Above and beyond arresting the pace of inversions, the centre-piece advertised benefit of the TCJA was that it would re-energize investment in domestic economic activity. But has it? And will it?
The last 18 months have no doubt witnessed a fractious and volatile time in US politics, with the 2017 tax reform legislation providing a year-end flurry that rivalled them all. The Tax Cuts and Jobs Act of 2017 (TCJA) visited significant unprecedented changes on the US tax code at all levels, much of it drafted in six short weeks behind closed partisan doors. Many of the implications of the Act remain to be seen, but the TCJA was clearly a boon to multi-national corporations that maintain tax residency in the United States.
For incorporated entities, perhaps the most celebrated feature of the TCJA was its dramatic reduction and flattening out of US federal corporate tax rates, dropping them from a comparatively hefty 35 per cent on the margin to a lower (and categorical) 21 per cent. Equally important for US multinationals, however, was the transition from a ‘worldwide’ tax regime – under which their corporate earnings wherever generated were subject to US tax once repatriated – to a territorial regime, where (subject to some exceptions) a US multinational will pay US taxes only on domestically generated earnings. For most domestic multinational corporations, these two prospective benefits more than made up for a one-time transition tax on the nearly US$3 trillion in earnings that had aggregated on the books of offshore affiliates. Moreover, these key reforms slowed (at least for the moment) the longstanding trend of ‘tax inversions’, where US multinationals would use an on-paper acquisition by a foreign-owned entity to move their tax residency overseas.
Above and beyond arresting the pace of inversions, however, the centrepiece advertised benefit of the TCJA was that it would re-energize investment in domestic economic activity, beckoning US investors back home and attracting other outside investors into the mix.
But has it? And will it? Thus far, most of the signs appear relatively tepid. Some of that investment hesitation may be due to the expectation that the TCJA will undergo several tweaks, making it rational to sit on the side-lines to wait out additional regulatory sausage making. At the same time, other aspects of the Act suggest that the boon to corporate finances may not translate easily into significant domestic (re)investment. There are at least three reasons to be sceptical.
First, the new corporate rates – while historically low for the US– are hardly a bargain by international standards. With its new 21 per cent rate, the US now appears to be, on the surface, in par with many other developed countries; but after including state corporate taxes (averaging around six per cent) the US once again sits behind many of the usual suspects for attracting inversions (such as Switzerland and the United Kingdom), and far above those of the reigning EU tax havens – Ireland and Cyprus (both at 12.5 per cent).
Second, the United States has been forced to retain (at some level) a worldwide corporate tax system for pragmatic reasons. The transition to a territorial regime under the TCJA potentially opens the door to aggressive profit shifting antics that have long been the bane of such regimes across the globe. The ostensible ‘solution’ to such strategic behaviour under the TCJA was to retain a vestigial worldwide tax (of approximately 13 per cent) on Global Intangible Low-Taxed Income (or GILTI) derived by a US multinational from controlled foreign subsidiaries. However, the Act’s provisions also permit foreign subsidiaries to exclude a deemed 10 per cent return on the tax basis of depreciable tangible property (such as office buildings and factories) used in the production of a foreign subsidiary’s income.
Although one can certainly understand the presence of the GILTI assessment as an anti-base-shifting device, it translates into two potential ‘GILTI pleasures’ for companies that have undesirable effects. Primarily, they may continue to feed the corporate inversion trend, since several international jurisdictions offer territorial regimes without a similar GILTI claw-back. Additionally, the 10 per cent tangible property exclusion provides a natural magnet for US multinationals to invest aggressively abroad rather than in the US, thereby reducing (or eliminating) the tax liabilities of their foreign subsidiaries.
Third, in the quirky world of corporate finance, a lower tax rate has two competing effects on the attractiveness of an investment. On the one hand, lower taxes free up a firm’s future net cash flows to be distributed among non-governmental constituencies, a clear positive for investment. On the other, a reduced tax rate ironically increases a company’s overall cost of capital, particularly for debt-financed investments, since debt financing effectively enlists the government as a fractional ‘partner’ in both the upside and downside of the investment. A reduced tax rate reduces the government’s partnership share, shifting more risk in the investor and increasing hurdle rates. Although this latter effect does not fully nullify the increased after-tax cash flows due to the reduced rate, it tends to dampen its effectiveness significantly. Couple this effect with, (a) the TCJA’s new (and potentially significant) constraints on the deductibility of corporate debt and (b) the continued demands of shareholders to unlock liquidity through dividend payments, and there may not be much of a runway to make significant, economy-expanding investments in the United States.
Thus far, the TCJA has only partially lived up to its given name (the ‘TC’ bit). Only time will tell whether it will do justice to the rest, but several aspects of the new law should make one sceptical (absent further tweaking) that it will.
Eric Talley is the Isidor and Seville Sulzbacher Professor of Law and Co-Director, Millstein Center for Global Markets and Corporate Ownership. He is an expert in the intersection of corporate law, governance, and finance, and he teaches/researches in areas that include corporate law and finance, mergers and acquisitions, quantitative methods, machine learning, contract and commercial law, alternative investments, game theory, and economic analysis of law. Talley has held permanent or visiting appointments at the University of California at Berkeley, University of Southern California, Caltech, University of Chicago; Harvard University; Georgetown University, RAND Graduate School, and Stanford University. He has also taught short courses at Columbia, UC Berkeley; the University of Miami; University of San Diego (London Program); University of Sydney (Australia); University of New South Wales (Australia); Tel Aviv University (Israel), the Interdisciplinary Center (Israel); ETH Zurich (Switzerland); and the University of Amsterdam (The Netherlands). In 2017, Talley was chosen by Columbia Law School's graduating class to receive the Willis L.M. Reese Prize for Excellence in Teaching. He is current Chair of the board of directors of the Society for Empirical Legal Studies (SELS) and was the SELS co-president in 2013–2014. He has also served several terms on the board of the American Law and Economics Association (ALEA). Talley is a frequent commentator in the national media, and he speaks regularly to corporate boards and regulators on issues pertaining to fiduciary duties, governance, and finance. Talley holds a J.D. from Stanford Law School, where he was articles editor for the Stanford Law Review; a Ph.D. in economics from Stanford University; and B.A. degrees in economics and political science from the University of California, San Diego. He is a native of Los Alamos, N.M.