Tax reform promised a deluge, delivered a drip of foreign earnings

One of the main pitches Republicans made in support of last year’s tax overhaul was that it will encourage U.S. multinationals to repatriate their massive piles of foreign profits.

The new law is “going to free up a lot of money to come back and build factories here and so on,” White House Council of Economic Advisers Chairman Kevin Hassett said shortly before passage of the law.

Last month, President Trump said, “[We] think it’s going to be close to $5 trillion. Over $4 [trillion], but close to $5 trillion, will be brought back into our country.”

{mosads}Nine months after the passage of the law, these promises have failed to materialize. A report by the Wall Street Journal found that the rate of repatriations proved sluggish.

Moreover, there is ample evidence that the money that is being brought back is used primarily to reward shareholders through dividends and stock buybacks and is not invested in “factories … and so on.”

Surprising? Not really. In fact, this is exactly what most tax experts expected would happen.

Before the passage of the new law, U.S. multinationals were subject to tax on their worldwide income. There was one important exception, however: Income earned by controlled foreign subsidiaries was not taxed until repatriated (for example, as a dividend to the U.S. parent).

With a high U.S. corporate tax rate of 35 percent, this created an incentive for U.S. multinationals to shift as much of their profits as they legally could to subsidiaries organized in low-tax countries and keep the profits there.

By some estimates, at the eve of the new legislation, U.S. multinationals held as much as $2.6 trillion of untaxed or low-taxed profits in offshore subsidiaries.

The new law prescribes that all past accumulated foreign earnings are deemed repatriated and subject to reduced taxation (15.5 percent on profits held in cash and cash-equivalents, 8 percent on everything else), instead of the headline rate of 35 percent.

This one-time transition tax is paid over an eight-year period, with no interest charge. Going forward, all foreign earnings will be exempt from U.S. taxation.

Republicans said that this will eliminate the incentive for U.S. multinationals to keep their earnings abroad. Money brought back will be put to good use in the U.S. economy, we were told. These expectations, unfortunately, were unrealistic.

The economic logic behind the Republicans’ thinking implicitly assumes that U.S. multinationals are liquidity-constrained at home. Meaning, U.S. multinationals held most of their cash abroad, and the tax imposed at repatriation simply makes the use of such cash for domestic investment a losing proposition.

If we just free this cash from taxation, domestic capital investment would mushroom. However, there is no evidence that prior to the enactment of the new law, U.S. multinationals were cash-constrained.

In fact, myriad exceptions and loopholes under the old law enabled U.S. multinationals to bring much of their earnings back at low cost or borrow against foreign earnings at low rates.

Companies also had plenty of cash from domestic earnings. If companies needed cash to finance domestic investment, they could access it. So maybe companies don’t bring all the money back now because, well, they don’t need it.

This also helps to explain why money that is being brought back is used to pay shareholders and not for new investment. Of course, paying shareholders is not a bad thing. But “tax reform will allow companies to buy back their own stock” is not a great sales pitch.

Moreover, there are multiple incentives for companies to keep their money offshore, even under the new law. For example, U.S. companies probably invest much of their existing earnings in marketable securities and other investment that generates passive returns.

Why hold such investment in the U.S., where passive returns are taxed at 21 percent (the new corporate tax rate), and not in the Cayman Islands (where passive returns are taxed at 0 percent)?

In addition, not all foreign profits are liquid. Some may be invested in real assets and overseas operations. Bringing these profits back would be enormously costly regardless of tax.

Ironically, another new provision of the new tax law may create a fresh incentive for U.S. multinationals to invest in foreign tangible assets like land, factories or equipment. This new provision imposes a new tax on certain foreign earnings attributable to intangible property like patents, trademarks and copyrights.

The tax is imposed on any foreign earnings above a certain fixed return from tangible assets. Thus, the more tangible assets a U.S. firm holds offshore, the less exposure it has to the new tax. Some commentators argue that this may motivate U.S. multinationals to reinvest foreign earnings in tangible foreign assets.  

Foreign laws may also create a barrier for repatriation. Foreign countries where earning are held may impose withholding taxes on outbound payments or have in place regulatory regimes that require companies to hold certain asset levels in the foreign country.

Finally, the fallacy of the repatriation promise can easily be demonstrated by the president’s argument: “Over $4 [trillion], but close to $5 trillion” will be repatriated. These amounts will not be repatriated because U.S. companies never held that much in untaxed offshore earnings. They held, as mentioned, about $2.6 trillion.

It is important to note that the new law does contain multiple provisions that can reasonably be expected to support domestic investment, such as the dramatic reduction in the headline corporate tax rate and new generous expensing provisions. Repatriation, however, has nothing to do with it.

Even if one accepts that exempting foreign profits is better than the old system (and many tax experts do), there was no good justification to tax past accumulated foreign earnings at low rates. These profits have already been earned.

Taxing them at the full, old rate of 35 percent would not have changed investment behavior (companies cannot “un-earn” money). And companies would still have enjoyed a significant time-value benefit derived from deferring U.S. tax payments on foreign earnings.

Congress simply left money on the table (for shareholders to grab). Not only that, by taxing such earnings at preferred rates, Congress effectively rewarded past tax planning by U.S. companies, with no upside for the government. What kind of a message does that send?            

Omri Marian is a law professor and the academic director of the Graduate Tax Program at the University of California, Irvine School of Law. He specializes in international taxation.