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Tax Reform: Repatriation’s Siren Song

e21 | 05/27/2011

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Every few years, the business community renews a campaign to create a “one time” special exemption to allow the foreign earnings of multination corporations to be repatriated back to America at a substantially reduced tax rate. The policy is usually advertized as stimulus, with an emphasis on how money “trapped” abroad could be brought home to support jobs in America. Very often, the campaign is helped by a high profile international transaction motivated, at least in part, by tax considerations.

This transaction (in this case, Microsoft’s acquisition of Skype) then becomes a talking point used to depict how investment can be directed outside the U.S. in part because of the tax penalty associated with repatriation. Finally, the campaign argues that a reduced tax rate on repatriated foreign income would actually lead to a surge in revenue collections. If the tax penalty with repatriation is so large as to keep foreign earned money abroad indefinitely, then the reduced rate would actually increase revenue, it is reasoned, because the money subjected to tax would have otherwise never flowed back to the U.S. In short, the case for a repatriation holiday often appears to be a win-win.

The last repatriation holiday was enacted in 2004. The good news is that an estimated $312 billion in foreign income was repatriated under the special section of the tax code created by the legislation, or 33% more than was anticipated by the Joint Committee on Taxation (JCT). The bad news is that very little of the money served the stated purpose of the legislation to increase investment and employment in the United States. Empirical research finds that between 60 cents and 92 cents of every dollar repatriated was a payout to shareholders. Although the legislation required corporations to demonstrate that the money was being used for a qualified purpose, the fungibility of corporate resources means these constraints are usually non-binding.

Why do corporations hold so much cash abroad in the first place? It’s largely a function of the corporate income tax system’s blended system of territorial and extraterritorial income taxation. The corporate income tax is imposed on all income no matter the country in which it was generated. However, the code also provides corporations with tax credits on foreign income tax paid so income is not doubled taxed and the effective tax rate on foreign-sourced income is not higher than the 35% U.S. rate. The code also allows for U.S. taxes to be deferred as long as the foreign earnings are kept abroad. If $100 million of income was earned in a country with a 20% income tax, for example, then the company could choose to keep $80 million abroad indefinitely, or send an $80 million (or lesser amount) dividend to its U.S. parent and pay an additional $15 million in taxes.

There is strong empirical evidence that suggests that the higher the marginal tax rate a corporation faces on repatriated earnings, the more cash it holds abroad. Large, profitable businesses that face no liquidity constraints in the U.S. generally have no need for that foreign cash because they can fund all of their domestic investments using domestic cash sources. The money, then, is inclined to be kept overseas in these cases not because the tax discourages its repatriation but because domestic investment opportunities can be financed by domestic profits.

Cash rich corporations that take advantage of the special repatriation window(s) are unlikely to use these foreign pools of liquidity to boost domestic investment because they already have sufficient cash to finance all desired domestic investment. The repatriated earnings in these cases are likely to be used to pay dividends or to buy-back outstanding shares of stock. (Although legislation generally specifies allowable uses for the repatriated income, money is fungible and no substantive barrier to share buybacks exists in practice.) There’s nothing wrong with either, but there’s also not much of an economic impact: the value of the cash on the balance sheet is likely to be reflected in the market value of the firm, so the stock purchases are not likely to push up the price on a one-for-one basis. The dividend is taxed on the way out to shareholders and simply results in a shuffling of liquidity from inside the corporation to its owners on the outside.

Notable in this regard is an IRS study demonstrating that pharmaceutical firms were among the largest users of the deduction, despite having very small aggregate capital expenditures. The cash was reportedly used largely to finance the acquisition of biotech firms that had already had promising drugs in development, not to finance incremental spending.

Research shows that accounting rules also loom large when it comes to corporate strategy regarding repatriating foreign income. FASB ASC 740 requires corporations to recognize the expected repatriation tax on income generated in low tax countries. Corporations can avoid this expense – and report higher earnings – when they designate foreign income as “indefinitely reinvested abroad.” However, if the corporation later elects to repatriate these earnings, it must reduce its earnings in that period to account for the repatriation tax expense, but cannot book any additional income since it had already been recognized when the “indefinitely reinvested” declaration was made.

