On Tuesday, 6 October 2020, the Commonwealth Treasurer, Josh Frydenberg delivered the 2020-2021 Federal Budget. The budget includes unprecedented spending that will see the country’s gross debt approach $1 trillion and the deficit exceed $200 billion. By contrast, the 2019 budget forecast a fiscal surplus for each year of the 2019-2023 forward estimates.
How to benefit from the investment allowance
A key feature of this year’s budget is the $27 billion investment allowance which brings forward tax deductions for capital or equipment purchases instead of following traditional tax depreciation schedules over the useful life of the asset.
In announcing the investment allowance, the Treasurer claimed that: “every sector of our economy, every corner of our country, will benefit. This is how we will get Australians back to work.”
In order for the investment allowance to provide a timely “cash kick” to corporate Australia, companies will need to:
- return to profitability quickly (deductions only provide a “cash kick” to companies if they are profitable, by reducing the tax payable on that profit); and
- have an ability to fund new investment in order to receive the brought-forward tax deduction.
The question of whether a company will return to profitability will depend largely on the industry it operates in and its competitive position within its market. Industries such as travel and hospitality are most likely to have a gradual path back to profitability and some structural changes in consumer behaviour caused by COVID-19 may cause some industries and companies never to return to pre-COVID-19 profitability levels. Therefore, if a particular company has a long journey to profitability, it may simply run out of cash before it has the ability to make investments, and enjoy the cash benefit of the brought forward timing of the tax deduction.
“Carry-back” of losses and the interaction with the investment allowance
In addition to the investment allowance, the Treasurer also announced a temporary ability for companies to “carry-back” losses incurred up to FY22 against profits made as far back as FY19 (tax deductions for losses have traditionally only been allowed to be carried forward not back). Therefore, if a company was profitable in earlier years an eligible capital investment tax deduction could increase current year losses and be carried back to reduce prior year tax bills which would provide a timely “cash kick”.
The second challenge for companies in getting a “cash kick” is whether they can fund the new investment. Industries and companies will have very different cash reserves and access to new debt or equity to fund capital investment again, missing questions around the breadth of industries and corporates that will benefit.
Typical cash flow profile of company impacted by COVID-19
A particular company’s access to debt and equity markets will depend on many things including its size, its industry, its cash flow and balance sheet. Whilst Government support initiatives such as JobKeeper have reduced the pain for corporate Australia and workers, many businesses have increased debt to fund losses and remain in business, in particular the deferral of rent owed to landlords and the capitalisation of borrowings owed to banks.
Typical disconnect between cash and profit over the COVID-19 period
Losses over the COVID-19 period have weakened balance sheets. While Government support measures have enabled many businesses to remain cash positive, this is out of sync with the underlying earnings and therefore not sustainable once those measures come to an end.
Increasing leverage (or reducing net assets) makes a company “less bankable”. Many borrowers will be approaching the banks for funding in the coming months with balance sheets that look very different to how they appeared at the start of the year.
Approach financiers on good footing
Our view is that the investment allowance is an effective stimulus initiative but its impact on corporate Australia will be uneven. Borrowers approaching lenders to fund capital investment that have a solid balance sheet and well-supported financial forecasts will gain access to capital and take advantage of the “cash kick” and drive growth.
However, COVID-19 has accelerated the structural headwinds for many industries such as fossil fuels, bricks and mortar retail, and companies without a competitive advantage in their own market. Ironically, for many of these companies, government support and increased debt available in COVID-19 have kept these “zombies” alive longer than ordinarily would have been the case, evidenced by the 60% decline in insolvencies when compared to prior years.
Insolvency appointments (month-on-month)
The trend of external administration appointments over the last several years has been steady, before decreasing by approximately 60% in the six month period from March to August 2020. This decrease suggests that many businesses that would ordinarily have required external intervention, are being propped up by the Government support measures, and remain likely to fail once those measures come to an end.
Unsurprisingly, the zombie companies will find it very difficult to secure funding next year when JobKeeper finishes, banks and landlords start asking to be repaid and they cannot afford large-scale redundancies.
Inevitably after any budget, there is media commentary on the “winners and losers” and corporate Australia will undoubtedly be identified as a winner from this budget. It’s worth acknowledging that there will be a significant increase in insolvencies next year, initially the delayed death of the zombies but then some quality companies that cannot access new debt will also fail too. The directors of these failing companies will clearly not feel like winners but the Treasurer has set the stage for accelerated structural shift away from tired industries and capital allocation in “winning” industries.
The Treasurer is implicitly (or perhaps explicitly) calling on capital markets, in particular debt provided by the Big 4 Banks and SME lenders to fund Australia out of the pandemic. As Government support tapers, company directors should prepare themselves to approach financiers on good footing.