Earnings reparation is receiving attention in corporate finance departments.
US companies have a limited time through the end of next year to repatriate earnings they have parked in offshore subsidiaries and pay US tax at only a 5.25% rate. The earnings must be repatriated in cash. Since most offshore subsidiaries redeploy their earnings in other investments, some companies are looking at borrowing money in order to pay cash dividends. Any earnings repatriated to the US must be reinvested in the US “including as a source for the funding of worker hiring and training, infrastructure, research and development, capital investments, or the financial stabilization of the corporation for the purpose of job retention or creation.” There is no time limit on the reinvestment.
Congress left many unanswered questions. The Internal Revenue Service is expected to issue a series of notices, no later than mid-January, with more guidance.
Questions are being asked about the requirement that the earnings must come back in cash. A foreign subsidiary can borrow to raise the cash, but not from affiliates. Any increases in shareholder or other related-party debt of offshore subsidiaries between October 3, 2004 and the end of the tax year in which the lower rate is being claimed are potentially a problem.
One question is whether there will be any limits on a subsidiary’s ability to borrow from banks to raise cash. Another question is whether the US parent can guarantee a loan from a bank to its offshore subsidiary. Many tax counsel are wary of such guarantees in situations where the subsidiary could not have borrowed on its own (as opposed to where it can borrow but the guarantee gives it a lower interest rate). A technical corrections bill introduced on November 19 in Congress would bar a US parent from “effectively funding” the dividends back to itself by making capital contributions or through other means.
Another set of questions revolves around the requirement that the money must be reinvested in the United States. Hal Hicks, an IRS associate chief counsel, suggested the IRS has tentatively concluded that the US parent company can use the cash to repay debt. However, the only substantive effect of raising cash by borrowing offshore and using it, after repatriation, to repay parent company debt is to shift debt offshore. Whether cash can be used to repurchase shares is still unclear. Also unclear is whether the cash can be used to make acquisitions. At a minimum, to the extent a target company has large foreign operations, the repatriated earnings could not be used to pay the portion of the purchase price attributable to the foreign operations.
Questions have also been asked about a statement in the new law that “[n]o deduction shall be allowed for expenses properly allocated and apportioned” to the repatriated earnings. Companies have been asking what tax deductions they will have to forego in order to take advantage of the 5.25% rate. For example, current tax rules require US companies to treat part of the interest they pay on purely domestic borrowing as a cost of their foreign operations in the same ratio as their assets are deployed at home and abroad. The questions were answered by the draft technical corrections bill that was introduced in Congress on November 19. The bill would only rule out deductions that are “directly allocable” to the repatriated earnings. The chairman of the Senate tax-writing committee, Senator Charles Grassley (R-Iowa), said in a “colloquy” – or an exchange on the Senate floor with another Senator – that the intention was only to deny deductions for expenses that were directly related to the earnings being brought back to the United States. Thus, Grassley said, deductions for interest, research and development costs, state and local income taxes, general sales and marketing costs, and depreciation and amortization would not be affected.
A company must repatriate more earnings to the US than it did each year on average during a base period. The 5.25% rate applies only to the “excess” repatriation. Calculation of the base period repatriations is complicated in “US sandwich” cases where the US company has both a foreign parent and foreign subsidiaries.