Best & Worst Corporate Cash Managers: Repatriation Nation
Companies complain that taxes on foreign earnings are inhibiting U.S. investment. Critics say that’s a smokescreen.
Companies’ trendiest excuse for holding more cash on the balance sheet than is required to run a business is the U.S. tax code. Global companies that want to expand dividends or repurchase shares face a prohibitive hurdle: untaxed foreign earnings outside the U.S. The majority of cash nowadays resides “trapped” outside the U.S. If repatriated, Uncle Sam can take a bite of up to 35 percent of these dividends from foreign subsidiaries, less credit for foreign taxes paid.
If, too, a foreign subsidiary extends a loan to a U.S. business, loan proceeds are treated as a taxable return of capital. And tax authorities are tough on such “fronted loans,” says one retired oil industry treasurer. “Any contract where payment was made to a different jurisdiction than where goods changed hands or where our affiliate was domiciled was carefully reviewed; we did not want to facilitate tax evasion.”
Companies perform gymnastics to avoid repatriation taxes as a result. With $18 billion in its global coffers, drugmaker Amgen had more than enough to pay for a recent buyback. Instead, it tapped capital markets. Rather than repatriate money, the Thousand Oaks, California–based company issued senior notes in November to finance a $5 billion Dutch auction tender offer for shares of common stock.
Although the prospect of taxes puts $44 billion out of reach today, large shareholders vote for leaving it there, Microsoft Corp.’s manager of investor relations insists. “Zero investors say go pay the tax and bring it back,” says William Koefoed, who directs Microsoft’s investor relations out of its headquarters in Redmond, Washington. To be fair, the world’s biggest software company has returned $177 billion to its shareholders in past ten years through dividends and buybacks.
Use of untaxed foreign earnings by U.S. corporations to purchase assets outside the U.S. results in no U.S. tax. So companies seek ways to spend it abroad. Acquisitions of European targets by U.S. strategic buyers increased sharply in 2011 from 2010, in number of deals and deal valuations, according to Bloomberg.
Case in point, Johnson & Johnson agreed in April to pay $21.3 billion for Synthes, a Swiss manufacturer of orthopedic devices. Coincidentally, the price tag roughly equaled J&J’s growth in cash since 2008.
Bulging coffers represent “dry tinder” to economist Richard DeKaser of Parthenon Group, a Boston-based consulting firm, who says he would not be surprised to see cash balances give way to a global surge in mergers and acquisitions. That may or may not bode well for shareholders of acquiring companies, given the frequent failure of M&A to meet expectations.
The pace overseas will nonetheless accelerate, Howard Lanser, director of M&A for Robert W. Baird & Co. in Milwaukee, contends. With ample cash, nimble strategic buyers these days can swoop up assets as fast as or faster than private equity players. A couple of years ago, private equity sources had the edge.
Some observers think cash balances could soon boost the economy. If easing tension in the Mideast lowers oil prices and advanced economies take prudent steps toward fiscal soundness, “business confidence could improve rapidly, enabling firms to invest their reserves,” according to a forecast published last autumn by U.K.-based Oxford Economics, a leading source of global economics data.
Some surplus cash held overseas is already finding its way to emerging markets, where growth is strong. Meantime, companies can park cash there at more attractive interest rates, albeit at greater currency risk.
So long as untaxed foreign earnings accumulate at any company, they will cloud financial reporting. Now you see them, now you don’t, according to Jack Ciesielski, Baltimore-based editor of the “Analysts’ Accounting Observer,” an investment research newsletter. Companies seldom report untaxed foreign earnings, much less related deferred tax liabilities. As a result, foreign revenue bolsters reported income alongside revenue in the U.S., but earnings remain as far from the grasp of shareholders as noncash contributions to the bottom line. “When they contain heaps of untaxed foreign earnings,” Ciesielski wrote, “consolidated net income and cash generated by operations have a quality problem: They wind up being first cousins to the financial reporting dreck normally avoided by investors.”
Still, piling up cash abroad gets a green light from the accounting overseers so long as companies declare to auditors that it is permanently invested, an easy bar to clear. The Securities and Exchange Commission is eyeing this issue, however. At a Regulations Committee meeting on September 27, 2011, SEC associated chief accountant Angela Crane noted the staff’s request for disaggregated financial information where foreign operations have what she called “a disproportionate effect on consolidated operations.”
Absent muscle to compel repatriation even when complaints that taxes prevent permanent investment look like a smokescreen, regulators have put pressure on a handful of companies to report hypothetical deferred taxes on foreign earnings. At the end of 2010, Google reported $16.7 billion in untaxed foreign earnings, Oracle Corp. reported $16.6 billion, Qualcomm $12.1 billion and much smaller Cardinal Health, to pick a company at random, $398 million, according to the “Analyst’s Accounting Observer.” In its 2011 form 10-K, Microsoft claimed that repatriating $44 billion would have made the company incur a tax of $14.2 billion after foreign tax credits and other adjustments.
Supporters of a tax holiday on repatriated earnings in 2004 cited job creation as its rationale. But the repatriated cash found its way to shareholders, lenders and corporate coffers before it trickled to hiring new workers. That outcome may sound just fine to institutional investors, but legislation depends on a larger constituency.
Apart from other consequences, warns Microsoft’s Koefoed, tax holidays invite “moral hazard,” in that companies might start piling up cash again until the next repatriation holiday. That’s one reason Microsoft throws its considerable weight behind permanent tax reform.
One solution would align the U.S. with most other industrial nations, where “territorial” tax systems prevail. If implemented successfully, say advocates, a territorial tax system would make movement of funds across borders as efficient as globalization has always promised without increasing the tax burden on companies.
The House Ways and Means Committee is preparing revenue-neutral legislation aimed at putting the U.S. on an even keel with the rest of the world, step one in putting foreign income within reach of shareholders. Along with features that include a 10 percentage point reduction in the corporate tax rate, to 25 percent, the bill would provide a deduction equal to 95 percent of foreign source dividends from a controlled foreign corporation to a 10 percent corporate shareholder.
Not so fast, contend labor unions, small business and other critics. By their lights revenue neutrality is a problem, not a solution. Tax neutrality just lets global corporations off the tax hook at a time when companies have billions of dollars of idle cash yet fire tens of thousands of workers. For its part, the Obama administration has proposed cutting the top corporate rate to 28 percent in return for the elimination of loopholes and the imposition of a minimal levy on cash kept overseas.