Wednesday, March 21, 2018

Tax policy colloquium, week 8: Lisa De Simone on the aftermath of the 2004 repatriation tax holiday

Yesterday at the Tax Policy Colloquium, Lisa De Simone of the Stanford Business School presented Repatriation Taxes and Foreign Cash Holdings: The Impact of Anticipated Tax Reform.

The paper examines how, in the aftermath of the 2004 repatriation tax holiday, U.S. multinationals (MNCs) responded to the possibility that there would be a second such holiday in relatively short order. Although the supposed rationale for the holiday was "just this once, and never again," there were many people who believed that there'd be another one soon. Indeed, I was among said people. And it might indeed have happened but for three intervening developments:

--A big part of the rationale for the repatriation holiday had been that it would lead to increased U.S. investment and jobs. Academic studies suggesting that the impact had been more in the direction of increasing share repurchases and/or M&A activity (shades of 2018!) had an adverse effect on lobbyists' talking points in favor of a new holiday.

--The Joint Committee on Taxation turned out to have under-estimated the immediate response to the holiday. Hence, the first-year revenue gain was higher than expected. This is one reason I expected a repeat. What could possibly be better, from Congress's standpoint, than raising revenue within the budget window while very likely losing revenue long-term, and making the companies that are paying the added short-term tax revenues happy because they have longer time horizons than the budget rules? BUT - evidence rapidly emerged to the effect that the hope for a second holiday was leading to increased profit-shifting - a subject of study in the paper we discussed yestereday - causing the JCT to conclude that a second holiday would lose revenue even WITHIN the budget window.

--Once Congressional Republicans were focusing on enacting a new set of international tax rules that included dividend exemption, they viewed a holiday as counter-productive in terms of the prospects for doing that, as it would both reduce the pressure in support and possibly undermine revenues to be gained from a transition tax on pre-enactment foreign earnings.

Among other things, the paper focuses on the distinction between the incentives created by (a) a repatriation tax holiday, as distinct from (b) enacting dividend exemption as a "permanent" item, with possibility of an accompanying  transition tax (as was actually enacted in 2017). BTW, for what it's worth, other countries that shifted to dividend exemption had no transition tax, and I believe I was the first in the US to call for it (in this 2010 paper), although full credit for the idea, in the conceptually similar context of domestic corporate integration, goes to the likes of David Bradford and William Andrews.

Anyway, the De Simone paper is based on comparing two types of US MNCs: those that were MORE likely to want to repatriate CFC profits soon, and those that were LESS likely to have this inclination. We can call the former group the "treatment"firms - those potentially responding more to the prospect of a second repatriation holiday - and the "control" firms that were less likely to respond to that in particular. Treatment firms were distinguished from control firms in part by examining  the characteristics of MNCs that actually had repatriated during the 2004 holiday. The paper also makes use of events that may have made the perceived prospect of an imminent new repatriation holiday seem either more likely or less so (such as, for the former, the introduction of a new repatriation holiday bill in 2008).

In the paper's analysis, treatment firms, as compared to control firms, generally were larger and more profitable but with lower recent total and foreign growth in pofitability, had higher market-to-book ratios, more working capital, more cash, and less debt, had indicia of greater cash needs, and had larger deferre foreign tax liabilities. So these were in general pretty strong firms, albeit possibly more cash-hungry than the norm. Cash-hunger would of course help motivate wanting to repatriate, as also might low recent growth in foreign profitability, but they do not stand out as firms that would have been unusually distressed, despite the crazy things that were happening in the world economy, in 2008 or thereabouts.

In the data, when a second repatriation holiday seemingly was in the cards, treatment firms, as compared to control firms, (1) had more growth in "excess cash" (although this could not be directly tied to excess cash in the hands of CFCs), (2) reduced share repurchases but not dividends more, (3) did more profit-shifting, (4) had more of a rise in "permanently reinvested earnings" (PRE) that they declared for accounting purposes, (5) had positive stock price effects, (6) did more lobbying for a new holiday, and (7) had more growth in "excess cash" even if they didn't so lobby. But these differences generally vanished after 2011, when arguably a holiday was no longer much in the cards, but the enactment of "permanent" dividend exemption arguably was.

I found the paper's empirics generally persuasive - reflecting, of course, that it's the result I would have expected - although matters of timing for the relevant expectations are inevitably hard to pin down. The main thing I might question or at least supplement, in terms of the paper's conclusions, is the mechanism suggested for relative rise in declared PRE among treatment firms. The mechanism that the paper suggests is that firms might view increased PRE as likely to increase the amount that they were allowed to dividend home at a reduced tax rate in the event of a new holiday.

In support of this interpretation, (1) the 2004 holiday capped tax-reduced dividends at the higher of one's PRE or $500 million, and (2) the 2008 "REAP Act" proposal that would have provided for a second holiday repeated this exact mechanism. But, on the other hand, (1) given the $500M number, I don't know to what extent treatment firms would have anticipated needing more PRE in the event of a second holiday, and (2) it's amazing to think that Congress might have been stupid enough to encourage PRE by making it the prerequisite for a tax benefit not just once, which is remarkable already, but twice.

