TWN Info Service on Finance and Development (Feb18/03)
9 February 2018
Third World Network

US tax reform could lead to repatriation of $2 trillion
Published in SUNS #8616 dated 7 February 2018

Geneva, 6 Feb (Kanaga Raja) - The United States tax reform bill adopted in December 2017 could lead to the repatriation of almost $2 trillion of overseas funds held by US multinational enterprises (MNEs), leading to sharp reductions in global FDI stocks, the UN Conference on Trade and Development (UNCTAD) has said.

In a special edition of its Investment Trends Monitor focusing on the US "Tax Cuts and Jobs Act", UNCTAD said the bill will have significant implications for global FDI patterns. It will affect MNEs and foreign affiliates accounting for almost 50% of global FDI stock.

UNCTAD said that the overview of the tax reform measures relevant for international investment provided in the Investment Trends Monitor is necessarily succinct and incomplete.

It does not consider all detailed provisions and measures applicable to specific industries.

Specific measures have been adopted affecting, for example, the energy sector and the financial sector, which could also have implications for cross-border investment, it said.

"The discussion also does not take into account broader macro-economic effects. Increased budget deficits due to the tax cuts could affect interest rates and the investment climate."

Decisions by the Federal Reserve could offset the fiscal stimulus, it said.

And developments in other policy areas, notably international trade, would have a strong impact on the activities of MNEs and on international investment.

According to UNCTAD, the outcomes will also very much depend on reactions in other countries. For example, China has recently put in place measures to encourage reinvestment by foreign MNEs in its territory.

Also, with the move to a territorial tax system the motivation to engage in a degree of tax competition increases for United States trade and investment partners that are small open economies (not offshore economies).

In fact, said UNCTAD, a number of countries have recently announced cuts in corporate income tax (CIT) rates.

"Increased tax competition could have a negative impact especially on lower-income countries, where corporate income taxes are more important for government revenues and rates are still relatively high."

Investors will face some uncertainty as the detailed effects of the tax reform bill are clarified, and as they wait to see how other countries, including United States tax treaty partners, react to some of the measures.

According to the UNCTAD Monitor, concerns have been raised that provisions in the reform bill may violate United States double taxation treaties (DTTs) and trade rules.

What seems clear is that global investment patterns could see important developments over the coming period, as the full implications and workings of the tax reform bill become clear.

In this context, UNCTAD highlighted the following findings:

* Repatriation of overseas funds, possibly to the tune of almost $2 trillion, will lead to negative outflows and a sharp reduction of United States outward stock (and inward stocks elsewhere);

* The removal of the need to keep earnings overseas could lead to structurally lower retained earnings in foreign affiliates of United States MNEs;

* This, combined with the anti-avoidance measures, could lead to a re-routing of FDI links in the international corporate structures of United States MNEs;

* The greater degree of freedom in the use of overseas cash might lead to a further increase in M&As (although perhaps more domestic M&As than cross-border M&As), but the curbs on interest deductibility might dampen this effect.

* The stimulus to investment in the United States provided by a lower CIT rate and full investment expensing might lead to higher inward investment in the United States, and possibly to further re-shoring of manufacturing activity.

"The impact on investment in the developing world remains to be seen. However, developing countries need real investments in productive assets, not cash parked overseas," said UNCTAD Secretary-General Dr Mukhisa Kituyi, in a press release.

At a media briefing on Monday (5 February), James Zhan, Director of the UNCTAD Division on Investment and Enterprise, said that this is a preliminary assessment in the sense that some of the details of the US tax reform act are still unfolding (or) still in the making and we need to bear that in mind.

He also said that firms are still studying the implications of the tax reform. "So the current assessment is more based on the parameters we have at the moment - the broad indicators that we can identify from the tax reform package."

Highlighting some of the key findings, he said one implication of the US tax reform is the stimulus that is put in place for investment in the US that will provide a lower tax rate, where the statutory rate of corporate income tax has been reduced from roughly 35% to about 21%.

