On Wednesday morning, the Dow Jones Industrials (DJINDICES: ^DJI ) built on their gains from yesterday, adding 28 points as of 11 a.m. EDT. The move followed the release of the latest ADP jobs report which found the private sector added 191,000 jobs during March. The biggest gainer for the morning was Caterpillar (NYSE: CAT ) , which climbed 1.8% despite having undergone a congressional inquiry into its foreign tax practices. Given that Caterpillar is far from the only Dow component to use offshore strategies to control U.S. taxes, some investors fear that increasing scrutiny will eventually cause the stock market to drop.
What Caterpillar faces
Some members of the Senate's Permanent Subcommittee on Investigations have argued that Caterpillar has used what panel Chairman Carl Levin (D-Nev.) called "dubious tax loopholes" to avoid paying U.S. taxes. For its part, Caterpillar responded to the inquiry transparently, emphasizing that the heavy-equipment maker employs legal means to comply with existing U.S. tax laws and that it pays all the tax that it owes. Other members of the Senate subcommittee took the opportunity to emphasize the flawed nature of U.S. tax law rather than any improper behavior from Caterpillar as the reason for what many see as an unfair ability to escape U.S. taxation on profits allocated to related foreign entities.
With billions at stake, Caterpillar is far from the only company to face criticism for its international tax management. Dow components Microsoft (NASDAQ: MSFT ) and Cisco Systems (NASDAQ: CSCO ) are just two of many companies with extensive holdings of foreign assets, with Microsoft also having faced an inquiry from Congress.
Will taxes bring down the Dow?
For investors, the big question is whether eventual changes in tax law will add to tax burdens for Caterpillar, Microsoft, Cisco, and the hundreds of other multinational companies that use tax planning to take advantage of international tax law provisions. If a permanent change in taxes leads to a long-term drop in after-tax earnings, then share prices could take a big hit, which would have a potentially huge impact on stock market levels.
What's more likely, though, is that any adjustment to tax law would be accompanied by lower corporate tax rates, which could offset the long-term impact of tax reform. Politicians in both parties have supported the idea of corporate-tax reform, making it more likely to become law eventually. Depending on how those laws are structured, it's probable that Caterpillar and other companies could end up paying one-time charges for any tax liability. If that happens, shares might take a short-term hit, but most investors are willing to dismiss truly singular negative impacts to corporate profits with only minimal impact on the stock price.
It'll take a long time for lawmakers to work through the issues involved in tax reform and come up with a solution to the issues facing Caterpillar and countless other companies. But even if the government reaches a solution, you shouldn't worry too much about the potential impact on Caterpillar or the stock market as a whole.
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