My alternative suggestions re. the reasons for a relative growth in PRE among treatment firms, as distinct from control firms, might include such possibilities as (1) declaring PRE and then bringing it home anyway is made less costly, for accounting as well as cash purposes, by a repatriation holiday, and (2) endogeneity: treatment firms might also have for other reasons been more inclined than control firms to value getting accounting benefits from aggressive profit-shifting.

Anyway, here are three of the paper's takeaways with my comments on them, plus two takeways that I would add:

Paper's first takeaway: The expectation of a second dividend holiday was a major reason for the run-up in firms' "excess cash" during the post-2004 period.

This is very plausible, and accords with findings elsewhere in the literature.

Paper's second takeaway: Expectations about future tax law changes can affect current corporate behavior, and can induce behavior that would have a negative impact on net present value in the absence of the anticipated changes. Here, the point being made is that (when repatriations are taxable) firms reduce their internal liquidity, and force themselves to play costly Twister games with their internal finances, when they shift profits to their CFCs for tax planning reasons.

This, too, makes sense. But, if one is refining broader models of how companies respond to prospective but uncertain tax changes, it's worth noting that here is truly a quintessential place where one would expect that. Two points about repatriating CFC earnings through an inter-company dividend: the potential tax law change matters a lot, and the independent economic consequences of the action being studied, and its timing, may be relatively slight.

As the so-called "new view" (although by now it dates back to a 1985 article by David Hartman) shows, a repatriation tax has zero incentive effects on the timing of taxable repatriations so long as (1) the after-tax rate of return is the same with or without a repatriation, and (2) the repatriation tax rate is permanently fixed and ultimately can't be avoided. So anticipated changes in the repatriation tax rate are absolutely at central stage in creating lockout, i.e., reluctance to repatriate today. When the repatriation tax rate can change, a sooner repatriation throws away the option value of waiting for a lower rate in the future. And when it's systematically likely to decline rather than go up - whether due to a holiday, a cut in the general corporate tax rate, or the enactment of dividend exemption with a lower-rate or no transition tax - then lock-out becomes especially strong.

That helps show the centrality of future vs. present repatriaton tax rates in deciding whether to repatriate today. But it also matters that this is simply a matter of shifting $$ from one pocket to another within the same firm. While this may matter more than zero - given the internal liquidity issues and potential costs of resulting Twister games - it might often be rather different than, say, (1) paying dividends outside the entity to the ultimate owners, or (2) deciding whether to sell one's appreciated asset (where present and expected future capital gains rates are key, but the sale might significantly affect one's diversification and risk exposure).

Paper's third takeaway: Temporary tax rules can have important subsequent planning effects that linger.

Agreed, and this is why the repatriation tax holiday was such a horrendously bad idea. Like non-credible, supposedly "once-only" tax or other amnesties, it made things a lot worse afterwards given the inevitable expectation that it might be repeated soon. The fact that something else ultimately happened instead did not prevent much of the harm from being realized.

My first additional takeaway: the accounting rule for PRE was really terrible. While it's now moot given that the repatriation tax has been repealed, this may have broader implications regarding accounting rules that create the opportunity for gameplaying based on corporate management's assertions and representations to the accountants.

Think about it: What the paper suggests is that companies that actually were MORE likely to repatriate their foreign earnings disproportionately got their accountants to agree to the opposite - i.e., that particular profits were going to be kept abroad indefinitely. This is akin to having a self-reported net worth contest in which the poorest systematically claim to be the richest.

My second additional takeaway: The core problem with deferral - i.e., with taxing US companies' foreign source income specifically when it was repatriated, rather than either immediately or not at all - was not that the repatriation tax rate was positive, but that it was not credibly fixed at a durable rate. The great thing about dividend exemption, all else equal, is that the zero percent rate is credibly fixed at zero, rather than that it is low or high. Again, given the new view, any fixed and ultimately inevitable repatriation tax rate avoids affecting the timing of repatriations (after-tax rates of return may matter too, but their effects on planning are multidimensional), but for positive rates this is presumably much harder to accomplish.

Just to make the point clearer conceptually, suppose it were plausible that Congress, in the future, might possibly enact a repatriation subsidy. (E.g., repatriate a $100X dividend from your CFC, and the Treasury will pay you $100X multiplied by the subsidy rate.) In that admittedly improbable scenario, merely exempting repatriations would lead to lock-in, since companies would want to wait for the possible future subsidy.

Given the difficulty of credibly fixing the repatriation rate, other than at zero, I'd argue that it makes sense to have any taxes on resident companies' foreign source income be levied immediately, i.e., in the year when they accrue for tax purposes. This is what countries' CFC rules generally do, including our own subpart F rules and now GILTI.

As I'll be explaining in my forthcoming international tax article on GILTI, the BEAT, and FDII, dividend exemption does not mean one has a "territorial" system, and indeed it's been widely recognized that the new US system is not a "territorial" one given the significant taxes it can impose on resident companies with foreign source income.

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