Could This Dividend Giant Go Tax-Free Soon?

Philip Morris International (NYSE: PM  ) has long been a dividend giant. Now, recent proposed legislation could mean that after 2015 it would potentially no longer have to pay U.S. taxes. If it passes -- and that's a big if -- this would mean Philip Morris' income and dividend would jump, boosting the stock.

Dividend giant
For a little history, Philip Morris was spun off from Altria (NYSE: MO  ) , the dominant tobacco company in the U.S. through its Philip Morris USA subsidiary, in 2008. Altria has more than a 20-year history of paying dividends and growing that dividend every year, which has resulted in it being one of the top stocks of the past 50 years. Philip Morris has followed Altria in its footsteps with a sizable and growing dividend of its own.

MO Dividend Chart

MO Dividend data. Source: YCharts.

When Altria and Philip Morris were combined, investors valued the conglomerate company at a low multiple given the legal risks in the U.S. Altria and the rest of the U.S. tobacco industry have for years faced lawsuits. Most recently, at the end of April, Altria was hit with a $10.1 billion judgment in Illinois over its marketing for "light" and "low-tar" products.

The international divisions were spun off as Philip Morris so that they would not be subject to the legal issues of the U.S. business. After the spinoff, Philip Morris could then be valued without the overhang of lawsuits. Now, the fact that Philip Morris has no U.S. operations could be a big benefit for the company if a certain proposed regulation passes.

Tax Act of 2015
For the past three years, Rep. Dave Camp (R-Mich.) has been working on an overhaul of the U.S. tax system to lower the overall tax rate from its current position as the highest in the developed world and modernize the international taxation system. Currently, the U.S. taxes U.S. companies on all their foreign profits at the U.S.' high rate when companies bring those profits back to the U.S. As you might expect, this has led U.S. companies to not bring profits back. U.S. companies are now sitting on an estimated $1.5 trillion-$2 trillion of profits abroad with the top 10 companies sitting on a combined $600 billion in offshore earnings.

To fix this, the Camp plan would institute a "participation exemption system" meaning that 95% of profits made by companies' foreign subsidiaries and distributed to the U.S. parent would be exempt from U.S. taxes. This would make multinationals' taxes far more competitive compared with the rest of the world and would end the current practice that discourages companies from returning profits to the U.S. and hampers the U.S. economic recovery.

Philip Morris boost
This has big implications for Philip Morris as the company only sells abroad. Under the proposed regulations, 95% of Philip Morris' income would be exempt from U.S. taxes, with the remaining 5% of profits subject to the new 25% corporate tax rate. Philip Morris' U.S. taxes would thus drop 99%.

The company would still have to pay taxes abroad but would basically be tax-free in the U.S. In 2013, it paid an effective tax rate of 22.9% on its foreign earnings. Bringing the profits back to the U.S. added 6.6% to the effective tax rate for an overall rate of 29.3%.

PM Pre-Tax Income (Annual) Chart

PM Pre-Tax Income (Annual) data. Source: YCharts.

Under the new system, the U.S. taxes would disappear. Philip Morris's net earnings -- that is earnings before minority interests -- was $8.85 billion in 2013. If the proposed Tax Act took effect in 2013, Philip Morris shareholders would have kept an additional $800 million -- 9% higher than otherwise and especially significant for a slow-but-steady grower like Philip Morris, whose net income has grown at half that rate for the past few years.

Bottom line
It's important to understand that many analysts believe that Camp's Tax Reform Act will never pass in its current form. But I believe the tax system it proposes will be the basis for any reform going forward and stands a reasonable chance of becoming law in the future. In any event, Philip Morris will remain a dividend stalwart and one of my main holdings. The possible boost from the Tax Reform Act is just icing on the cake.

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  • Report this Comment On May 09, 2014, at 2:36 PM, Lou1s wrote:

    Why is the distribution of the foreign subsidiaries dividend tax free only to the parent company? Why not bring back the funds as proposed, but distribute those dividends to all stockholders at their individual tax rate? Sounds good to me.

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