Will Airlines Actually Face A 35% Tax Rate?

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Includes: AAL, DAL, UAL
by: The Unhooded Falcon

Summary

Most major carriers are using previously generated net operating losses, or NOLs, to pay virtually no federal corporate taxes.

A big turnaround in the industry is producing record profits rapidly consuming the NOLs.

Airlines have many choices as to how to avoid federal corporate taxes in the future.

The poor historical track record for airline profitability has one major positive for airlines today: They have virtually no federal corporate tax burden. This stems from accumulated net operating losses, or NOLs, that serve to offset future profits.

But, as profits continue to soar, major carriers including American Airlines Group (NASDAQ:AAL), Delta Air Lines (NYSE:DAL), and United Continental Holdings (NYSE:UAL) are burning through their remaining NOLs. Now, investors should note that although the 35% federal statutory corporate tax rate may appear to be a threat to profits, major airlines have several options to reduce their tax bills.

NOL Accumulation

Prior to the past few years, major airlines have had a rough time. High oil prices, tough competition, and the recession caused American, Delta, and United Continental to rack up billions in losses each.

But having previously lost so much money, these airlines now have substantial NOLs offsetting future federal corporate taxes.

Airline NOLs remaining as of 12/31/2014
American Airlines Group $10.1 billion
Delta Air Lines $12.0 billion
United Continental Holdings $9.6 billion

Source: Airline 10-K forms

Since these NOLs effectively shield income from the federal corporate tax rate of 35%, they are quite valuable to the companies as they can allow years of income to be earned virtually tax-free.

Using the NOLs

With the airline industry now producing record profits, the companies are burning through NOLs faster than ever before. In terms of cash flow and earnings, this is actually great news. Savings on taxes are allowing airlines to invest in new aircraft, pay dividends, buy back shares, and slash debt.

But the NOLs will eventually have to run out once they are fully used up. Based on current earnings estimates, combined with the remaining NOLs, American Airlines could run out of NOLs as early as late 2016 likely making it the first carrier to fully use its NOLs. Calculating when the other airlines will run out of NOLs is more variable since they rely on estimates further in the future. However, both Delta and United are likely to exhaust their NOLs in the next several years.

Delta Air Lines has already recognized that the NOLs will eventually run out and realized most of its NOLs as a deferred tax asset gain at the end of 2013. Consequently, Delta now reports earnings fully taxed even though the airline is paying virtually no taxes.

Tax Avoidance

Some investors may be concerned that airline earnings will be slammed with a 35% tax hit once the NOLs are exhausted, but there is more to the story.

First, since Delta reports its earnings fully taxed at U.S. rates, successfully reducing its tax rate below the statutory level could actually lead to higher reported earnings once NOLs are exhausted.

And second, airlines are unlikely to wind up paying a 35% tax rate or even a rate close to it. The business of owning aircraft lends itself to massive yearly deductions for depreciation of equipment. With American and United being particularly aggressive in new aircraft purchases, these carriers should be able to utilize significant depreciation deductions for several years following the end of the NOLs. Although Delta has not been as aggressive in new aircraft purchases, the aircraft it does purchase and the newer aircraft already owned will also allow it to benefit from depreciation tax savings.

The mobile nature of aircraft may also allow airlines to transfer some assets overseas where the airline could use them to reduce their tax bill. Some of the top contenders for aircraft movement include the United Kingdom and the Netherlands with corporate tax rates in the low 20% range. Last year, Bloomberg speculated that Delta may be able to benefit from its Amsterdam-based joint venture with Air France-KLM (OTCPK:AFRAF) or through its joint venture with U.K.-based Virgin Atlantic Airways.

American Airlines Group also has a joint venture with British Airways that could help it access the U.K.'s 21% corporate tax rate. For its own part, United has a joint venture with Air Canada (OTCQX:ACDVF) that could give it access to Canada's corporate tax rate in the mid-20% range.

Tax Takeaway

While major airlines would prefer to continue with the practice of using NOLs forever, these tax saving losses are likely to run out over the next several years if the airline industry keeps going strong.

Depending on the source and calculation methods, the effective corporate tax rate for U.S. companies generally falls between 12% and 27%, but both levels are well below the 35% rate that many investors dread. On top of this, airlines have highly mobile and depreciable assets as well as powerful partners in foreign nations.

While the NOLs have provided a nice tax holiday for airlines, the time will come when these companies have to join the corporate world in devising new tax-avoidance strategies. But, due to their asset mix and incentive to reduce their tax bills, I am confident these carriers will not be paying near the 35% rate.

Disclosure: I am/we are long AAL, DAL, ACDVF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author does not guarantee the performance of any investments and potential investors should always do their own due diligence before making any investment decisions. Although the author believes that the information presented here is correct to the best of his knowledge, no warranties are made and potential investors should always conduct their own independent research before making any investment decisions. Investing carries risk of loss and is not suitable for all individuals.

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