There's a large, safe, efficient market in tax-advantaged securities for corporate investors. So why don't more companies pursue opportunities that yield the highest return on their cash? Here's what you need to know about the risks and rewards.
Scenario One: As controller of a consistently profitable company with a growing hoard of surplus cash to invest, you take time to study the short-term yields that are available within your investment guidelines.
Your bank's 4.82 percent overnight rate roughly matches its 4.80 percent one-month CD rate, but you can earn 5.04 percent on a three-month T-bill and 5.41 percent on one-month commercial paper rated A1/P1. You can get the credit quality and diversity you require in the commercial paper market, so you make the obvious choice and move 80 percent of your surplus out of the bank into commercial paper. That's 59 more basis points — $3,540 a year on a $600,000 investment. Not bad for a morning's work.
Maybe. But that $3,540 is taxable income, and at your 35 percent federal income tax rate, your after-tax yield is only 3.52 percent. Of course the bank return was taxable income, too, so you still raised the effective after-tax yield by almost 39 basis points.
But you skipped over tax-exempt variable-rate preferred stock. It didn't catch your eye because it was yielding a paltry 3.57 percent on 28-day maturities. But because it is tax-exempt, the after-tax yield also is 3.57 percent, five basis points higher than the after-tax yield on the commercial paper you bought.
Scenario Two: You are controller of a high-tech venture with a potential blockbuster product in the late stages of development. You are also flush with cash after a successful $4 million initial public stock offering. You know how much your entrepreneurial bosses hate taxes, so you invest the $3.2 million surplus left over from the stock sale in tax-exempt preferred stock yielding 3.57 percent.
Dumb move. Since your keystone product isn't even in production yet, there are no sales and no taxable income. Your operating expenses easily will exceed your investment income, so your company will pay no taxes this year, and in your case, taxable commercial paper yielding 5.41 percent provides an after-tax yield that is also 5.41 percent. You just cost your company 184 basis points or a whopping $58,880 (annualized) on your $3.2 million kitty.
Welcome to the world of tax-advantaged investing, where what you see isn't always what you get, where you may need a good calculator to compute the after-tax taxable equivalent yields on your investments, and where you have to consult regularly with the tax department to be sure your investment strategy stays in step with the company's tax status.
Sure Boost for Taxpaying Firms
Yield spreads between taxable and tax-advantaged securities will fluctuate, but companies in the 35 percent income tax bracket almost always will earn more after-tax income from tax-advantaged securities. Otherwise, these securities would have no buyers, points out Ronald C. Hart, an Atlanta-based Merrill Lynch senior vice president, who specializes in corporate cash investments.
In spite of this well-established fact, many companies that would benefit from tax-advantaged investments do not use them, he says. They're just not aggressive about pursuing the highest effective yields, plus they are used to doing business with banks, and banks generally don't have tax-advantaged paper to offer.
Also, the market keeps the reward for using most tax-advantaged securities relatively modest. Unless a taxpaying company really has a lot of cash to invest, the small gains may not justify disrupting a bank arrangement that is operationally efficient — i.e., one does not require active management from the controller's staff and does not entail dealers' fees and custodial accounts for safekeeping the securities.
Nevertheless, many sophisticated investors routinely use tax-advantaged instruments on a large scale, and new corporate investors will find a large, safe, efficient, liquid market in which issuers regularly issue securities designed specifically for their needs.
The available instruments that shelter earnings from federal income taxes fall into two groups:
- Municipal securities issued primarily by state, county and city governments and government agencies. Income earned on these eligible securities is 100 percent exempt from federal income taxes. This subsidy from the federal government blesses municipalities and their agencies with a chance to fund their projects at a reduced cost and blesses taxpaying investors (corporate or individual) with a slightly better after-tax return on their investment.
- Stock dividends paid from one corporation to another. Individuals pay taxes on stock dividends, but corporate investors generally are entitled to shelter 70 percent of the dividends received from corporate stock from federal income taxes.
Municipal Securities. Munis are offered in a wide range of maturities, but within the money market spectrum, seven days, 28 days, 35 days and six months are common. Major issuers are rated by Moody's, Standard & Poor's and others.
Most of the municipal paper trading in the short-term market today is rated AAA or AA. The secondary market for munis sold prior to maturity is solid but may cost you a few basis points.
However, rather than buy, hold and sell specific municipal securities, investors today are gravitating to tax-exempt mutual funds—portfolios of munis offered by Nuveen and other fund managers, Hart says. Investors simply buy and sell shares of the fund whenever they wish and qualify for the tax break. Using a mutual fund instead of direct securities usually costs them about 50 basis points in yield but offers convenience and administrative savings.
