2023-04-18 13:22:32 ET
Summary
- Deep inside the Inflation Reduction Act of 2022: A pair of new taxes aimed largely at big tech.
- One is a corporate alternative minimum tax designed to hit companies like Apple and Amazon, while another is a 1% excise tax on share buybacks.
- These both kicked in on January 1, 2023, and both are likely to be raised again in the future.
- Q1 earnings reports for Big Tech stocks are the first time that most investors will learn about this.
Investors can't get enough of big tech this year, with the broad Nasdaq index ( QQQ ) now up over 21% in 3.5 months year-to-date as of my writing this. One of the stranger things about this face-ripping rally is that rising valuations have come amidst falling earnings estimates for mega-cap tech stocks like Apple ( AAPL ), Amazon ( AMZN ), and Microsoft ( MSFT ). This is fine if you're playing these names on momentum, but declining business profits vs. rising valuations are nearly always red flags for long-term investors.
Adding insult to injury, popular big tech stocks are a target of a fairly large 2023 tax increase drawn up specifically for them. Many investors are now taking the opportunity to load up on popular low-fee sector funds like Vanguard's Information Technology ETF ( VGT ) or the SPDR Technology Sector Fund ( XLK ). However, I actually think the window here before earnings may be the last clear chance traders get to sell these for higher than their fundamental value. In large part, this is because big tech profits are proving to be an irresistible piggy bank for Congress. To these points, I would fade the mega rally in tech.
New Taxes Will Eat Into Tech Profits
Deep in the caverns of the Inflation Reduction Act of 2022 , there are a pair of new taxes specifically drawn up to hit big tech. These taxes kicked in on Jan. 1 of this year, so investors are likely to find out about these new taxes when Q1 earnings are reported later this month.
1. The 15% Corporate AMT
The first is a federal corporate alternative minimum tax of 15% on companies with $1 billion or more in annual average income. Importantly, this applies to "financial statement income" and as such designed to negate the transfer pricing games that large companies have gotten so good at playing over the years. These legal tax avoidance programs have weird names like " Double Irish" and " Dutch Sandwich, " and are designed to funnel money earned in high-tax jurisdictions like the US and EU into offshore tax havens via countries like Ireland and The Netherlands . If you visit Dublin and are paying attention, you'll notice the massive glass offices of American tech companies like Google ( GOOG ) (GOOGL) and Meta ( META ). They look a bit out of place, but there's a big money reason why they're there.
With out-of-control budget deficits facing Congress, the jig is now up on these, and big tech companies are now required to pay a 15% federal corporate alternative minimum tax. This is on top of state income taxes (largely to California), so I would expect effective tax rates to be higher than the naive expectation would be from looking at past financial statements. I took an unscientific sample of big tech companies and it looks like they're paying about 12%-13% in taxes right now on average over the past few years, so this is akin to a tax increase of about 2%-3%. There's some guesswork involved because you have to account for shifting tax rates year-to-year, and also have to account for some tax paid to California by companies based there. Companies are pretty good at avoiding CA tax as well but I'd imagine they fork over at least some money. To see what any given company's corporate tax rate is, you can use Seeking Alpha's financial statement tool, for example, I pulled up Amazon , which had an effective tax rate of around 11%-12% in prior years but 0% last year due to losses.
The Congressional Budget Office confirms my handicapping as being fairly accurate. Here's what they had to say when I checked their report on the matter:
The CAMT is projected to raise $222 billion over the next 10 years, an increase of 5.8% of corporate revenues, which is equivalent to the revenue that would be raised by increasing the regular 21% rate by slightly more than two percentage points. Relatively few corporations would be affected by the tax. One study estimated about 80 firms would be affected, 16% of the Fortune 500.
Think about this! They're saying the impact on overall revenue is like raising the corporate tax rate by 2%-3%, but it only applies to these 80 companies. Raising roughly $20 billion per year with a tax that only applies to 80 companies or so is a huge tax increase on those 80 companies. Analysts have been revising earnings estimates downward for a while now, but I don't think that by and large they're aware of this yet. Since this tax only applies to companies with over $1 billion in average profits and federal tax rates under 15%, it's pretty easy to know which stocks will be hit by this. Big tech is the prime target.
If we take the CBO at its word, these new taxes are worth about $5 of S&P 500 profits, or at the current multiple of about 19x, about 95 points on the index, meaning the S&P 500 index will be a little over 2% lower than it would be otherwise. For a rough rule of thumb, you can take 5% off of the 2023 earnings estimates of big tech stocks for this new tax, thus implying about a 5% drop for tech sector funds like VGT and XLK. If you're buying big tech stocks up 20% or more this year and aren't aware of this, consider yourself warned. Additionally, the likelihood of this being raised again is fairly high, in my opinion.
2. The Buyback Excise Tax
Another nugget in the Inflation Reduction Act is a 1% excise tax on buybacks . The CBO has estimated that this will raise about $74 billion over the next 10 years, and the Biden Administration has indicated that they would like to quadruple the tax from 1% to 4%. Since the tax was passed, buybacks haven't slowed down at all. If the tax was designed to discourage buybacks, it seems to have had the opposite effect. Big companies seem to be racing to buy back as much stock back as possible before the tax is raised again. It's likely these companies' lobbyists have indicated what the writing on the wall says, so they're getting their money in while they can, irrespective of valuation.
The biggest buybacks on Wall Street belong to the usual suspects here as well- Apple is No. 1, followed by Google, Meta, and Microsoft, respectively. Here, we can add another 1% to their corporate income tax rates on top of the 5% or so that the corporate AMT is likely adding for these companies. This is another sneaky tax from an investor perspective because the immediate effect of Q1 buybacks was to create demand for big tech stocks and drive prices up, while the longer-term effect is to decrease net income after taxes. If Apple makes good on its promise to buy back $90 billion in stock this year, then that's another $900 million tax increase on the company from the buyback excise tax-erasing about 1% of Apple's overall profits for the year. These taxes add up, and they're likely to be raised again in the future.
Bottom Line
The US government is in dire need of revenue, and they're raising it in large part from large, profitable corporate taxpayers. This means companies like Apple, Google, Amazon, and Microsoft are getting hit by new tax increases, with more likely on the way. Is this priced into the market? My guess is that it isn't because of the relative obscurity of the new taxes. Some tech stocks are much better than other - the higher the valuation you're paying, the bigger the impact of losing a chunk of your future profits to Uncle Sam is likely to be. If you don't understand how much the bull market of the last 10 years was driven by tax cuts and lower interest rates, then you're likely to dramatically overpay for stocks. Tech sector ETFs and the Nasdaq are a clear sell here.
For further details see:
A Sneaky $300 Billion Tax Increase That's About To Hit Big Tech