Wells Fargo Asset Management published a paper entitled, "Tax Reform - Overseas Cash and Repatriation Implications," we learned from a new Wells Tweet. They explain, "Prior to 2018, the United States' relatively high corporate tax rate incented many domestic companies with international operations to locate foreign subsidiaries in tax-haven countries and delay U.S. tax payments. Under the pre-reform tax code, these foreign subsidiaries were subject to the same 35% maximum federal statutory corporate tax rate as their domestic counterparts, with income taxes being levied on those profits when foreign cash was repatriated, or returned, to the United States. Foreign subsidiary income that remained overseas was recorded with a deferred tax liability on parent financial statements, but no cash was paid out for U.S. taxes. The foreign subsidiary typically paid taxes to the country of domicile at the prevailing overseas tax rate, resulting in an overall lower U.S. effective corporate tax rate -- currently estimated at 18.6%. To offset double taxation, the corporation claimed a foreign tax credit when cash was repatriated to the U.S., so the total taxes owed to the U.S. were net of foreign taxes already paid."
The Wells piece says, "In the face of high barriers to repatriation, overseas cash balances have accumulated since the last repatriation holiday in 2004 because cash has not been needed for general corporate purposes, such as domestic acquisitions, capital investments, or dividend payments, due in large part to easy and relatively cheap access to capital markets. Estimates show that untaxed overseas cash and cash equivalents total approximately $1.022 trillion."
It explains, "The information technology ($671 billion) and health care ($151 billion) sectors account for 80% of total S&P 500 Index untaxed overseas cash, and the top 20 companies with the most overseas cash account for $835 billion, or 82%, of total S&P 500 Index overseas cash. In examining the investments of those 20 companies, about 36% of the overseas cash is invested in corporate notes and bonds, with another 29% invested in U.S. Treasury and agency securities."
Wells tells us, "This new approach means that U.S. companies will no longer owe U.S. taxes on income earned abroad, while the income earned in the U.S. by foreign companies will face U.S. taxes. While future foreign earnings will generally not be subject to U.S. taxes, foreign earnings prior to 2018 -- those not yet brought back to the U.S. and therefore not yet taxed -- will not escape taxation, as this corporate tax overhaul comes with a one-time tax on prior income currently stranded overseas. The new law taxes all prior earnings at 15.5% on earnings held overseas in liquid investments and at 8% on earnings that have been reinvested in more permanent assets such as property or equipment. And since the tax is levied whether or not the earnings are repatriated, companies are free to leave or move the money as it suits them."
They explain, "The question occupying most observers is what will happen with all of the overseas cash under the new tax law and its deemed repatriation tax? A good starting point is to examine corporate behavior following the last repatriation holiday. In 2004, Congress passed the American Jobs Creation Act of 2004; it provided a repatriation holiday for overseas earnings of multinational companies by excluding 85% of repatriated earnings from taxation, provided certain capital expenditure measures were met."
Wells writes, "In practice, repatriated earnings in the year following enactment exceeded most expectations, running at about 40% of overseas earnings and totaling about $300 billion, a five-fold increase from the previous five-year average. With an average effective tax rate of 5.25%, it was clear this was an attractive proposition. However, uses intended by the legislation did not materialize. Although expressly prohibited, the vast majority of repatriated earnings -- 92% of every dollar -- went to share repurchases and, to a lesser extent, dividends in the guise of capital that had been 'freed up' by repatriation; less than 1% was invested in capital expenditures."
The paper continues, "Because this time around is not like the last repatriation, we think the impact to U.S. markets will be minimal, primarily because taxation of foreign profits will occur whether or not the cash is actually repatriated into the U.S., and the changes to the tax structure are permanent. With companies having easy access to capital markets in the past 13 years, there seems to be very little impetus to bring money home to make more capital investments. To the extent the taxation frees up cash to come home, it is likely corporate behavior will mirror the past and they will reward shareholders through share repurchases or special dividends."
It comments, "So what becomes of the cash holdings overseas? In analyzing the potential impact of these flows on the U.S. money markets, it is important to remember that the holders of offshore cash are sophisticated money managers themselves, with access to generally all the investment options abroad that they would have in the U.S. Put another way, the money is already largely invested in the short-term securities the holders want to own, and it seems likely it will end up in those same investment categories after it is moved. If that is how it plays out, it seems any impact on the money markets will be obscured by whatever other supply and demand factors are moving around the vast money markets."
Wells states, "That said, while the overseas money has been sitting and growing since 2004, the U.S. money markets have changed significantly over the past several years. The regulatory changes for money market funds (MMFs) that took effect in 2016 made prime MMFs less appealing to large institutional investors -- the same types of companies as the potential repatriators -- pushing about $1 trillion from prime MMFs to government MMFs. To the extent some of the overseas money is currently invested in prime-type instruments and the companies want to park the money temporarily in the U.S. pending further deployment, it may end up in government MMFs, resulting in slightly less demand for prime instruments and greater demand for government securities."
The piece adds, "One thing that seems to be certain is that cash balances will shrink. The one-time deemed repatriation tax must be paid and we know it will total 15.5% of the approximately $1 trillion in cash trapped overseas. And then there is the tax due on profits that have been reinvested, the amount of which is not known. A simple Google search reveals estimates of total foreign untaxed profits ranging from $1.6 trillion to $2.1 trillion, which would mean an additional 8% tax on a base ranging from $600 billion to $1.1 trillion. How companies choose to pay this roughly $250 billion tax bill, whether through corporate earnings, domestic or international cash balances, or a combination, remains to be seen and will ultimately drive the amount by which foreign balances shrink."
Finally, Wells writes, "And as to the timing of those flows, corporations may opt to pay the balance due either up front or in eight installments, so the timing also is uncertain. While many multinational companies have been some of the largest investors in fixed-income securities in recent years, in the future, their sophisticated investment staffs likely will continue to invest firm money in similar securities, albeit in a reduced capacity. With the Federal Reserve seemingly intent on continuing to raise the benchmark lending rate, this could mean more attractive all-in yields in the future."
