Q. We’ve been hearing about a lower tax rate for repatriating foreign earnings under a provision of the American Jobs Creation Act. What is this about?
The American Jobs Creation Act (AJCA) of 2004 includes a repatriation provision that is entitled, “Incentives to Reinvest Foreign Earnings in United States”. This section provides a significant one-time tax break to US corporations that repatriate foreign earnings from controlled foreign subsidiaries (CFCs). Under this repatriation provision, a US corporation is allowed a deduction equal to 85 per cent of cash dividends received from CFCs. This results in an effective tax rate of 5.25 per cent on repatriated dividends instead of the usual 35 per cent rate. The repatriated dividends must be reinvested in the US in certain permitted uses. The AJCA was signed into law on October 22, 2004.
Q. Are the repatriation provisions also known as the HIA or Homeland provisions?
Strictly speaking, there is no Homeland Investment Act (HIA). The repatriation provisions were initially introduced into Congress as the Homeland Investment Act about two years ago. The Homeland Investment Act was never passed but the essence of the original repatriation provision was ultimately included as Section 422 of the AJCA. While people that have been involved with the repatriation provisions since their introduction continue to speak of the HIA or the Homeland provisions, they’re referring to the AJCA’s repatriation provisions. Most press articles also refer to them as the AJCA repatriaton provisions. Not surprisingly, tax attorneys and tax publications are the most precise in their characterization of the provisions – referring to them as the IRC 965 provisions – for the new section of the Internal Revenue Code that was created by Section 422 of the AJCA.
Q. What is the benefit of the IRC 965 deduction to US multinationals?
Historically, the 35 per cent US tax rate on dividends received from CFCs has discouraged companies from repatriating earnings from offshore subsidiaries operating in low tax jurisdictions. In other words, there’s been little incentive for them to repatriate their earnings from low tax jurisdictions as it would likely result in a possible doubling or tripling of their tax burden. As a result, many corporations instead opted to permanently reinvest foreign earnings in their offshore subsidiaries. IRC 965 provisions should enable these companies to repatriate their offshore earnings at a very attractive tax rate during this one-time opportunity. These funds can then be put to work here at home for new investments, to reduce corporate debt, and to stimulate job creation. These reinvestment options can obviously deliver substantial benefits for US multinationals – not to mention the US economy.
Q. How much money is currently reported as being permanently reinvested offshore?
In 2003, more than half of the S&P 500 companies reported permanently reinvested foreign earnings, totaling more than $500bn. The grand total for all US multinationals is estimated to exceed $700bn. Banc of America Securities (BAS) estimates that $300bn to $400bn may be repatriated in 2005-2006 by corporations seeking to benefit from this one-time repatriation opportunity.
Q. Have any US companies already announced that they will take the deduction?
Yes. Hundreds of companies have already reported their intention to potentially repatriate their trapped offshore earnings in their most recent SEC filing. The most prominent of these has been Pfizer Inc, which has indicated it might repatriate up to $29bn, and possibly an additional $8.6bn more depending on subsequent IRS guidance on the repatriation provisions.
Q. Are there limits on the amount of cash dividends to which we can apply the deduction?
Yes. There are several limitations. One notable limitation is referred to as the “financial statement” limitation which restricts the repatriation benefit to the amount of earnings reported as permanently invested outside the US on the taxpayer’s most recent audited financial statement certified on or before June 30, 2003. If the applicable financial statement fails to show a specific amount permanently reinvested outside the US, but does show a specific amount of tax liability attributable to such earnings, then the limitation is the tax liability grossed up at a 35 per cent rate. However, in all situations – whether reported in financial statement or not – companies are allowed to repatriate a minimum of $500m at the tax advantaged rate.
Q. What if our company repatriates foreign earnings as cash on a regular basis? Will those dividends qualify for the deduction?
To qualify for the deduction, your repatriated cash dividends must be extraordinary. That means they have to exceed your annual average repatriation level during a three-year base period. The base period is determined by taking your five most recent taxable years ending on or before June 30, 2003, and eliminating the two years with the highest and lowest repatriation amounts.
Q. What are the requirements for reinvesting repatriated dividends in the US?
The repatriation provisions states that you must create a formal domestic reinvestment plan, approved by your senior management and board of directors. A non-exclusive listing of permitted uses of dividend proceeds includes their use for worker hiring and training, infrastructure development, research and development, capital investments, certain acquisitions of business entities with US assets or financial stabilization of the corporation for the purposes of job retention or creation. The plan cannot designate repatriated funds for executive compensation.
Q. To what taxable period can we apply the repatriation provisions deduction to?
The deduction can be applied to your first taxable year beginning on or after the AJCA’s effective date of October 22, 2004. This is what most corporations will choose to do. Alternatively, you could elect to take the deduction in your last taxable year beginning before the AJCA’s effective date.
Q. Assuming we make the decision to repatriate, what kind of help can we expect from our global banking partners?
There are four specific areas that an AJCA-ready banking partner can help you with:
- Pre-Repatriation Funding Solutions
- Pre-Repatriation Foreign Exchange Hedging Solutions
- Repatriation cash and liquidity management
- Post-Repatriation Capital Structure Advisory
Q. What do you mean by funding?
Since earnings must be repatriated as cash dividends, you may need to fund the difference between the desired repatriation amount and the cash on hand in overseas subsidiaries. For example, BAS can provide short-term and long-term financing solutions (including several proprietary structures), which clients can use to convert earnings on the books into cash that can be repatriated. In certain circumstances, BAS can also provide “financeability” assessments on subsidiary financing without a parent guarantee that some tax directors seek. In addition, BAS can advise on potential rating agency implications of various funding strategies.
Q. What are the key FX issues?
For many CFCs, the functional currency of an offshore subsidiary is the local currency, so repatriation in US dollars will result in significant FX exposures. In 2005, we’re forecasting significant strengthening of the dollar by the end of year. If CFC cash balances are in currencies that weaken against the dollar, those balances will decline in value. Consequently, you’ll want to talk to your bankers about hedging strategies such as forward contracts or options you can use to “lock in” exchange rates for foreign currency balances you plan to repatriate.
Q. What should we be considering in terms of cash and liquidity management?
Repatriating offshore cash requires effective offshore and onshore working capital management structures, funds transfer solutions, and FX services that streamline your multi-currency cash flows and automate funds transfers as much as possible. You’ll also need top-quality information reporting services to track the movement of funds for your accounting purposes. To find out what specific types of solutions will work best with your offshore and onshore treasury systems, you’ll need to talk to your bankers.
Q. How does post-repatriation capital structure advisory fit into the repatriation picture?
As you assess the impact of your reinvestment alternatives on your capital structure, BAS, for instance, can help you optimize your debt buyback and assess M&A opportunities and other strategic considerations. In turn, Client Investment Strategies and the Columbia Management Group can provide you with investments and investment advisory services.
Part 2 of this article will appear shortly.
Note: The ideas expressed in this article do not necessarily represent those of Bank of America . Bank of America takes no responsibility for the accuracy or completness of this information. This article contains suggestions only and is not meant to substitute for your own internal procedures which are appropriate for your company. This information is not legal or tax advice. You may wish to consult your advisors to discuss your company’s legal or tax needs.