a higher rate and thus will see a bigger relative boost). This means that the tax overhaul could benefit other sectors more than it benefits tech, changing market dynamics which have tended to favour tech. As a result, other stocks could rise faster than tech stocks, putting the sector at a relative disadvantage. The caveat here is that tech companies, which have spent years hoarding cash overseas, will benefit more than most from the repatriation clause in the tax overhaul. Tech companies are likely to bring a lot of cash home under the new provisions. Obviously, they will have to pay a fairly sizeable tax charge on their offshore cash holdings, which will hit earnings – for example, Microsoft reported a quarterly loss of $6.3 billion in January that was wholly due to a $13.8 billion tax payment the company made with respect to its offshore cash. However, once repatriated the cash can be distributed to investors or invested to boost growth, both of which are positive for the sector. Nevertheless, Goldman Sachs took the relativity story seriously enough to cut their tech stock weighting when the tax overhaul was enacted. This is not a risk to disregard. The second issue has to do with credit quality. This is a little complicated, but it’s important. Basically, rating agency S&P has argued that the tax overhaul is credit-negative for the tech sector. While the sector will see some improvements in earnings due to lower taxes and will gain access to offshore cash resources, S&P believes that the industry’s credit profile will weaken over time. This is because so far, tech companies have enjoyed tip-top credit ratings because of all the cash they have overseas. For years, Apple, Microsoft, Google and the rest of them have been hoarding cash overseas and borrowing money in the US to do share buybacks and pay dividends. Their offshore cash has served as security for their loans. But if they repatriate the cash and spend it all on dividends or new investments, suddenly they look a lot riskier from a credit perspective. They still have the debt, but the cash is gone. Bottom line: the tax overhaul may be good for the S&P 500, but it may not be quite so good for the FAANGs. And since the FAANGs and other tech stocks have been a major driver of overall stock market growth for the last few years, this could mean that the next few years look very different for investors.  - Felicity Duncan