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OVERVIEW: We have been out of consensus on the possibilities of tax reform since last summer, just like we were out of consensus on ACA reform. With Saturday morning’s Senate vote that includes both tax and health care reform, it appears increasingly likely we will be right on both. We didn’t expect it to happen in the same bill, but we will take it. The Tax Cut and Jobs Act of 2017 includes several provisions that impact health care, most of which we covered in our tax reform call on Nov. 22, 2017. Click here for replay and materials. Health care is, of course affected by those provisions of tax reform that impact most U.S. industries:
Additionally, the health care sector will be affected by three provisions unique to the sector:
The Senate action early Saturday morning means the focus for the next several weeks will be on the Conference Committee charged with resolving differences between the House and the Senate. Next steps are:
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To update our deck from Nov. 21, below is the most current status of major health care-related provisions:
CORPORATE TAX RATE
Both the House and Senate versions of the tax reform bill reduce the corporate tax rate from 35 percent to 20 percent. That change will take the U.S. corporate rate from one of the highest in the developed world to slightly below average.
The change in the corporate tax rate is a tailwind for most U.S. domiciled health care services companies. HCA and THC both report effective tax rates of 29 and 27 percent, for example.
Until Saturday afternoon, it appeared that the 20 percent corporate rate was under no threat by the Conference Committee. However, President Trump alluded to a change by suggesting to the press he would consider an increase to 22 percent. Senator Marco Rubio was not pleased. He had argued for an expanded child tax credit on Friday night but was defeated by concerns that his efforts would result in an increase in the corporate rate.
The reduction in the corporate rate is complicated by the Senate’s decision to retain the corporate Alternative Minimum Tax. Because the corporate AMT calculation does not include most credits and deductions, companies in pharma and medtech sectors that get the benefit of large Research and Experimentation credit may suffer.
Likely Conference Committee outcome: 20-22 percent corporate rate with repeal of the corporate AMT
TAX RATE FOR PASS-THROUGH ENTITIES
The differing approaches between the House and the Senate on how to level the playing field between pass-through entities and C-Corps is one area of substantive differences. The House has favored a flat 25 percent rate on all passive income and a bifurcation of other income into “business income” and “ordinary income.” The business income associated with the pass-through would be taxed at 25 percent while the ordinary income would be taxed at the appropriate individual rate.
The Senate took a different approach. Instead of applying a flat rate to business income, the upper chamber is proposing a 23 percent deduction on Qualified Business Income of pass-through entities until 2026. Qualified Business Income is defined as all domestic business income other than investment income. Investment income includes dividends, other than those paid by REITs, interest income, short-term capital gains, long term capital gains, etc. For pass-through entities other than sole proprietorships, the deduction cannot exceed 50 percent of wages paid to employees and owners/shareholders.
Health care providers like physician’s practices and ambulatory surgery centers as well as clinical research organizations are frequently organized as pass-through entities. The lower effective tax rate for the members of these organizations will mean a tailwind for entities that sell into pass-through entities, like device makers and health care IT.
Importantly, both bills include REIT dividends in the preferential tax treatment of pass-through entities. The House bill accomplishes this change through a 25 percent rate applied to passive income. The Senate meets a similar goal by applying a 23 percent deduction to REIT dividends. No matter which approach prevails, dividends from health care REITs like SBRA, HCP and HCN would be subject to a tax rate below the top individual marginal rates.
Although not an issue for health care investors, the special treatment of REITs in the Senate bill gave rise to concerns about disparate treatment of other publicly traded pass-through entities. For that reason, the final Senate bill applies the 23 percent deduction to publicly traded partnerships like Master Limited Partnerships and LLCs.
Likely Conference Committee outcome: Senate approach of 23 percent deduction, however application to REITs and publicly traded pass-through entities may get tossed overboard in response to criticism regarding the benefits to Blackrock and political influence of Steve Schwartzman.
INTEREST EXPENSE DEDUCTION
Both bills include provisions that limit the net interest deduction to 30 percent of a company’s adjusted taxable income. The Senate bill defines adjusted taxable income as a corporation’s taxable income computed without regard to deductions for net interest expense, net operating losses and other adjustments as determined by the Secretary of the Treasury. The House version adopts the current law definition which excludes from the calculation net interest expense, net operating losses, depreciation and amortization.
The difference between those two definitions will be important. Applying the 30 percent limitation to EBIT will affect a good many more businesses than if applied to EBITDA and the score from the Joint Committee on Taxation reflects that fact. The Senate provision is expected to increase revenue by $308B over ten years. Using the House definition increases revenue by just $171B. If the conference committee adopts the House definition, they would need to find budgetary offsets elsewhere.