This is slightly lower than the average corporate income tax in the European Union at about 22% and the average in the OECD countries which is about 24%.

He noted that this is only the statutory corporate income tax. In reality, according to analysis by UNCTAD and that of other international organisations, the average effective corporate income tax rate is already much lower.

So the impact of the lowering of the corporate income tax on inflows of foreign investment into the US may not be that obvious.

Overall, Zhan concluded that "the US tax reform will affect global FDI flows significantly in scope, but maybe less so in scale. It all depends, and the impact is unfolding."

Asked if the repatriation of cash will have any actual effect, Zhan said, with respect to the $2 trillion of overseas funds, it is more of cash rather than real investment or potentially big investment either in countries where the cash is located or potentially repatriated back to the US, and therefore for the US, investment in real sectors.

He said that we do see some companies that have announced their intention to use the funds to invest back in the US.

The question is in what form? It could be more of expansion of existing production in the core business rather than expansion in other areas.

For example, if the US needs investment in infrastructure like roads, bridges and railways, then perhaps those companies that have a huge amount of cash in the IT industries may not be able to do much in this area.

Zhan also said that the repatriation of cash may be used for the buyback of shares or paying dividends. There are many other ways of using that, he added.

Richard Bolwjin, Head of the Investment Research Branch at the Division on Investment and Enterprise, also highlighted its macro-economic impact.

He said that even if the money at the moment is not being invested in tangible assets, it is still a part of financing financial flows to developing countries and as such is part of the external sources of finance that are helping to make up for savings shortfalls in developing countries.

So, even if the money is not currently invested in tangible assets, it is still doing something, he added.

The UNCTAD document highlighted some of the main features of the US "Tax Cuts and Jobs Act" adopted last December, noting that although details are still being worked out and it will be some time before firms have assessed all the implications, the bill included changes to the corporate tax regime that are likely to have important consequences for international investment.

These changes will affect both cross-border investment into the United States and the investment positions of United States MNEs abroad.

As such, they could have a significant impact on global investment patterns, given that almost half of global investment stock is either located in the United States or owned by United States multinationals (MNEs).

According to UNCTAD, measures that will directly affect the investment climate in the United States include:

(i) A reduction of the statutory corporate income tax (CIT) rate from 35% to 21% effective from 2018.

(ii) Immediate full expensing of investment cost.

(iii) The capping of deductible interest to 30% of taxable income.

Measures directed at the international tax regime for MNEs include:

(i) A switch to a territorial tax system through a 100% deductibility of dividends of foreign affiliates.

(ii) A transitional measure for existing overseas retained earnings in the form of a mandatory deemed repatriation subject to a one-off tax payment (15.5% on cash, 8% on illiquid assets).

(iii) A set of anti-avoidance measures, including a tax on global intangible low-tax income and a tax on payments to overseas affiliated firms that erode the tax base in the United States.

According to the UNCTAD document, the headline measure of the bill is the reduction in corporate income tax from 35% to 21%.

The measure is undoubtably beneficial for business in the United States, and it brings the nominal rate in line with the rate in most major developed economies - such as the 22% average rate in the EU and the 24% average in the OECD countries.

However, said UNCTAD, the effect on international investment of this measure per se is likely to be limited.

The many tax breaks in the complex fiscal environment in the United States already resulted in an average effective tax rate (AETR) close to the OECD average.

And MNEs (both United States MNEs and foreign investors in the United States) enjoyed an even lower rate than domestic businesses due to opportunities to avoid tax through their international networks.

According to UNCTAD, the impact of the rate reduction on international investment is also likely to be limited because while nominal income tax rates can be a factor in investment decisions, they are not among the most important investment determinants.

Other locational factors, such as access to markets, technology, R&D facilities and labour costs are generally far more significant determinants.

