On December 22, 2017, President Trump signed The Tax Cuts and Jobs Act, which resulted in sweeping changes to the U.S. tax code. The Act decreased the corporate tax rate to 21% from 35%, in addition to modifying specific provisions around interest, depreciation, carrybacks, and repatriation taxes. The change in tax rate will have the biggest impact on purchase accounting. In the energy industry, this will manifest itself in several ways. This blog post explores some of the impacts to valuations performed under fair value accounting in ASC 805 and ASC 820.
Cash Flows and Returns
When we evaluate prospective financial information, a lower tax rate will result in higher after-tax earnings. The value of the tax shield created by depreciation and deductions will be influenced by both the lower corporate tax rate (which reduces the tax shield’s value) and accelerated depreciation of qualifying capital equipment purchases (which increases the tax shield’s value). This could mean incentives for energy-oriented companies to (i) create a more modernized drilling rig fleet sooner that are best suited for today’s multi-frac lateral wells and (ii) accelerated plans to create more infrastructure and pipelines in active basins such as the Permian, Bakken and Eagle Ford. In addition, it also could drive more refinery and LNG liquefaction plant development.
In most cases, a lower tax rate will increase cash flows, increasing the internal rate of return on acquisitions for a given purchase price. On the other hand, if lower tax rates drive higher purchase prices, internal rates of return may be unchanged. In terms of the weighted average cost of capital (WACC), the lower tax rate actually increases the after-tax cost of debt. Keeping other inputs constant, this modestly increases WACCs.
Relief from Royalty
Under the relief from royalty method, after-tax royalties avoided increase as the tax rate falls. However, the tax amortization benefit (TAB) component of the intangible value also declines as a result of the lower tax rate, which serves to partially offset the increase in after-tax cash flows.
In a scenario analysis used to value a noncompete agreement, a lower tax rate will again decrease the tax amortization benefit. Since both scenarios under the with and without approach will reflect the same tax rate, the impact of the new lower rate will be muted. As a result, the fair value of noncompete agreements may well be somewhat lower under the new tax rate.
The cost approach, which is often used to value assets such as the assembled workforce or some technologies, the impact depends on whether a pre-tax or after-tax measurement basis is used. If fair value is measured on a pre-tax basis, the fair value of such assets is unaffected. If measured on an after-tax basis, costs avoided net of tax will be higher under lower tax rates, although this gain will be offset somewhat by the decrease in the TAB.
Multi-Period Excess Earnings Method
The impact of the tax rate on assets valued under the Multi-Period Excess Earnings Method (MPEEM) is more ambiguous since two key elements will be affected – the contributory asset charges and the tax rate used to derive after-tax cash flows. On the cash flow side of things, the lower tax rate will result in higher cash flow but a lower TAB. As far as contributory assets are concerned:
- Relief from royalty asset charges will increase under a lower tax rate
- With and without scenario analysis with level payments charges will potentially decrease due to the lower base value
- Cost approach asset charges may increase or decrease depending on the net effect of taxes and TAB calculations
Reserves & Goodwill
The net impact of a lower tax rate on goodwill will vary by transaction. Since reserves are typically viewed through a pre-tax lens, the value of reserves could be muted (all else held constant). However, we note that if tax incentives increase CapEx and drilling plans, then more reserves could move up the category chain (P2 to P1 for example) and thus increase the fair value of reserves. If the lower tax rate results in a higher transaction price, the aggregate increase in fair value will likely result in a larger allocation to goodwill. This would apply more to intangible based energy companies. Upstream companies typically do not book goodwill. If, instead, the lower tax rate increases the projected IRR on a transaction, the impact on residual goodwill is harder to predict and will depend on the composition of the assets acquired.
The changes to corporate taxes under the new bill are wide-ranging. In addition to the effect of lower rates discussed in this post, fair value specialists need to be alert to how other specific provisions of the bill may influence individual energy companies.
Impact of Tax Rate Decrease on Valuation Method
- Cash Flows/Returns Higher after-tax cash flows/impact on returns depends on transaction price
- Tax Amortization Benefits Decrease
- Relief from Royalty Method Increase (potential offset by decrease in TAB)
- Cost Approach (pre-tax) No Change
- Cost Approach (post-tax) Increase (potential offset by decrease in TAB)
- With and Without Scenario Potentially lower (potential offset by decrease in TAB)
- MPEEM May Increase or Decrease (depends on magnitude of other changes)