Executives of public corporations are clearly conscious of earnings targets, as they are extremely important to the company’s share price. Therefore, the ability to defer a tax expense and increase earnings is often too attractive to pass up; the problem is that failing to account for the expected tax makes it even more costly to repatriate the income in a later period.

While one could argue that this accounting rule strengthens the argument that the money would not otherwise come back to the U.S., it also creates a built-in lobbying force behind occasional tax holidays. Enactment of the repatriation holiday in 2004 dramatically increased the magnitude of foreign earnings labeled as “permanently reinvested” abroad. Rather than accounting for the tax expense of earnings likely to be repatriated, corporations realized that they could increase earnings in the near-term by labeling more foreign income as “permanently reinvested” – and then pressure Congress to enact another holiday in the future. The most obvious “dynamic response” in behavior to the first tax holiday was the corporate community’s expectation that another tax holiday would be forthcoming in the future.

Additional complexities make analysis of the repatriation holiday even more difficult. First, on average 40% of US corporations with foreign source income are not taxable because they are in loss, and annually these firms account for 13% of repatriated dividends. The frequency and magnitude of repatriation could be a function of the volatility of profits, as companies with sufficient domestic losses could repatriate foreign income at a zero tax rate. But the evidence suggests that the opposite occurs (companies with positive profits are more likely to repatriate despite the tax hit), which again reemphasizes the role played by domestic investment opportunities. If a company generates large losses at home, it may not want to repatriate foreign earnings despite the fact that it can do so on a tax-free basis.

There is also the challenge of understanding how much money would have been repatriated anyway – and the location of the earnings. Corporations can use the tax credits generated in high tax countries to offset the tax on income repatriated from low tax countries. The interaction of credits generated in one set of countries with income generated in another is further complicated by the fact that credits tend to come from other developed economies, while the low-tax income comes from jurisdictions like Bermuda and Luxembourg. Since corporations get to decide what foreign sourced income qualifies for the special deductions, the total volume of income repatriated tells us very little about how much incremental liquidity was actually generated because each repatriation plan was part of hundreds of corporations’ multi-year tax-planning and cash management strategies. If ten years’ worth of Bermudian income is repatriated in a single calendar year to replace dividends that would have otherwise been paid from a Japanese subsidiary, the gross dollar volume can seem large even if no incremental earnings were repatriated.

It’s no secret that the corporate income tax is horribly inefficient and poorly targeted. The problem is developing the political will to reform the system, given its disparate impact on so many constituencies. The tax code is so complex that effective tax rates vary widely from the statutory rate of 35%: the overall average effective marginal rate is 24%, while some corporations pay a fraction of that, notably GE with an effective rate of just 5%.

The problem is that corporate income is an ill-defined concept, with outlays for capital expenditures treated differently than outlays for salaries or administrative expenses and different activities receiving different credits and deductions. But moving to a system based on cash flow or gross receipts where the business pays a tax on all of its revenue with two simple deductions for payroll expenses or cost of goods sold is opposed fiercely by some conservative voices who view it as akin to a VAT and therefore likely to result in a much larger government.

A special repatriation tax holiday is hardly good policy; it is likely to result in a substantial net reduction in revenue because of the expectation it creates for future holidays, and would lessen the pressure that would otherwise exist for fundamental tax reform. If the goal is to boost domestic capital expenditures, this is not the right policy course to pursue either because it impacts available cash and not investment opportunities. If the goal is to reduce the distortion to investment decisions created by extraterritorial income taxation, this policy is probably worse than current law because of the unevenness in capital flows it generates (huge inflows one year to take advantage of the holiday, substantially lower subsequent inflows until the next holiday). In fact, it is not clear what public policy goals this proposal would advance – if done outside a broad based reform of the code – aside from the near term interests of a relatively small number of large firms that want to avoid paying corporate income taxes on foreign-sourced earnings.