GLIDE PATHS FROM THE FISCAL CLIFF

BY Kishore Jethanandani

The countdown to a descent from the fiscal cliff has already begun. The most pessimistic

companies have chosen their glide paths, even before the President and Congress have

concluded their negotiations, to avoid the risk of falling over. They have taken pre-emptive

measures to minimize their taxes on dividends, capital gains and income.

The capital markets are agog with a Christmas gift called special dividends. Oracle, for

example, is paying out three quarters worth of dividends before the year end. A very

significant number of American corporations are issuing special dividends this year to save on

the higher taxes that are likely to kick in next year. Markit, a financial data firm, reports that 134

U.S. firms will issue special dividends in the fourth quarter of 2012, up from 31 in 2011.

Never mind if there is not enough cash in the USA to pay out the dividends. Much of the

cash-pile of corporations is stashed away overseas to keep it out of the hands of the

taxman. By a sleight of financial engineering, the cash overseas is being leveraged to raise

debt in the USA to pay for the dividends! Costs of debt are low and its does not hurt it all is

charged to lower taxable profits.

Decisions on long pending acquisitions have been hastened as companies look to book

capital gains before the year end. Starbucks’ acquisition of Teavana Holdings Inc happened

faster as the board and the bankers factored the tax savings that would be realized from

completing the deal by the end of the year instead of delaying it till 2013. Monroe Capital, a

financier of merger transactions reports a surge in mergers over September and October

with deal volume up 20% for the year.

Firms are also willing to shorten the lock-in periods for shares issued at the time of IPOs so

that the early investors can realize capital gains before the end of the year. Palo Alto

Networks recently freed some of its shareholders from the lock-in period to let them sell.

Executives are taking recourse to non-qualified deferred compensation to minimize the

impact of higher taxes on post-tax income. Incentive pay, such as bonus, can be deferred

over and above the pre-tax deductions allowed for retirement. Executives close to

retirement can ask for accelerated payments before the end of the year. Younger

employees can do the converse by postponing compensation.

The fiscal cliff is also beginning to cast its pall on the prospects of capital issues as

forecasts for growth turn bearish. Stock and debt prices are expected to decline next year

and costs of capital issues are expected to rise as recession sets in. Consequently,

companies are rushing into the corporate bond market to take advantage of the low yields.

General Electric Corporation’s giant $ 5 billion dollar issue in October of 2012 was seen by

market players as a signal that companies are preparing for the worst. Altogether,

companies raised $26 billion in just one week of October.

While some companies expect the worst to happen, several other scenarios are possible.

We will review the scenarios and their likely impact.

SCENARIO 1

Congress and the President are unable to reach a consensus beyond extending the middle-

class tax cuts. Tax rates for income (including carried interest), dividends and capital gains

for higher-income groups rise to Clinton era levels. Payroll holiday ends. Defense and

government expenditures are cut as agreed under the sequester agreement, emergency

unemployment insurance ends and doc fix does not happen. Fiscal cliff happens as the

scheduled cuts of $728 million go into effect. The uncertainty over the resolution of the debt

ceiling looms over the economy. The economy goes into a moderate recession as growth

rates decline by 2%.

SCENARIO 2

Congress and the President reach a consensus. Tax rates for higher income groups rise to

Clinton era levels. Carried interest is treated as ordinary income. Doc fix is allowed.

Emergency unemployment insurance and payroll tax holiday ends. The President concedes

cuts in discretionary expenditures of Government to 2008 levels, the eligibility age for

Medicare is raised by two years, and Cost-of-living adjustments for social security are

lowered. Both parties agree to work on reform of the tax code in the future. Economic

growth rises modestly to 2.5% compared to an average of 2% for the last four years.

SCENARIO 3

The President and the Congress maintain the status quo, with some changes, and agree to

work for fiscal reform in the future. The middle-class cuts are extended, and the rich pay tax

rates mid-way between current and Clinton-era levels. Carried interest is treated as ordinary

income. Both parties agree on modest cuts in deductions against taxable income. Doc fix is

allowed. Emergency unemployment insurance ends, government expenditure levels are

frozen at current levels but not reduced to 2008 levels and payroll holiday ends. No

changes are made in the eligibility age for Medicare. COL adjustments for social security

remain at current levels. Expenditure cuts under the sequester agreement don’t happen.

The economy continues to grow at a lower rate of 1.5%.

SCENARIO 4

The President and the Congress are unable to reach a consensus. However, the cuts under

the sequester agreement do not happen. The House concedes Bush-era tax rates for the

middle class but abstains or votes present for tax rates increases for the higher income

groups. The President loses House concessions for lower deductions on income taxes.

Congress retains its control over setting the debt limit. The incumbent government is unable

to propose a budget for another year. Doc fix happens. No changes are made in the

eligibility age for Medicare and COL adjustments for social security are kept intact. Payroll

holiday and emergency unemployment insurance expire. Economic growth declines to

0.5%.

VOTE

The scenarios described above have been rumored to have been proposed or discussed.

The odds of any of the scenarios are hard to estimate. We have, therefore, decided to have

a vote. Our membership is large enough to be a representative sample and the results to be

statistically valid. Please vote to find out.