Tax Reform Repatriation of Offshore Earnings

(Lee Sheppard for Forbes) -- This article explains how companies would get a tax reduction for repatriation of all that mythical “offshore cash” that is supposed to save the U.S. economy. It is a follow-up to my previous post making predictions about tax reform.

I previously wrote that:

There will be deemed repatriation of deferred foreign earnings at a much lower rate than the prevailing rate or the new rate. “Deemed” means the companies will be taxed regardless of whether they dividend their deferred foreign earnings. There will be a higher rate for companies that have cash. Deemed repatriation means two things. Companies need not move cash to the extent it is tied up (it usually is in the U.S. in liquid assets). And the constructive dividend will show a large revenue fillip.

Let’s break it down.

Loose interpretations of financial accounting rules are driving the tax result. If multinationals booked the deferred tax liabilities that they are supposed to, we wouldn’t be having this argument. Basically, we’re letting multinationals argue that their abuse of the financial accounting rules should be rewarded with a tax cut. Indefinite reinvestment is an exception to the general rule that a deferred tax liability must be booked for deferred foreign earnings unless the company can show a concrete use for the funds (ASC Topic 740-30-25-17).

Why are people who know better letting an accounting abuse drive the debate? It’s an agreed fiction on the part of both parties to justify a corporate tax cut that voters wouldn’t approve of, especially while they are being told that the country with the reserve currency “can’t afford” programs they count on and need.

It’s going to happen—the upfront revenue gain is too tempting. Total deferred foreign earnings are believed to be approaching $3 trillion. The immediate, up-front revenue gain that the federal government could show on a deemed repatriation could be as much as $200 billion. That would be used to fund corporate income tax rate reductions, which cost about $100 billion for each percentage point decrease over the 10-year budgeting period.

Why do we care about the cost of rate cuts? Isn’t the government supposed to be cutting business taxes to inject money into the economy? Deficit hawks have taken control of the process. For them the entire tax reform package must not add to the (mismeasured and phony) budget deficit during the 10-year period after it goes into effect. Moreover, the House Freedom Caucus actually wants to cut spending in course of the budget resolution negotiation. So every nickel counts.

That means that the stimulus from corporate rate cuts could be mainly psychological—the hoped-for incantation of Keynes’ animal spirits rather than an affirmative injection of money into the economy. Wall Street may be disappointed in the size of the eventual tax cut, which is baked into equity prices.

How can a company be taxable on something it didn’t even do? Companies would be taxed as though they distributed deferred foreign earnings regardless of whether they did so. It wouldn’t be the first time that the tax law created a legal fiction that a transfer happened when it didn’t to produce the desired tax result.

It wouldn’t even be the only instance of a constructive transfer in the current tax reform plans—the special lower partnership rate calls for deemed salary to service partners. A long record of case law treats business owners as paying themselves salary when they didn’t pay themselves a market rate.

The corporate tax law contains a lot of constructive transfers, because corporate transactions are very formal and flexible. Shareholders are frequently trying to extract earnings from a corporation without being taxed on dividends. So the tax law has many statutory and judicial rules the treat dividends as having been paid when the substance of the arrangement is the receipt of earnings.

The accumulated earnings tax treats closely-held corporation owners as receiving dividends when they hoard too much cash in the corporation (section 535). Cash received in an otherwise tax-free reorganization exchange can be treated as a dividend (section 356).

Which companies have wads of cash? The FANGs, Microsoft, Cisco, Oracle and Big Pharma, especially Pfizer. Moody’s recently reported that corporate cash holdings were at record levels -- $1.84 trillion, 70 percent of which represents deferred foreign earnings. Apple, Microsoft and Google added to their stashes. Apple has $246 billion in cash, much of which represents deferred foreign earnings.

Apple is unusual in that it doesn’t classify all of its undistributed foreign earnings as indefinitely reinvested. Apple’s most recent 10-K treats $110 billion—roughly half of its $216 billion of unrepatriated foreign earnings--as indefinitely reinvested. The deferred tax liability for that would have been $36 billion. Apple shows $32 billion deferred tax liability on the other half of that $216 billion.



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