Repatriating Foreign Earnings: Tax Breaks, Hedging And Job Creation, Part II
There are three critical factors any CFO should consider before repatriating earnings under the American Jobs Creation Act. First, since the dividend has to be paid in US dollars, you should hedge your foreign exchange rate to make repatriation as advantageous as possible, particularly if the funds to effect the dividend distribution have to be borrowed under a foreign currency denominated loan. Second, you will need to pay close attention to foreign taxes that have been or will be imposed on the repatriated earnings.
There is no point in repatriating foreign earnings under a Domestic Reinvestment Plan if the aggregate foreign income tax rate imposed on those earnings equals or exceeds the 35 per cent US corporate income tax rate. In that case, no additional US tax would be due in any event and the related foreign income and withholding taxes would not be available, as either a credit or as a deduction, to shelter other foreign source income from US income taxes. Of course, as discussed in Repatriating Foreign Earnings: Tax Breaks, Hedging And Job Creation, Part I, you will also want to design a Domestic Reinvestment Plan that best meets your company’s needs and provides for alternative investments if developments make current plans for using the repatriated earnings obsolete.
If you plan to repatriate foreign earnings, you will need to pay close attention to the US foreign exchange rates for the country or countries involved, particularly if you plan to convert cash or investment assets held by the foreign subsidiary into US dollars or borrow funds under a foreign currency denominated loan to pay the dividend. If you believe the local currency is overvalued in relation to the US dollar, future swings in exchange rates may be of relatively minor concern. Indeed, repatriation may be an excellent strategy to lock in the current exchange gains that have already been reflected in your company’s reported earnings.
On the other hand, if you believe that the local currency is unduly depressed, and, therefore, likely to rise in value against the US dollar, exchange rates may be a major concern. In that case, you may wish to consider a number of techniques to minimize the potential damaging effects of a negative swing in exchange rates.
One option to minimize your company’s currency risk is to pay the required dividend in installments, timing the distributions to take advantage of favorable ebbs and flows in the currency markets during the taxable year. However, this technique may be of limited usefulness given the requirement that all of the repatriated earnings be brought home in a single taxable year.
Another option to minimize unfavorable foreign exchange rates is to develop a strategy to hedge foreign currency exposure. By hedging, your company is essentially taking out an insurance policy against a negative event. While hedging will not prevent a negative event from happening, it can reduce or eliminate the impact of the negative event if it occurs.
Two of the most popular ways of hedging are through forward contracts and options. A forward contract is a firm obligation to buy from or sell to your lender a fixed amount of foreign currency on a specific future date at a specified exchange rate. An advantage of the forward contract is that it removes the impact of foreign exchange volatility on the profit or cost of a future transaction. Once the rate has been agreed upon, your company is protected from all future exchange rate fluctuations. A disadvantage of the forward contract is that it removes the opportunity to enjoy upside potential if the rate is more favorable for your company.
A foreign currency option provides protection from an adverse exchange rate movement, while enabling the owner of the option to benefit from favorable movements. The key characteristic of a foreign currency option is that it is a right rather than an obligation. A disadvantage of an option is that it requires a premium to be paid at the time the option is purchased. Depending on the size of the notional amount of the option, this could be an expensive upfront cost. However, a number of strategies can be used to reduce the up-front premium.
The foreign exchange rate has always been an important component of any overseas transaction. With the sheer volume of capital likely to move around as a result of the Act, it is especially important for CFOs to keep the exchange rate in mind.
When repatriating, CFOs must compute the effective foreign income tax rate that has been imposed on the unrepatriated earnings of your foreign subsidiaries. You must also determine the extent to which the earnings have already been taxed to your company under Subpart F of the US Internal Revenue Code.
Typically, most foreign jurisdictions impose income tax on earnings derived from business activities conducted within their borders. In addition, most foreign jurisdictions impose withholding taxes at a specified treaty rate on dividends paid out of those accumulated earnings to a US-based parent corporation. The combined effective rate of tax in many cases equals or exceeds the 35 per cent US corporate income tax imposed on large corporations.
In such cases, it would be counter-productive to elect to treat dividends paid out of such highly taxed income under the Act. Imagine that you repatriate $100,000 of income from a foreign subsidiary, which has been taxed at a 40 per cent average rate. Imagine further that the country of its residence imposes a 5 per cent withholding tax on the remaining $60,000 when it is distributed as a dividend. The country of residence has now taxed $43,000 ($100,000 of pre-tax income times 40 per cent, plus $60,000 after tax dividend times 5 per cent withholding tax). In this instance, no US federal income tax should be due because the US income tax of 35 per cent ($35,000 out of $100,000 in this case) will be offset by $43,000 of foreign tax credits. The US parent will have $7,000 of unused foreign tax credits that it may be able to use to insulate other foreign source income from US federal income tax. Qualification of the dividend under the Act will not produce a better result. Under the Act, 85 per cent of the $60,000 dividend will be exempt from US federal income tax and the balance of the dividend will be insulated from tax by available foreign tax credits. In this case, however, 85 per cent of the foreign tax credits will also be disallowed and the excess foreign tax credit will be reduced from $7,000 to $1,050 (15 per cent times $7,000).
CFOs should also carefully consider the extent to which the accumulated earnings of your foreign subsidiaries constituted income that has already been taxed to your company under Subpart F of the Code. First, under the Act, such earnings are generally taken into account on an annual basis in determining the extent to which dividends received from your foreign subsidiary are extraordinary. Second, such previously taxed income generally must be distributed in cash first before any distributions from that subsidiary will be taken into account in determining the amount of extraordinary dividends that qualify under the Act.
Mine Safety Appliances Co. (MSA) is a global provider of sophisticated safety products and does business through subsidiaries in 30 different countries on six different continents. Before the Act passed, Mine Safety had not brought back foreign earnings because of the high combined US and foreign tax rates applicable to repatriated dividends.
Dennis Zeitler, CFO of Mine Safety Appliances, reports that the opportunity to bring retained earnings back to the United States at a substantial tax savings caused him to re-evaluate his company’s policy of minimizing foreign dividends. In conjunction with the company’s auditors, the treasury staff at MSA reviewed the balance sheet with respect to overseas assets to determine the optimal countries from which to repatriate based on the effective foreign tax rates. Of course, Zeitler was not able to bring back all of the money his company earned overseas. Some of his earnings were accumulated in countries where the income and withholding tax rates were so high as to make it disadvantageous to bring the money out of the country. In the end, MSA found that repatriating earnings from European countries was the most profitable. Once the source, amounts and timing of the dividends were decided, Zeitler began focusing on the appropriate foreign currency hedge.
Since the company’s plan was to repatriate euros, Zeitler opted to use a forward contract. As explained earlier, a forward contract has the benefit of a predetermined fixed rate and in this case a definitive US dollar equivalent of the euro. The decision to use a forward contract, as opposed to an option or some type of customized hedge product, was largely based on the fact that the euro had appreciated approximately 20 per cent against the US dollar over the prior 18 months. Zeitler did not want to risk losing the positive earnings generated by that appreciation.
As discussed earlier in this article, it is important that treasury managers carefully evaluate the tax and exchange rate impacts of this legislation. With regard to hedging currency risks, forward contracts, option contracts and other customized strategies should be considered.