Proposed Tax Changes Would Affect Cash Flows and Valuation

September 10th, 2010 by hackel Leave a reply »

The Obama administration’s proposal to make the research and development credit permanent and to allow for a temporary 100% tax deduction for qualified capital expenditures is sure to boost cash flows.  However should the IRC deduction 199 benefits be rolled back for the major oil companies, as is being currently discussed,  the impact to certain firms could be harmful in out years.

Other firms, many of which are not obvious candidates for the 199 benefit, have seen drops in both their effective and real tax rates. For example, in its March, 2010 10Q, World Wrestling Entertainment Inc. (WWE) explained its reduction in its effective tax rate, from 35% to 33%, was due to the 199 allowance.

All US enterprises with productive capacity take advantage of the 199 provision.

Enacted in 2004 as an export tax incentive, this provision allows a deduction, as a business expense, for a specified percentage of the qualified production activity’s income (or profit) subject to a limit of 50% of the wages paid that are allocatable to the domestic production during the taxable year. The deduction is 9% for 2010.

Analysts must determine the effects a rollback would have on a case by case basis as many oil majors are already in a low “cash rate” despite reporting a higher effective rate. To the extent capital spending is continuing to grow, the positive impact of the 100% deduction will overcome the loss of the 199 credit in those tax years. However, the loss of later years tax depreciation (as this is a temporary measure), combined with the loss of the 199 credit, will most likely force these same enterprises into a much higher tax rate.

Kenneth S.  Hackel, CFA.

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