A surprising number of public companies, usually “Subchapter C corporations” for federal tax purposes, have realized substantial capital losses. For such corporations, capital losses are deductible only against capital gains. If a corporation is not able to generate sufficient capital gain during the tax year that the loss was realized, the capital loss can be carried back three years and then forward five years, at which point the loss will expire worthless if sufficient gain has not been realized to absorb the loss.
Not surprisingly, companies that have incurred significant capital losses often don’t anticipate being able to generate sufficient capital gains to fully utilize the losses. Unfortunately, many of the possible “solutions” proposed to management by legal, tax and accounting advisors to absorb the losses are highly structured transactions that lack a meaningful business purpose and real economic substance. Therefore, for financial reporting purposes, management often takes a valuation allowance against the losses, meaning management has made the determination that it is more likely than not that such losses will expire worthless after five years.
Since the presidential election, interest rates in the U.S. have risen all along the yield curve. Perhaps that’s not terribly surprising, given that Mr. Trump’s victory has increased expectations of fiscal stimulus, inflation and continued heavy issuance of U.S. Treasury debt. Many corporate executives, investors and economists are starting to suspect that this may finally be the beginning of the long-anticipated “normalization” of the U.S. Treasury yield curve. There are, of course, many valid reasons why a sustained rise in U.S. interest rates may not occur, or occur as quickly and substantially as some currently expect. For instance, in Europe and Japan pensions and insurance companies remain starved for yield, which could help keep a lid on U.S. rates. And it’s not yet clear how much of Mr. Trump’s policy agenda will be enacted, and any backtracking, for instance, on proposed fiscal stimulus might send yields tumbling down once again.
That said, the senior executives and board of directors (“senior management”) of most companies are well aware of the possibility (and perhaps probability) of a rising rate scenario, and some wish to protect their companies against the prospect of inflation, as well as the business risks and other deleterious effects to their businesses, which could accompany a rising interest rate environment. For instance, a company’s capital structure might include debt or other liabilities that are tied to a floating rate; should interest rates increase, the cost of these liabilities will also rise. Or a company or financial institution might hold financial assets or investments that pay a fixed return; a rise in rates will likely negatively impact the asset’s value. Of course, rather than seek protection from rising rates, others view this as an opportune time to instead seek to profit from the normalization of the yield curve.
In any event, if senior management does expect interest rates to rise in the U.S., there are many tools a corporate investor might use to help guard against, or take advantage of, rising interest rates, and they all can have very different tax consequences for the company.
Case Study
ABC Corp., a large public company and a “C” Corporation for tax purposes, has a capital loss carryforward of $25 million. ABC Corp. is profitable, generating net income of $25 million per annum, and pays federal tax at the 35% rate. ABC Corp. realized its capital loss back in December 2013, and the loss will therefore expire in December 2018 unless sufficient gain can be utilized to absorb the loss. ABC Corp.’s capital structure includes a considerable amount of floating rate debt, and a sizeable amount of corporate cash (that’s not needed as a “cash alternative”) is invested in a diverse portfolio of taxable fixed income securities with a duration from 1 to 5 years.
Since early 2014, senior management has explored a number of potential solutions that have been proposed by ABC Corp.’s legal, tax and accounting advisors; however, senior management concluded that most of these strategies, by their very nature, did not have a meaningful business purpose and lacked robust economic substance. Therefore, for financial reporting purposes, senior management took a valuation allowance against those losses, having determined that it was more likely than not that the losses will expire worthless in December 2018.
Nevertheless, the investment community remains mindful of ABC Corp.’s capital loss carryforward, because most sophisticated institutional investors believe that public companies that actively plan for and manage their tax attributes, by improving future after-tax cash flows, enhance shareholder value. Not surprisingly, during quarterly conference calls, shareholder meetings, investor conferences and other meetings with investors, institutional investors ask detailed questions to gain insight into what senior management’s plan is, if any, with respect to the potential utilization of its capital loss carryforward.
Since the presidential election, senior management has become concerned that the U.S. yield curve will continue to normalize, with the potential to significantly increase the cost of the company’s floating rate debt, while reducing the value of its corporate bond portfolio. Senior management recently met with the company’s financial, legal and tax advisors to explore how the company might guard against the risk of rising rates in the most cost-effective and tax-efficient manner. Along these lines, senior management explored numerous tools the company could use such as ETFs, TIPS, options, forwards, futures and swaps, among others. Each of these tools can deliver the desired protection against rising interest rates, but they all have differing tax consequences for the company.
After a comparative analysis of the available techniques, given ABC Corp.’s circumstances, senior management has decided that the most straight-forward, cost-effective and tax-efficient strategy is to establish a short position in U.S. Treasuries (“UST”) with a fairly short duration (i.e. approximately 24 months). With interest rates still near historic lows, the company’s “worst case” scenario can be defined with a fair degree of precision, and the company’s potential maximum loss will be limited. That is, the company can benefit from what is effectively free “put protection” currently offered by the market.
For instance, in a “worst case” scenario (i.e. interest rates decrease), an investor who establishes a short position in a two-year UST can simply keep the short position open until just before maturity of the UST. In that event, assuming the yield-to-maturity (YTM) on the UST is 1% on the date the short position is established, the investor would be required to pay the YTM of the bond for two years (i.e. a total of 2% of the principal amount of the bonds shorted). During this period the investor will earn interest on the short sale proceeds and cash margin held by the bond dealer. Therefore, here the investor’s maximum loss is 2% less the amount of interest earned on the short sale proceeds and cash margin held with the dealer.
