Under current law, earnings of foreign corporate subsidiaries of U.S. corporations are generally subject to U.S. taxation when the profits are actually or deemed to be “repatriated” to the United States (for example, the subsidiary pays a dividend to the U.S. parent). This has caused U.S. companies to keep an estimated $2.6 trillion of foreign earnings abroad, a problem which lawmakers have tried to solve in the past, for example, by instituting so-called “repatriation tax holidays.” To change our current system of international taxation—as congressional Republicans and the Trump Administration have both called for—any tax reform package will likely address foreign earnings abroad.
In a worldwide system of international taxation, the home jurisdiction taxes the foreign earnings of all its residents. Under current law, U.S. corporations can generally avoid paying U.S. corporate tax on foreign earnings by keeping those earnings within foreign subsidiaries. Only when the earnings are distributed up to the U.S. parent corporation in the form of a dividend (or when the earnings are deemed to be distributed) does the United States levy a tax (subject to credits for any foreign taxes paid on such earnings). This process of sending the offshore earnings back to the United States is colloquially referred to as “repatriation.”
To avoid paying a tax on repatriation, many companies simply retain the foreign earnings within their foreign subsidiaries, leading to an estimated $2.6 trillion in untaxed offshore earnings. Under current law, the foreign earnings would be subject to tax (as a deemed distribution) if they are invested in “United States property” (including tangible property located in the United States). In an earlier attempt to get some of this cash back to the United States, Congress enacted the 2004 American Jobs Creation Act, which included a voluntary repatriation at 5.25%, allowing U.S. corporations to pay tax on repatriated earnings at a reduced tax rate, provided the repatriated funds be used for investment (referred to as “repat for roads”). However, studies found that the legislation, while providing a short-term revenue boost, would likely decrease revenue over a ten-year period, and that repatriated earnings were used for already-planned projects. And, according to JPMorgan, the repatriated earnings also had little to no effect on the strength of the dollar.
The sentiment that the repatriation tax holiday was a failure leads many to believe that future legislation regarding offshore earnings will include a “deemed” or “forced” repatriation of these earnings. However, the use of the repatriated earnings continues to be of some debate, and a number of commentators have highlighted that such earnings would likely be used to send cash back to their shareholders, either in the form of dividends or stock buybacks, pay down existing borrowings, and fuel domestic acquisitions, suggesting that infrastructure spending may need to be mandated by the federal government.
Both President Trump and the House Republicans have proposed a repatriation tax, in some form. The Trump Administration recently announced that its tax reform plan would include a “one-time” lower repatriation tax rate for overseas income. It is unclear whether this repatriation would be optional or forced (“deemed”), and at what rate the repatriated earnings would be taxed (pre-inauguration, President Trump had proposed a one-time rate of 10% on overseas profits).
The House Republican Blueprint has proposed a deemed 8.75% tax on accumulated foreign earnings held in “cash or cash equivalents” and a 3.5% tax on the remainder. Under the House Republican proposal, companies would pay the resulting tax liability over an eight-year period. There are a few outstanding issues with a dual-rate proposal, including: what may be considered a “cash or cash equivalent” for the purposes of this tax; whether there would be a look-back rule for “cash or cash equivalent” assets recently invested to take advantage of the lower rate; and the impact on financial services companies of an over-inclusive definition.
As discussed in our post on Territoriality, the Trump Administration and House Republicans have proposed switching from a worldwide system of taxation to a territorial one (where the United States would only tax U.S. source income). Such a change would be an opportunity to “press reset” on the U.S. taxation of foreign earnings. Notwithstanding the upfront cost of repatriation, without repatriation, U.S. corporations may be forced to track pre-tax reform earnings separate from post-tax reform earnings, which would be cumbersome and leave value “trapped” offshore. As of yet, neither proposal suggests repatriation would be “optional” or tied to infrastructure spending. However, some have suggested that, if the broader plans for tax reform are thrown further in doubt, a proposal for deemed repatriation could be used to raise revenue for a substantial infrastructure spending bill.