Repatriation of Foreign Earnings: Prudent Stimulus or a Null Event?

Consistent with accommodative monetary and fiscal policies in the United States during the past several years (ultra low interest environment, reduction in effective tax rates associated with dividend income among other reforms), the introduction of the Homeland Investment Act, frequently referenced as a subsection of the American Jobs Creation Act of 2004, represents a significant attempt to at least temporarily change the US corporate tax hegemony in the context of a global revenue “tug of war” between countries. The impetus for HIA was to introduce an incentive, via a temporary tax amnesty (one to two years), for multinationals to repatriate certain accrued profits held offshore. Typically profits are retained offshore either to provide a source of liquidity for local operations or to avoid punitive tax consequences; the latter being at the core of HIA.

The Salient Aspects of HIA

1. Provision extends temporary reprieve allowing multinationals to subtract from US tax by up to 85 per cent of foreign repatriated profit. Effectively this translates into an income tax liability of 5.25 per cent for US entities. Compared to the commonly applicable 35 per cent rate this obviously represents a dramatic reduction.
2. The overseas entity must constitute a “Controlled Foreign Corporation” or CFC, where the majority of stock equity is controlled by US shareholders.
3. To qualify under HIA, CFC declared dividends must be in the form of cash, be substantively different from any normal occurring dividend, and cannot be infused via the parent. In other words the dividend must constitute funds that were derived from, and self-contained in, a CFC. Additionally, they must be extraordinary in nature relative to any regular dividend pattern originating from the CFC.
4. The dividend is required to be invested in a board-sanctioned plan that is deemed appropriate under HIA. Among others, this would include types of R&D, employee education, job genesis programs and capital pursuits of the firm.

The Mechanics Underpinning the Utility of HIA

As a rule of thumb revenue is assessed for taxation purposes in the US exclusively on a post repatriation basis. In other words, accumulated profit that is derived in foreign jurisdictions could hypothetically continue to increase, without tax consequence, in perpetuity provided the funds remain offshore. This might be considered an extreme example but in actuality it’s not beyond plausible considering:

1. Worldwide corporate tax rates have decreased dramatically over time.
2. If preferred, US corporate entities can maintain US dollar denominated holdings offshore in domains with effective tax rates close to zero.
3. Many US institutions already have sizable domestic US dollar liquidity reserves with little natural necessity or legal requirement to repatriate funds within a finite timeframes.
4. Foreign Tax Credits (FTC) under HIA can actually be applied strategically to ultimately reduce US tax liability within a fairly liberal time interval of up to 10 years.

Although overseas profit held in non US dollar (FX denominated) accounts results in ongoing foreign exchange translation exposure, it’s important to appreciate the following points that lessen this concern:

1. With the advent of the euro, the dollar is no longer perceived as being the only ‘game in town’ from a reserve currency of choice. This is as true with respect to multinational cash balances as it is with central bank holdings.
2. Multinational entities might very well enjoy benefits associated with diversification of their more liquid assets across an array of major currencies. This is especially true in periods of secular depreciation of the US dollar. Over time this would moderate the year-to-year translation related volatility and its impact on consolidated equity.
3. From the standpoint of avoiding adverse P&L impact, translation adjustments are generally accounted for exclusively on the balance sheet until a materializing event occurs, e.g. sale of an overseas subsidiary. This allows avoidance or deferment from interim income statement concerns.

Prospective Repatriation and the Currency Markets

There’s been a cacophony of divergent sentiment expressed regarding what the cumulative repatriation amounts might mean for the relative strength of the US dollar. The estimates of how much might eventually be repatriated vary but there appears to be somewhat of a consensus view that it would be in the vicinity of $250bn – $500bn.

At the end of the day it’s hard to argue, as impressive as the figures are, that they will constitute more than a minor blip relative to the liquidity levels experienced in the FX market as a whole. Supporting this is the fact that depending on the methodology and source used, daily FX turnover averages in excess of $1trillion and in all likelihood is closer to $2trillion.

In that context, it would not be exceptionally difficult for the currency markets to digest any prospective repatriation flows. Indeed, if one accepts the premise that currency markets are highly efficient, the natural conclusion would be that the majority of expected repatriation activity is already priced into the market.

Consistent with this fairly benign US dollar effect is the dimension that a significant amount if not a majority of foreign subsidiaries’ liquid holdings are already dollar denominated. Furthermore, certain companies during the early part of 2005 have undoubtedly already undertaken putting into effect dollar hedges.

Treasury Concerns and Considerations

One of the focal points for corporate treasury in preparing for what might well turn out to be an unprecedented (note that the potential transaction size in many instances will far exceed the norm for the firm), one-time currency event is how to most appropriately manage the FX risk. Anecdotally, it appears although the intent is to develop a “plan of attack”, undoubtedly involving derivatives in many instances, it appears to be at this juncture nothing more than that. This aspect is crucial considering that most corporate FX policy and control frameworks are probably grossly inadequate in encompassing a unique situation of this prospective scale.

FX Related Questions for Treasury

• To what degree is the existing FX policy statement inadequate; what deficiencies require a board approved mandate prior to invoking?
• Process and controls around atypical, ultra-sizable FX and derivative related transactions.
• To what extent is prevailing in-house expertise adequate to determine most appropriate course of action in addressing FX risk involved?
• Extraordinary tax or financial statement concerns associated with an FX hedge event of this nature?
• Derivative specific considerations with respect to acceptable techniques, instruments and tenure.
• Capital control or central bank regulatory constraints associated with prevailing overseas, FX denominated holdings.
• The adequacy of prevailing FX facilities, present FX consortium to insure competitive pricing as well as acceptable counterparty risk.

Final Thoughts on HIA

Considering HIA represents un-chartered waters from an economic stimulus perspective it’s difficult to ascertain what the net effect on the US economy will be. Prima facie, it appears that capital markets overall reacted favorably to its enactment although the true litmus test is ultimately what domestic projects are undertaken by multinationals as a result of HIA and to what extent they provide positive spillover to the US economy as a whole. Only time will tell, as institutions capitalizing on HIA are only just beginning to provide guidance into what their plans for the repatriated funds are.