By David L. Bernard
TaxBlawg’s Guest Commentator, David L. Bernard, is the recently retired Vice President of Taxes for Kimberly-Clark Corporation, a past president of the Tax Executives Institute, and a periodic contributor to TaxBlawg.
My recent post titled The Repatriation Dilemma: Cash may be King, but is Earnings Per Share the Ace of Trump? discussed how taxes may be one of the reasons why cash is building in the balance sheets of corporate America. Specifically, the U.S. tax cost that may result from repatriating cash earned outside the U.S. in low-tax jurisdictions may simply be too high. While shareholders wonder why cash build-ups are not resulting in increases in share buy-backs and dividends, company executives “doing the math” conclude that spending up to a third of the cash in U.S. taxes to repatriate is not prudent.
The post triggered much interest. There have been phone interviews with both the Wall Street Journal and CFO Magazine regarding potential stories. A former Chief Tax Officer (CTO) recalled similar analyses and decisions during his “in-house” days, but did not take issue with the conclusion. Another reader lamented that it was just another example of how U.S. multinationals choose not to take part in the U.S. economy. (Hmmm, do you wonder if he or she purposely pays more tax than legally obligated?) In any event the level of interest in this topic suggested that a sequel is warranted.
As alluded to in the opening paragraph, many executive office conversations end with the conclusion that low-taxed earnings should be retained outside the U.S. until an alternative use for the cash is identified, or until U.S. tax laws are again temporarily modified to permit low-taxed repatriations as was done in the American Jobs Creation Act of 2004. So what does the Chief Tax Officer do now? Clearly his or her input has led to this decision. Now that the “Tax Cop” has protected the effective tax rate metric once again, is the work done? Absolutely not. The remainder of this post offers ideas the CTO may suggest to the CFO and Treasurer to effectively use low-taxed cash “trapped” outside the U.S.
One concept is to use the foreign affiliates’ excess cash to either repay or notionally offset the third-party debt of other foreign affiliates. This may be accomplished by creating a captive treasury “pooling” center operated by either a financial institution or by the company’s shared services center outside the U.S. Affiliates with excess cash would make deposits at the pooling center. Affiliates with third-party debt would borrow from the pooling center to repay their debt. Note that such a pooling center would normally be established in jurisdictions with low rates of withholding tax on outbound interest payments.
There are a number of issues that have to be considered if a pooling center is being contemplated. First, the accounting and treasury functions will have to determine the appropriate functional currency and the hedging policy to be followed by the pooling center. The CTO should be mindful of the requirements of Code section 482 and any corresponding provisions in the domiciles of the foreign affiliates involved in the program.
Absent the “look-through” rule of Code section 954(c)(6), subpart F income can also be an issue due to the potential receipt of interest income by controlled foreign corporations. However, subject to the limitations of section 482 noted above, the spreads between rates paid to depositors and those charged to borrowers generally can be managed to mitigate the possible U.S. tax on the spread.
Withholding tax rates on outbound interest payments in the borrowers’ countries are also a factor to consider. Finally, a dividend withholding tax issue could arise in depositor countries that have a shareholder benefit rule, whereby cash loaned to an affiliate of the common shareholder is treated as a deemed dividend. Canada is an example of such a country. The CTO should be diligent in considering the tax rules of each country that is home to an affiliate that is a party to the arrangement.
Smaller or mid-size companies that want to avoid the costs associated with establishing a pooling center may wish to consider a notional pooling arrangement with a third-party bank, whereby the excess cash and outside debt are effectively offset in an arrangement with a single lending institution for a fee. This may not only eliminate the cost of the pooling center, but may also help manage tax and currency issues because cash and debt do not move. However, interest paid on debt is reduced thereby achieving the non-tax financial goals.
Direct loans from cash rich affiliates to affiliates with third-party debt may be an attractive alternative to pooling or notional pooling assuming the right fact pattern. For example, if an affiliate with excess cash in a low-tax jurisdiction loans money to an affiliate in a high-tax jurisdiction, the objective may be to maximize the interest rate that can be paid in the high-tax jurisdiction (assuming “look-through” is extended). In other words, tax planning can be accomplished while effectively employing low-taxed cash. Obviously the withholding tax implications of direct loans versus loans to and from a pooling center must be analyzed. Other concerns may again include the shareholder benefit (deemed dividend) rules and local debt-to-equity rules.
To the extent new investments are planned in jurisdictions where a tax holiday, high investment credits, or low statutory tax rates exists, the low-taxed cash can be used for the equity investment in the new subsidiary (or branch). This “stacks” future low-taxed earnings under existing low-taxed earnings within the corporate organization chart and effectively isolates these “problem” earnings pools. Note that with the recent changes to section 956, companies should avoid using low-taxed earnings as a source for equity investments in high tax jurisdictions.
Investments in U.S.-owned intellectual property (“IP”) should also be considered. Although the buy-in arrangement may not be much different in tax effect than a cash dividend, off-shoring IP can produce long term effective tax rate benefits. Moreover, there may be U.S.-owned IP that has substantial tax basis relative to current value, thereby mitigating the upfront cost. Also, the value of U.S.-owned IP with a low-tax basis may be at a low point due to current business conditions (and/or perhaps a depressed stock price and market capitalization). This would also make the initial U.S. tax cost more palatable. In any event, the CTO should always be on the lookout for opportunities to offshore U.S.-owned IP.
Finally, terms of all intercompany transactions should be reviewed for opportunities to tax-efficiently repatriate foreign earnings. For example COD terms may be advisable on sales to affiliates with pools of low-taxed cash. On the flip side, on sales by affiliates with such cash pools to the U.S., the CTO may consider recommending extended payment terms. It is also possible that the accumulation of low-taxed cash was due to a temporary circumstance, such as a limited duration tax holiday or investment credit. In such cases when tax begins to be paid by the affiliate prices for all intercompany transactions should be reconsidered, including prices for raw materials, finished goods and services, and royalties for IP.
In summary, while it may be easy for the CTO to “Just say no” to the original repatriation question, it is incumbent upon the CTO to continuously bring ideas forward to effectively use the cash generated in low-tax jurisdictions. This is the difference between a “Tax Cop” and a “Business Partner”.