MIAMI — Delta Air Lines is weighing the creation of subsidiary companies overseas as a tax abatement strategy in advance of becoming a full cash taxpayer in 2018. According to a November 6 report from investment firm Wolfe Research, Delta is weighing the creation of international subsidiaries that would house its international equity interests, including investments in foreign carriers, joint ventures, and perhaps other business units such as its maintenance operation.
One potential location would be Amsterdam, which offers a 25% tax rate, and could easily house Delta’s European joint ventures (JVs) with Air France – KLM and Virgin Atlantic, as well as its 49% stake in Virgin Atlantic amongst other assets. US companies pay taxes on all profits recorded by the main US entity, so shifting the profits from the JVs and equity investments to the foreign subsidiary would allow Delta to pay lower tax rates on a portion of its income. This is of particular importance as the airline shifts from paying taxes on paper to outlaying actual cash.
This strategy was hinted at by Delta CEO Richard Anderson on the carrier’s quarterly earnings call for the third quarter of 2015. On the call, Anderson stated that Delta’s international financial focus, “is another differentiator for Delta that goes back to our international focus and our minority investments, equity investments around the world in our joint venture strategies,” adding that Delta, “can have an advantageous tax position versus… domestic competitors” and that it would update investors on the new tax strategy at its Investor Day in December of this year.
The tax burden on US airlines is steep
US airlines are subject to a byzantine series of taxes. Like other businesses, they still have to pay federal, and where applicable state corporate income taxes, as well as payroll taxes on the salaries of their employees and property taxes on the various facilities they own. But beyond that, there are a series of aviation specific taxes and fees that combine to elevate the tax burden on US airlines to almost a “sin tax” like those faced by tobacco or gambling/casino companies.
These range from taxes on jet fuel, to excise taxes on airline tickets (7.5%), to various fees imposed by the Department of Homeland Security (DHS) to help fund the Transportation Security Administration (TSA). What this all works out to is that an average to 20-25% of what passengers pay for a plane ticket is taxes or fees paid to the government, while airlines pay an effective tax rate (taxes net of any deductions or credits) of roughly 38%.
Despite these figures, the US continues to suffer from gross underinvestment in its aviation infrastructure. And, Delta is no different than the industry at large – as it projects that for 2015, it will be subject to an effective tax rate of 37% for the year.
The numbers behind Delta’s foreign subsidiary plans
According to filings with the SEC for the third quarter of 2015, Delta still has $10 billion in net operating loss carry forwards. An operating loss carry forward is an accounting mechanism that allows companies to apply operating losses incurred in previous years towards their tax payments in future years. Delta lost money in 2008 and 2009, and combined with tax carry forwards from pre-merger Northwest, it had a huge net operating loss to apply to future years. So even though Delta has been profitable since 2010 and has reported income tax on its profit-loss statements, it hasn’t actually had to send any cash to the IRS to pay those taxes.
And that is really good for investors, who actually care about the amount of cash Delta brings in and can thus use to pay them through dividends or share buybacks, as well as boost the value of their shares through indirect effects from investments back into the business. At present, Delta’s remaining carry forwards means that it won’t have to pay cash taxes till the back half of 2017 and won’t become a full cash taxpayer till 2018 under current projections. But at that time, some of Delta’s cash will start going to the IRS instead of Delta’s shareholders.
Right now, Delta has a series of investments that could be moved to a foreign subsidiary. The most notable of these is its 49% stake in Virgin Atlantic, which returned roughly $11 million in 2014 and will return more than double that in 2015 on the strength of the UK economy and the low price of fuel. Additionally, Delta owns stakes in partners including AeroMexico, Gol, and the recently announced China Eastern.
Beyond its direct investments in foreign carriers, Delta also has JVs with several airlines, including Virgin Atlantic, Air France-KLM, and Virgin Australia across the Pacific. It also plans to build JVs with Gol and China Eastern once bilateral agreements with Brazil and China respectively become less restrictive. And a joint venture with Korean Air to Asia is still a distinct possibility. In an ideal world, Delta would immediately shift ownership of these JVs and the hundreds of millions of dollars in included profits to one or multiple foreign subsidiaries.
The legal treatment of the JVs is unclear in this scenario
But it is unclear whether Delta will legally be allowed to shift its joint ventures in such a manner. International flying between the US and various jurisdictions is governed by bilateral air service agreements (ASAs), and regulators on either side of the Pacific or Atlantic might react poorly to Delta’s plans and force the flying rights for the international routes to remain with the parent company in the US. For the US and European Union, the ASA is fully Open Skies with an accompanying free trade agreement for most industries, so at first glance, European subsidiary ownership of the associated JVs and equity stakes would appear to be possible.
At the very least, there is a dark irony in the fact that Delta (or at least its unions) is amongst the carriers complaining about Norwegian Air Shuttle leveraging the EU’s labor laws to access lower cost labor in Ireland for its US flights while seeking to use an analogous loophole to lower its own tax payments. Even without the JVs, there are enough cash savings to be realized from the equity investments alone to justify the one time setup costs and added legal complexity.
Delta’s contrarian ethos
As Brett Snyder noted last week on his Cranky Flier blog, Delta has a tendency to zig where other airlines zag. This contrarian streak is visible in almost every facet of its strategy and it permeates the airline and its organizational culture. Sometimes Delta is ahead of the curve on an idea – for example it was the first US carrier to identify the arbitrage available given the pricing of used aircraft in the market. Incidentally, this is one of the reasons it is throwing off so much cash that it needs to protect.
At other times, it is completely out there, such as with its purchase of the Trainer refinery. Our suspicion is that this situation is more of the former. If Delta is able to effectively reduce its cash tax burden with this strategy of international subsidiaries, then rivals such as United (who has its own newly minted equity investment in Brazilian carrier Azul) and American won’t be far behind with foreign subsidiaries for their own JVs and applicable assets.