Dividend-Paying Stocks. To provide attractive securities for this market, take advantage of the lower rates they can pay and still attract investors, corporations have designed a suitable type of adjustable-rate preferred stock (ARP). To qualify for the tax break, investors must own the stock for at least 46 days, so issuers provide preferred stock that matures every 49 days, rounding the holding period out to an even seven weeks so that the stock always turns over on the same day of the week.
The ARP pays a fixed rate of interest over the seven-week period, then resets the rate, often through a process called a Dutch auction, for the next seven-week period. That auction or other reset mechanism effectively keeps the yield in line with prevailing interest rates in the short-term market.
The tax break on stock dividends, called the dividends received deduction or DRD, attracts political attention from time to time and is once again being assailed as corporate welfare. Dealers in preferred stock watch Congress carefully and say that any change this year will be token (maybe 1 percent) and not retroactive. However, if Democrats regain control of Congress, keep the White House, and get serious about balancing the budget, the DRD may be in real jeopardy.
The secondary market for ARP is spotty, but of course you lose the DRD if you sell without holding for 46 days, so ARP is not the paper to buy if you think you may have to liquidate in the secondary market.
DRD securities offer more opportunities for more aggressive yield-enhancement strategies because any corporate equities held over 46 days are eligible. Highly rated money market paper like 49-day ARP has traditionally been favored to protect liquidity and credit quality. However, current technology makes it possible to use sophisticated hedging techniques to buy higher yielding equities and hedge away the unacceptable credit and liquidity risk, while still earning a higher return than standard money market instruments pay, reports Stuart M. Goldstein, vice president of Wharton Management Group, New York.
Coping with Change in Tax Status
Controllers of companies with a stable tax status can settle into the appropriate groove and operate more or less on autopilot, but when there's a change in the corporate tax status, there also may be a need to change the cash investment portfolio.
The penalty for being in tax-advantaged investments at the wrong time is much greater than the penalty for being in taxable investments at the wrong time. It is particularly important for controllers to have lunch with the tax folks when a normally profitable company announces a major restructuring that will involve large one-time losses that might create an unusual loss on the tax books and result in no income taxes owed for the year.
Investment pros speculate, off the record, that ValuJet could be a prime example of a company that had to bail out of tax-advantaged investments quickly. The company is known to have been historically profitable and to have had a lot of invested cash. If that cash was invested in tax-advantaged securities and the company's chances for having taxable income in its current fiscal year vanished when it was grounded, then it could increase its current investment return substantially by shifting quickly to taxable securities.
When untaxed companies make the transition to profitable, taxpaying status, their controllers should look into converting to tax-exempt investments. Struggling companies that have just turned profitable seldom have large pools of investable cash, but a well-funded start-up might have large cash holdings when it turns profitable and could benefit substantially from converting to tax-advantaged investments.
One other regulatory constraint should be considered. It is economically possible for many companies to borrow large sums of money that are not needed for the operation of their business and then use those funds simply to invest in tax-advantaged securities. When the tax deduction allowed for interest payments on the debt is combined with the tax-free interest earned on the investments, a positive after-tax spread may result, rewarding investors for pursuing this tax arbitrage strategy.
The federal government does not wish to subsidize arbitrage profits, so the IRS is likely to challenge large debt pools used to fund tax-sheltered investments. The IRS has issued something called the 2 percent de minimus rule, which says that no more than 2 percent of a leveraged company's total assets can be invested in tax-sheltered instruments, Hart explains. Before making tax-exempt investments that might run afoul of the de minimus rule, be sure to consult your tax counsel.
Bob Prantis, treasurer of Xilinx Inc., San Jose, Calif., invests a cash pool that increased in size from around $150 million to roughly $400 million after the company issued convertible debt last November. This taxpaying company traditionally has kept its short-term investments in tax-advantaged instruments, but now has split its portfolio after the convertible offering.
Tax arbitrage was not our purpose, and we felt that we could still properly make all our investments in tax-advantaged instruments. But, after conferring with our tax department, we chose to keep 20 percent of the portfolio taxable, he explains.
The new funds also led to a barbell portfolio, split by maturity. The original funds have stayed short, invested mostly in 35-day paper, Prantis explains, but he moved quickly at a time when interest rates were falling to place the new money in a six- to 12-month maturity range. He prefers to use tax-exempt municipal securities rather than the 49-day preferred stock eligible for the DRD.
Xilinx still is following a conservative investment approach, he insists — just getting the best after-tax return on a cash portfolio that steers clear of credit risk or liquidity risk. All securities are rated AA or higher, he notes.
In the end, it's not how much you make on your invested cash that counts but how much you get to keep. Investment decisions always should be made with full awareness of the company's tax status and the after-tax consequences of the investments you choose.