It said the reduction of the CIT rate by 14 percentage points is dwarfed by the labour cost differentials between the United States and, for example, the Asian economies that have been the manufacturing location of choice for many United States MNEs; hourly labour compensation costs in manufacturing in the United States are three times higher than the average of the five Asian economies that host most United States outward FDI stock in the sector.

According to the UNCTAD document, a more impactful measure, in terms of stimulating investment, may be the full deduction of capital expenditures on equipment.

This will provide a significant boost to firms in capital intensive sectors. A few large firms, including AT&T, Boeing and Apple announced significant new investments in the United States shortly after the adoption of the bill.

The effect is partly diluted by the cut in the CIT rate (full deductibility of expenditures would have been a greater boon under the 35% headline rate).

"Further dilution might occur through potential upward price pressures for capital equipment, but on balance past studies have shown a significant impact of comparable investment tax credits on capital expenditures in the United States."

However, said UNCTAD, while the measure will positively affect capital expenditures by both domestic firms and affiliates of foreign MNEs, the effect is likely to be most pronounced for expansions or upgrades of existing operations (with the possibility to reduce tax liabilities on existing income streams).

"The impact on new foreign investment flows into the United States is much less clear," it said.

A dampening effect on investment might come from the cap on the deductibility of interest expenses to 30% of taxable income.

In the current low-interest rate environment, and after the deleveraging that has taken place among corporations over the past decade, this cap will not pose a significant limitation for most businesses.

However, it could increase the cost of capital for highly leveraged businesses and for private equity investors, and it could affect M&A deals, including cross-border M&As, that rely on adding high levels of debt in acquisition targets.

According to UNCTAD, the most significant change to the tax regime for MNEs is the shift from a worldwide system (taxing worldwide income, with credits for taxes paid overseas) to a territorial system (taxing only income earned at home).

This brings the United States regime closer to the majority of OECD economies. The shift is accomplished through a 100% deductibility of received foreign dividends.

The switch to a territorial system removes the anomaly of the regime whereby overseas earnings incurred tax liabilities that became payable only upon repatriation of funds to the United States, leading to vast amounts of deferred tax liabilities parked overseas.

As a result, United States outward FDI stock is made up to a large extent of accumulated overseas profits, or retained earnings.

As these retained earnings could be deployed for capital expenditures on a pre-tax basis, the possibility to defer tax liabilities indefinitely has effectively acted as a stimulus measure for the overseas operations of US MNEs.

The possibilities provided by the United States international tax regime have allowed some of its MNEs to operate with significantly lower global average effective tax rates than their competitors from other regions.

For example, General Electric has been found to have a global AETR of less than 10% compared to more than 30% for its direct competitor Siemens (Germany).

UNCTAD said as the incentive for United States MNEs to maintain large stocks of retained earnings overseas will be much reduced, the impact on FDI patterns could be significant.

The shift to territoriality and the huge existing stock of overseas deferred taxes necessitate a transitional measure included in the reform bill.

All deferred taxes will be treated as if they were being repatriated, and taxed at relatively favourable rates (compared to the full statutory rates) of 15.5% for retained earnings held as cash, and 8% for non-cash assets i.e. earnings that have actually been reinvested.

This measure is widely expected to have the most significant and immediate effect on global investment patterns, said UNCTAD.

It noted that a tax break on repatriation has been long awaited by MNEs, since the last such break in 2005 in the form of the Homeland Investment Act (HIA).

At the time, a one-time reduced rate was offered for repatriated funds, which led to about $300 billion of retained earnings being brought back to the United States - causing significant negative outward FDI flows.

Overseas retained earnings of the United States MNEs are now much higher. At $3.2 trillion - with some $2 trillion held in cash - they are now about seven times the level in 2005.

"Mandatory deemed repatriation could thus potentially lead to very large capital flows back to the United States to the extent that it could affect the dollar exchange rate."

