Why Apple Investors Should Thank President Obama

By Markets Fool.com

U.S. corporations have been begging for corporate tax reform for years. Under the current system, companies are hit with a repatriation tax of up to 35% when they bring money earned internationally back to the U.S. As a result, many U.S. firms -- led by Apple -- have collectively stashed $2 trillion outside the country to avoid this tax hit.

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President Obama recently proposed a solution that would immediately levy a 14% tax on U.S. corporations' overseas cash and then charge a 19% tax on future overseas earnings. This could leave Apple with a tax bill of up to $22 billion on its foreign cash holdings. But this proposal would be far better for Apple shareholders than the status quo. Read on to find out why.

Cash piling up offshore
In the past few years, Apple has become the biggest holder of offshore cash. Meanwhile, it has aggressively spent its U.S. cash on dividends and share buybacks, even borrowing tens of billions of dollars to avoid repatriating any of its foreign cash and triggering a tax liability.

As of late December, Apple had $157.8 billion of cash held offshore, compared to just $20 billion in the U.S. This is making it increasingly hard for Apple to return cash to shareholders. There are practical limits on how much debt Apple can issue to fund buybacks, even if that debt is matched dollar for dollar with overseas cash.

Enter President Obama's corporate tax proposal
President Obama has proposed a major change to corporate tax law in order to encourage companies to bring home their overseas cash without losing out on lots of tax revenue.

First, his proposal calls for a 14% tax on overseas cash that U.S. corporations have already earned. Unlike previous voluntary "tax holidays" that only applied to cash that corporations wanted to repatriate, President Obama's proposed tax would be mandatory -- it would apply to all overseas cash held by U.S. corporations.

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Second, Obama's proposal would institute a 19% tax rate on all income earned overseas by U.S. corporations going forward. (Companies would get credits for taxes paid abroad in this scheme.) Third, the standard corporate tax rate in the U.S. would be reduced from 35% to 28%.

This proposal would be great for Apple
Based on Apple's $157.8 billion foreign cash horde, a 14% tax would hit the company with a $22 billion bill. In practice, Apple might owe substantially less than that amount, since it has already paid tax on some of its foreign income.

But even if Apple had to pay the full $22 billion to satisfy its tax obligations on its overseas cash, President Obama's proposal would still be great for shareholders. After paying $22 billion, Apple would be left with about $136 billion that it could repatriate and use to support further increases in its capital return program.

With that amount of money, Apple could buy back nearly 20% of its 5.8 billion outstanding shares. This would dramatically increase the company's long-term EPS.

Additionally, the proposed 28% domestic corporate tax rate and 19% international tax rate would reduce Apple's long-term tax burden. In recent years, Apple has recognized an effective tax rate of about 26%.

With nearly 65% of Apple's earnings coming from overseas, its federal tax rate under the proposed system would be about 22% before the benefit of the R&D tax credit. Assuming that state and local corporate taxes roughly offset the R&D credit, Apple's overall tax rate might drop by 4 percentage points -- boosting its net income by $2.5 billion or more.

Furthermore, since there would no longer be an incentive to stash its cash overseas, it would be easier in the future for Apple to return its free cash flow to shareholders in the form of dividends and buybacks.

An alternative plan
President Obama's proposal isn't the only corporate tax reform plan making the rounds on Capitol Hill. Senators Rand Paul and Barbara Boxer recently proposed a voluntary repatriation tax holiday that would offer an even lower 6.5% tax rate.

This might seem more enticing than President Obama's proposal -- and for some companies, that might be true. However, the Paul-Boxer bill includes restrictions on how the repatriated cash can be used. Depending on how the bill is interpreted, this could significantly limit its benefits for Apple.

The key terms of the Paul-Boxer bill are that a portion of the cash repatriated must be used for increased spending on things like employee pay, R&D, CapEx, and acquisitions. Additionally, the repatriated cash cannot be used to support increased executive compensation, dividends, or buybacks.

This is potentially problematic for Apple. The company could probably find productive ways to invest several billion dollars a year in incremental R&D, CapEx, and/or acquisitions. Indeed, the company has been steadily increasing its R&D spending by more than 30% annually.

However, Apple has more than $150 billion in offshore cash. That's almost certainly more than Apple could invest at a reasonable rate of return. The best use for most of that cash would be returning it to shareholders through dividends or buybacks.

It's unclear how much leeway would be permitted under the Paul-Boxer bill for shareholder returns. Apple spent more than $55 billion in FY14 on dividends and buybacks. If it was allowed to continue spending that amount each year, the Paul-Boxer bill would not be much of an imposition.

On the other hand, if the bill would prevent Apple from using any of its foreign cash for future buybacks, then it wouldn't be nearly as helpful as President Obama's proposal.

The biggest risk is deadlock
While President Obama's corporate tax reform proposal would be great for Apple, plenty of other companies are unhappy about it. As Tim Cook noted in 2013, Apple is unusual among U.S. corporations in that it isn't lobbying for zero taxes on foreign earnings.

Thus, the biggest risk for Apple may be that the latest effort at corporate tax reform gets caught up in Washington gridlock like previous attempts. Plenty of people on both sides of the aisle oppose solutions like President Obama's proposal. Liberals argue that it's corporate welfare. Conservatives argue that taxing foreign income will just chase corporations out of the U.S.

The truth is that it's an imperfect solution to a difficult problem. But a proposal that would make the country's largest holder of untaxed overseas cash happy to cough up $22 billion to Uncle Sam just might be the best compromise available.

The article Why Apple Investors Should Thank President Obama originally appeared on Fool.com.

Adam Levine-Weinberg is long January 2016 $80 calls on Apple and short January 2016 $120 calls on Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.