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It is estimated that foreign subsidiaries of U.S. companies have approximately one trillion dollars in available cash which could be brought back to the United States, but companies are reluctant to do so because the associated U.S. tax cost is too high to bear.
Allowing U.S. based multinational companies to repatriate cash from their foreign subsidiaries at a substantially reduced rate of taxation would provide additional short term tax revenue and provide funds that U.S. based corporations could invest domestically, thereby giving a boost to the U.S. economy.
From 2004 to present, U.S. tax legislation on repatriation has become increasingly stifling. Foreign cash has built up to historically high levels but is not being brought back home at a time when the U.S. economy most needs a boost.
Other countries allow their companies to repatriate funds either tax free or with minimal rates of income taxation. In the U.S. however, funds repatriated from foreign subsidiaries are often treated as taxable dividends, the tax effect of which may be minimized through the use of foreign tax credits for income taxes paid by the foreign subsidiaries' on their local country earnings.
Under U.S. tax law, dividends received by U.S. companies from foreign subsidiaries are taxed as a dividend to the U.S. company, but the U.S. company is eligible to take a foreign tax credit for income taxes paid by the foreign subsidiary associated with the dividend paid. To the extent that the foreign subsidiaries' earnings are taxed at a rate lower than the U.S. tax rate, the U.S. parent's tax on the dividend received would be not be sheltered by foreign tax credits.
The U.S.Congress’ attitude toward U.S. taxation of repatriated funds has become less accommodating over the last six years. Consider the following:
In 2004, Congress passed the American Jobs Creation Act which allowed a temporary one time dividend received deduction to U.S. companies for funds repatriated from their foreign subsidiaries. This provision allowed U.S. companies to repatriate foreign funds at an effective U.S. tax rate of 5.25 percent. The reduced rate applied if companies used the repatriated funds for certain permitted purposes, designed to promote U.S. investment. Estimates put the amount repatriated under this program to be over $300 billion. An independent 2008 survey conducted for a University of Tennessee conference estimates that sixty five percent of firms sampled indicated they would repatriate nearly 60 percent of their foreign funds if a similar provision was enacted again.
Absent this one time dividend, U.S. companies have historically relied on cash repatriation strategies to bring their foreign funds back to the United States. These strategies typically allow funds to be brought back either tax free, or through the use of foreign tax credits to offset residual U.S. tax. The net result was that U.S. companies typically paid no or low rates of U.S. tax on such funds. A popular repatriation strategy was known as the “Killer B” transaction, which used certain elements of the tax free corporate reorganization provisions to bring cash back to the U.S. with no U.S. tax cost. Under this strategy, stock of a domestic parent company would be used by one of the parent's foreign subsidiaries to acquire the shares of a related or unrelated corporation. The parent's stock is acquired by the foreign subsidiary for cash or other property. Since the parent receives cash (or other property) in exchange for its own stock, the parent is not required to recognize gain or loss on the transaction. Finally, since the transaction occurs within the context of an acquisition of a target's stock in exchange for stock of a parent company, the transaction is treated as a reorganization under Internal Revenue Code Section 368(a)(1)(B) of the U.S. internal revenue code (hence the name "Killer B"), and the entities involved are accorded tax free treatment.
On May 17, 2011, the IRS and Department of the Treasury issued final regulations that apply to these repatriation transactions. Under the final regulations, the foreign subsidiary's cash (or other) payment to parent in exchange for parent stock will be treated as a distribution to parent of an amount equal to the value of the cash or other property used in the transaction. Distribution treatment would most likely cause parents to recognize dividend income, which would be subject to U.S. tax.
In 2010, President Obama signed into law H.R 1586 which contained five of six international provisions designed to increase the effective U.S. tax rate to U.S. multinationals on funds repatriated from their foreign subsidiaries. In Congress’ technical explanation of this tax bill, these 5 provisions were dubbed “revenue raisers.”
U.S. companies now have limited tax planning strategies at their disposal to repatriate foreign funds in a tax efficient manner. Companies with cash available in foreign subsidiaries are now faced with the following choices:
1. Repatriate funds and pay the residual U.S. income tax. Many U.S. companies have foreign subsidiaries that are taxed at rates significantly lower than the U.S. tax rate. As a result, the repatriation of these subsidiaries’ funds would result in incremental U.S. taxes that are higher than what U.S. companies are willing to pay.
2. Leave the funds in the foreign subsidiaries. Studies have shown that U.S. companies owning foreign subsidiaries with significant available cash would prefer to increase borrowing in the U.S. to satisfy cash needs as opposed to repatriating available funds from their foreign subsidiaries to satisfy such cash needs. Further, studies have indicated that, as an alternative to paying U.S. taxes on repatriating funds, U.S. companies leave their foreign funds invested in a foreign country, and are even willing to accept a lower rate of return compared to if such funds were invested in the United States, simply because the U.S. tax cost of bringing those funds back is prohibitive. The fact that U.S. companies are willing to make those choices as an alternative to paying U.S. taxes to bring funds home indicates that the U.S. tax system is not conducive to the mobility of foreign capital.
3. Repatriate funds using a tax strategy that results in an acceptable U.S. tax cost. There are still a few repatriation strategies available, depending on the specific fact patterns of a U.S. Company. One such strategy is known as a Cash D transaction. Under this strategy, a foreign subsidiary can acquire the assets of a related foreign company in a transaction that qualifies as a tax free reorganization under IRC Section 368(a) (1) (D). The U.S. parent of the acquired foreign subsidiary receives cash in the transaction. Under the applicable reorganization provisions, if U.S. parent's tax basis in the shares of its foreign subsidiary is high, minimal or no dividend income would need to be recognized by U.S. parent on the receipt of cash in the transaction. Cash D transactions, even though limited in its applicability, currently sits on a short list of repatriation transactions that the IRS would like to eliminate.
In a survey of U.S. companies that took advantage of the onetime dividends received deduction discussed above, 23 percent of repatriated cash was used to hire and train U.S. employees, 14.7 percent was used for U.S. research and development activities, 12.4 percent was used to pay down domestic debt and 7 percent was used to fund acquisitions. Other uses were for increased advertising and marketing spending, funding of worker retirement fund contributions or additional compensation to U.S. employees.
President Obama recently extended certain tax cuts for 2011 and 2012. Congress should consider granting U.S. companies the ability to repatriate their foreign funds at a lower effective rate, perhaps permanently or for a limited period of time. Similar to the 2004 legislation, a provision can be established that such funds must be used for permitted purposes designed to boost the U.S. economy.
I think it is safe to assume that absent this type of legislation, U.S. companies will simply not repatriate their funds, as evidenced by the fact that foreign cash has built up to its current levels and has not been repatriated. In addition, the “revenue raisers” contained in HR 1586 increasing the tax cost to U.S. companies repatriating funds may not turn out to be revenue raisers if U.S. companies leave their funds overseas.
On a practical note, foreign subsidiaries of U.S. companies face pressure to provide an adequate return on invested funds. Most multinationals, whether U.S. or foreign, generally prefer to have excess cash repatriated to its home country, wherein currency risks can be effectively managed, and parent company debt can be paid down.
This topic has generated a substantial amount of interest recently. Congress' action in this regard may provide some much needed relief to U.S. based multinational companies.