However, a key contrast with the 2005 HIA is that, at the time, funds had to be repatriated in order to benefit from the reduced rate.

As a result, an estimated two-thirds of the total funds available for repatriation were brought back (with the remainder presumably reinvested in non-liquid assets, or required for overseas operations).

The current tax reform bill does not include such a requirement (or incentive) to actually repatriate funds.

Therefore, MNEs may opt to keep a larger share of retained earnings overseas, either to finance future expansion and M&As, or because yields in emerging economies are higher.

Ultimately, the impact will depend on the actions of a relatively small number of very large MNEs that, together, hold the bulk of overseas cash.

UNCTAD noted that five high-tech companies alone (Apple, Microsoft, Cisco, Alphabet and Oracle) together hold more than $530 billion in cash overseas i.e. one quarter of the total amount of liquid assets that are estimated to be available for repatriation.

The 50 top overseas cash holders in the S&P 500 have parked about $925 billion of cash outside the United States. The largest cash holders are IP-intensive MNEs in high-tech, pharmaceuticals, engineering and a few branded consumer goods companies.

It said the potential impact on global FDI positions is clear. Mass repatriations could cause significant negative outward FDI flows and a large drop in the outward FDI stock position of the United States, from the current $6.4 trillion to possibly as low as $4.5 trillion, with adverse consequences for inward FDI stocks in other countries.

About one quarter of United States outward stock of FDI is located in developing countries. However, it is likely that a relatively large share of the stock located in developing countries is invested in productive assets and therefore non-liquid or not easily repatriated.

Looking only at holdings of liquid assets, the largest portion (almost 40%) of funds available for repatriation appear to be located in the United Kingdom and its offshore territories.

"The impact of funds repatriations on actual investment in the United States is a great unknown," said UNCTAD.

The 2005 HIA has been widely criticised as a "windfall" for MNEs and their shareholders, which did not lead to significant additional capital expenditures and jobs.

Current expectations are again that a significant part of the funds will either be returned to shareholders through dividends or share buy-backs, spent on M&As (which do not lead to immediate investment in additional productive capacity), or used for debt reductions or higher pension contributions.

"Projections for the actual stimulus effect vary wildly, with proponents of the reform predicting significant new investment, and others (including the Federal Reserve in its projections underpinning monetary policy) adopting a more cautious stance."

According to UNCTAD, the tax reform package includes further measures to persuade MNEs to bring back certain assets and activities to the United States, and at the same time to combat tax avoidance and erosion of the tax base in the United States.

A key measure aimed at MNEs that hold intangible assets and intellectual property (IP) overseas for the purpose of booking profits from royalties in lower tax jurisdictions is the global intangible low-taxed income (GILTI) regime and the foreign-derived intangible income (FDII) rules.

According to UNCTAD, the effects of these measures will be felt by "the most GILTI MNEs" including high-tech and pharmaceutical firms.

Tech MNEs in particular will be affected. Their overseas retained cash holdings are almost eight times their tangible assets, compared to two times for other MNEs. And their global AETR is significantly lower.

The GILTI and FDII measures could lead to changes in practices and international corporate structures in United States MNEs with the associated re-routing of FDI positions, it said.

UNCTAD said the reform package also aims to tackle other types of erosion of the tax base in the United States.

The bill includes a base erosion anti-abuse tax (BEAT), which is an alternative minimum tax designed to curtail excessive earnings stripping through payments to foreign related parties.

The BEAT measure could lead to affiliates in the United States of foreign MNEs paying more tax under the new regime, despite the reduction in the statutory CIT rate.

The tax reform bill has been, and is, controversial in many quarters, and the ultimate effect of the measures in it is hard to predict. The intent of the combination of provisions is clear: to bring back overseas funds of United States MNEs and to stimulate the investment of these funds in productive assets.

Equally clear is that the reform package will have significant implications for global FDI patterns over the coming years, UNCTAD concluded.