Amounts that would be disallowed – net interest expense in excess of 30 percent of adjusted taxable income – could be carried forward to future years.
The House and the Senate bills also limit deductibility of multinationals that, due to the high corporate tax rate, have incentives to originate debt in the U.S. For a U.S. corporation that is a member of an international financial reporting group or, in the parlance of the Senate, a worldwide affiliated group, the deductibility of net interest expense would be limited to the extent the U.S. corporation’s share of the group’s global net interest expense exceeds 110 percent of the U.S. corporation’s share of the group’s global EBITDA. This limitation would apply in addition to the 30 percent limitation discussed above.
The Senate bill includes a provision that phases in the multinational interest limitation from 130 percent in 2018 to 110 percent in 2022.
The limitation on interest expense is, of course, a negative for highly leveraged domestic and multinational companies. Health care is more highly leveraged relative to other sectors.
The difference between applying the 30 percent limitation to EBIT or EBITDA will have a meaningful impact on how much the change affects companies. For example, HCA, will be close to the 30% limit as a percentage of EBIT but not as a percentage of EBITDA:
Likely Conference Committee outcome: Limit of net interest deduction to 30 percent of EBIT and phased –in limitation for multinational corporations.
COST RECOVERY
Both the House and Senate bills call for full and immediate expensing of qualified property acquired and placed in service in 2018 through 2022. This provision represents an increase in the permitted depreciation from 40 percent in 2018 and 30 percent in 2019. Eligible property includes tangible personal property with a recovery period of 20 years or less under MACRS and certain off-the-shelf computer software.
The Senate version of the provision retains current law requirements that eligible property be new and placed into service for the first time by the taxpayer. The House version repeals the requirement that original use of the property begins with the taxpayer. The Senate version includes a longer phase-out of the provision. Instead of terminating on Jan. 1, 2023, the additional depreciation would be available until 2027 in stepped down percentages.
The intent of the provision is to encourage investment. At least in theory, the change in cost recovery rules should be a tailwind for equipment manufacturers like HOLX. However, health care industry has not historically taken advantage of the additional depreciation like other capital-intensive sectors including manufacturing and utilities.
In 2013, when bonus depreciation was 50 percent, the primary beneficiaries were manufacturing and utilities:
Likely Conference Committee outcome: Full and immediate expensing for qualified property until 2023 with phase out through end of 2026. Eligible property will be new and used for the first time by the taxpayer.
REPATRIATION AND CHANGES TO TREATMENT OF FOREIGN INCOME AND TAXES OF U.S. CORPORATIONS
Changes to the way in which the U.S. treats the income of foreign subsidiaries of U.S. corporations is the raison d’être of the tax reform bill. These changes are designed to repatriate stranded overseas income and put an end to practices that encourage its accumulation and other unproductive tax-driven practices.
Changes to the treatment of foreign earnings must be considered together and in conjunction with the new, reduced tax rate of 20 percent, which is globally more competitive than the current 35 percent rate. The major changes included in both the House and Senate versions of the bill are:
- Foreign source portion of dividends paid by a foreign corporation to a U.S. company that is at least a 10 percent shareholder would be exempt from U.S. taxes
- Indirect foreign tax credits and deductions would be repealed
- Excise tax on inversions of 12.5 (Senate) to 20 (House) percent would be assessed
- Tax holiday of 14 percent (House) to 14.5 percent (Senate) of liquid stranded and 7 percent (House) to 7.5 percent (Senate) of illiquid stranded overseas income payable over eight years
Additionally, the Senate version includes a number of provisions that recognize the impact of changes to the treatment of foreign income has on businesses heavily dependent on intellectual property:
- U.S. shareholders of a Controlled Foreign Corporation must include on a current year basis their global intangible low-taxed income similar to the treatment of subpart F income
- U.S. corporations would be allowed a deduction of 37.5 percent for years 2018-2025 and 21.875 percent thereafter for foreign derived intangible income
- Controlled Foreign Corporations would be permitted tax-free transfers of intangible property to U.S. corporations
When taken together, these changes use a carrot and stick approach to repatriating capital and discouraging future accumulation overseas. The carrots include reducing the U.S. federal corporate tax rate to 20 percent while eliminating deductions and credits for foreign taxes paid that result in low effective tax rates. Other carrots include a tax holiday for stranded overseas income and tax free transfers of intellectual property. Other sticks include excise tax assessments on inversions.