However, in the event that rates do begin to normalize, as senior management expects, the company will be in a position to benefit handsomely.
This strategy is intriguing to senior management for another important reason: the company’s otherwise non-deductible capital loss carryforward. Given current interest rate levels, if structured properly, establishing a short position in a two-year UST will generate both capital gain and interest expense. Here’s why.
Interest rates in the U.S. are currently near historic lows, but many U.S. Treasury bonds were issued many years ago when interest rates were much higher. These seasoned bonds, often referred to as “off-the-run” bonds, currently trade at a significant premium over par because today’s interest rates are significantly lower than when the bonds were issued. By shorting bonds that are currently trading at a significant premium to par, the investor generates both capital gain (i.e. as rates begin to rise and the bond is “pulled to par”) and interest expense (i.e. as the investor makes the “in lieu of” coupon payments to the lender of the bond). The gain generated on the closing out of the short UST position is short-term capital gain (Code Sec. 1233), while the “in lieu of” coupon payments are treated as interest expense (Rev. Rul. 72-521 and Rev. Rul. 62-42), which for a “C” corporation such as ABC Corp. is deductible without limitation against any form of income, including operating income.
Therefore, the company’s capital loss will be deductible against the capital gain generated by closing out the short position, while the interest expense generated by the strategy will be deductible against the company’s ordinary income. In effect, this strategy converts ABC Corp.’s otherwise non-deductible capital loss carryforward into currently deductible interest expense.
Senior management decided to implement this strategy. ABC Corp. established a short position in a U.S. Treasury bond with a two-year maturity that was executed through a Primary U.S. Government Bond Dealer on exactly the same pricing, terms and conditions that were then available in the marketplace to any sophisticated institutional investor. Senior management entered into this strategy with the belief that the one-year U.S. Treasury rate was likely to rise significantly during the next twelve months.
The short position was closed out one year later, management’s view on rates was correct, and the results were attractive. As stated above, the company has a $25 million capital loss carryforward, and generates $25 million of taxable operating income per year. The transaction generated $27.5 million of capital gain and $25 million of net interest expense, resulting in a profit of $2.5 million. The $25 million capital loss carryforward is deductible against $25 million of capital gain and is thereby fully utilized. The $25 million of net interest expense is currently deductible against $25 million of ordinary income.
ABC Corp. earned a profit of $2.5 million on a cash investment of $7,500,000 (i.e. the cash margin typically required for a transaction of this size and duration which is not capital intensive) to generate a 33% pre-tax return and, due to the net interest expense, an even greater after-tax return. The bottom line is that ABC Corp. earned an attractive return on its investment while effectively converting its otherwise non-deductible capital loss carryforward into currently deductible investment interest expense which would have otherwise expired worthless.
In addition to helping the company protect against inflation and business risks caused by rising interest rates, implementation of this strategy has two other important business purposes.
First, sound corporate governance policy recognizes that senior management has a duty to prudently manage a company’s assets, which includes determining if deferred tax assets such as capital losses can be utilized in the interests of shareholders, creditors and other stakeholders. Implementation of this capital markets-based solution enabled ABC Corp. to more efficiently and effectively utilize the company’s deferred tax assets, and aided senior management to satisfy and maintain, respectively, its corporate governance obligations and best practices.
Second, as mentioned above, since ABC Corp. realized its capital loss in 2013, institutional investors have been trying to determine exactly what, if any, senior management’s plan is with respect to the utilization of the company’s capital loss carryforwards. This underscores important investor relations (“IR”) considerations. IR is a strategic management responsibility that integrates corporate finance, communications, marketing and securities law compliance to enable the most effective two-way communication between a company, the financial community, and other constituencies, which ultimately contributes to a company's securities achieving fair valuation (i.e. definition of the National Institute of Investor Relations). Most institutional investors believe, and the existing literature supports the view, that public companies that actively plan for and manage their tax attributes, by improving future after-tax cash flows, increase shareholder value. That said, the implementation of this strategy enabled ABC Corp. to more efficiently and effectively utilize its deferred tax assets, and through the transmission of this information through the IR function to the investment community, should contribute to ABC Corp.’s securities achieving fair (i.e. higher) value in the stock market.
Summary
Senior management of companies that are “Subchapter C corporations” for federal tax purposes might find the strategy of establishing a short position in U.S. Treasury bonds with a fairly short maturity (i.e. about two years) intriguing if senior management is of the view that short-term interest rates are poised to rise and the company possesses capital loss carryforwards that are currently non-deductible and could potentially expire worthless.
Besides helping to protect a company against inflation and the deleterious impacts of rising interest rates, implementation of this strategy has two additional and important business purposes. First, it assists senior management to better satisfy and maintain, respectively, its corporate governance obligations and best practices. Second, through the investor relations function, the strategy should help contribute to ABC Corp.’s securities achieving fair (higher) value in the stock market.
Tom Boczar is the CEO of Intelligent Edge Advisors. Jeff Markowski is Managing Director of Capital Markets at Intelligent Edge Advisors.