Other than the tech sector, there is no other industry more affected by changes to the tax treatment of foreign subsidiaries. Health care companies represent a significant amount of stranded overseas income:
Over the short term, the repatriation of some or all of this stranded income will provide a nice tailwind, likely in the form of buybacks and M&A. Because the repatriation window is open for eight years, however, the impact will be more diffused than with prior efforts to attract stranded income back to the U.S.
Over the long run, multinationals will have a tougher time manipulating their tax rate. SYK, 70 percent of whose sales are in the U.S., has seen their effective tax rate drop from 55.6 percent in 2014 to 12.3 percent in 2016, largely as a result of establishing an EU regional headquarters and strategically deploying intra-company transfers. Assuming no benefit from foreign taxes and similar repatriation patterns as 2016, SYK’s effective income tax rate could increase from 12.3 percent to 21.5 percent as a result of tax reform.
For PFE, the story is a little different. Again, assuming no changes other than elimination of the tax benefit created by foreign income, PFE’s effective rate could drop from 13.4 percent to 12.2 percent. The impacts that occur will depend on how aggressively a company has exploited the U.S. treatment of foreign earnings.
Likely Conference Committee outcome: Split the baby on excise tax and repatriation rates, adopt Senate’s IP provisions.
ELIMINATION OF INDIVIDUAL MANDATE PENALTIES
The big news for health care is the Senate’s version of the tax reform bill reduces penalties for the individual mandate to zero, having the same effect of repeal.
There are few objective studies on the role the individual mandate plays in decisions to purchase health insurance. We do know that the mandate has been weakly enforced since implementation. We also know that insurers have frequently factored weak to no enforcement into their pricing.
In 2014, eight million individual tax returns included the individual mandate penalty. In 2015, that figure fell to 6.6 million but is expected to rise in 2016 in response to the increased coverage costs associated with exchange policies. In any event, anywhere from 12 to 16 million people, assuming a return represents 2-2.1 people, are opting to pay a penalty instead of enrolling in a health insurance plan.
If the individual mandate does not factor into health insurance coverage decisions, it most definitely drives the politics. Headline numbers that announced CBO estimates of 23-24 million more uninsured people drove Congressional sidelined efforts to repeal the ACA last summer. What went unnoticed for many is that a significant driver of the CBO’s estimates was the individual mandate.
For example, the CBO’s score of the House-passed American Health Care Act suggested that 10 million people total would exit Medicaid coverage in 2018 and 2019 even though the AHCA made no changes to the Medicaid program until 2020. Similarly, the CBO projected 4 million people would leave their employer-based insurance between 2018 and 2019. The AHCA made no major changes to employer-based insurance.
These estimates are, of course, the result of effective repeal of the individual mandate identical to what is in the tax bill. The CBO has since walked back their estimates of the impact of ending the individual mandate but it retains its influence.
The end of the individual mandate penalties means that any subsequent changes to the ACA will not include this provision and the resulting legislation will not garner the dramatic headlines of the estimated uninsured. Further, any changes to the ACA that might encourage enrollment, such as a revival of the reinsurance program, will likely result in a CBO score that reduces the uninsured rate and making it easier to find the necessary 60 votes in the Senate.
In short, an end to the individual mandate means supporters of the ACA will have one less defense to mount, making additional changes to the law more likely in the future.
Likely Conference Committee outcome: End to individual mandate penalties.
ORPHAN DRUG TAX CREDIT
The House version of tax reform calls for complete repeal of the orphan drug credit. The credit is available to research organizations for up to 50 percent of qualified expenses. The Senate version simply reduces the credit from 50 percent to 27.5 percent.
The Senate version makes another distinction. The orphan drug credit would not apply to testing a drug if the drug has previously been used to treat any other disease or condition, and if all diseases combined affect more than 200,000 people.
The orphan drug credit is projected to cost the Treasury $75B over ten years due largely to the proliferation of orphan drug designations. Congress has taken note of this increase and is looking to rein in growth.
Likely Conference Committee outcome: Credit is retained but Senate version applies
MEDICAL EXPENSE DEDUCTION
In a deal with Sen. Susan Collins, the Senate version includes a restoration of the pre-ACA threshold for deducting medical expenses to 7.5 percent from 10 percent of Adjusted Gross Income for two years.
This provision was included in ACA repeal bills throughout the summer in both the House and the Senate so there is very little disagreement among Republicans about its inclusion.
Likely Conference Committee outcome: Pre-ACA 7.5 percent threshold is restored for two years
Call with questions, thoughts and ideas. Staying up late reading the fine print is in our job description which means we may also be qualified to serve in the U.S. Senate.
JT Taylor
Managing Director
Macro Policy
Ext. 273
@HedgeyeDC
Emily Evans
Managing Director
Health Policy
Ext. 231
@HedgeyeEEvans
