Tax Holiday for $1 Trillion May Lure Back Profits Without Growth

Google Ireland is not a branch office of the U.S.-based search giant Google Inc. (GOOG) It’s a separate corporation, and American tax collectors can’t touch a dime that Google Ireland earns from its core business until it sends profits back home to the mother ship in Mountain View, California.

The term of art for bringing the money back is repatriation -- the same as for a soldier captured abroad. U.S. multinationals have more than $1 trillion in profits stashed in overseas subsidiaries.

Some of the companies with the most money squirreled away say they’re prepared to bring a big chunk of it home. All they want in return is a temporary tax break that wouldn’t cost the U.S. Treasury anything, since it’s money that would otherwise be kept abroad and not taxed at all. The tax break would actually raise billions of dollars from applying the reduced tax rate to the money that’s been repatriated.

What’s not to like? John T. Chambers, the chief executive officer of Cisco Systems Inc. (CSCO), told securities analysts in February that “you’re now seeing political leaders at all levels understand” the case for a tax holiday on repatriated foreign profits. “I think this one has well over a 60 percent probability of being resolved in a positive way,” he said.

Photographer: Paul McErlane/Bloomberg

Google, with a separate corporation in Dublin, Ireland, is among companies seeking fundamental changes in tax law for repatriated profit. Close

Google, with a separate corporation in Dublin, Ireland, is among companies seeking... Read More

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Photographer: Paul McErlane/Bloomberg

Google, with a separate corporation in Dublin, Ireland, is among companies seeking fundamental changes in tax law for repatriated profit.

Although a lobbying campaign is just getting under way, Representative Brian P. Bilbray, a California Republican, has already introduced a bill that would let companies bring home money tax-free if they used it for research and development or facilities expansion.

Fundamental Changes

Aside from Cisco, the coalition for repatriation relief includes Adobe Systems Inc. (ADBE), Apple Inc., CA Technologies, Duke Energy Corp. (DUK), Google Inc., Microsoft Corp. (MSFT), Oracle Corp. (ORCL), Pfizer Inc. (PFE) and Qualcomm Inc. (QCOM), Bloomberg Businessweek reports in its March 21 issue.

The group is seeking fundamental changes in tax law. If it can’t get them right away, it still wants the tax holiday. Its opening position is that there should be no conditions on how the money is used. Chambers argued in the Wall Street Journal last October that a repatriation might create as many as 2 million jobs.

It’s a seductive argument -- reap billions in tax revenue from money that’s currently untaxed and generate economic growth to boot. On closer inspection, though, the coalition’s argument has some logical loopholes. An almost identical holiday passed by Congress in 2004 and taken mostly in 2005 did little to boost jobs or investment, according to several independent economic studies.

No Cash Shortage

Some economists say a holiday today might be even less effective because cash isn’t a constraint in 2011 -- it’s bountiful, thanks to the Federal Reserve’s loose-money policy. U.S. nonfinancial corporations have $1.9 trillion in liquid assets, the Fed says. No more than half of that -- probably significantly less -- is offshore. An unknown portion of the $1 trillion-plus in foreign-held profits isn’t cash. It’s tied up in foreign factories, offices and the like and can’t easily be repatriated.

“The problem is lack of demand or lack of investment opportunities” in the U.S., says Dhammika Dharmapala, an economist and law professor at the University of Illinois at Urbana-Champaign.

Granting another holiday so soon might induce companies to stash even more money abroad, convinced that if they wait long enough another holiday will arrive, says Thomas J. Brennan, a professor at Northwestern University School of Law in Chicago.

Lawmakers Reluctant

Lawmakers have thus far been cool to the idea of a repatriation holiday. Passing one without reform “makes a farce out of the whole system,” says Kent Conrad, a North Dakota Democrat on the Senate Finance Committee. Even corporate America isn’t unanimous in its support.

“A one-time repatriation of profits is a bad idea,” says Gregory J. Hayes, chief financial officer of United Technologies Corp. (UTX) “My fear is that we’ll have a repeat of 2004. If companies repatriate these profits and spend it on things like share buybacks, that will create such negative connotations around tax reform with the public.”

Still, the idea lingers. Congress and the Obama administration are turning over trash cans in search of ways to accelerate growth and bring down the unemployment rate without stimulus measures that increase already-huge budget deficits. Hence the appeal of what looks like a free lunch. For government, the challenge is to choose emergency fixes that won’t end up causing long-term harm.

“The problem is, there’s no lobby group for good government,” says John L. Buckley, former chief Democratic tax counsel for the House Ways and Means Committee.

‘Mulcting the Treasury’

Tax collectors have been struggling to get their hands on the profit from international operations since the early days of the corporate income tax, enacted in 1909. Each year brings another strategy for legal tax avoidance.

“All are alike,” President Franklin D. Roosevelt wrote to Congress in 1937, “in that failure to pay results in shifting the tax load to the shoulders of others less able to pay and in mulcting the Treasury of the government’s just due.”

Legal avoidance is booming, according to data collected by Bloomberg Businessweek from the footnotes of annual 10-K statements of companies on file at the Securities and Exchange Commission. Congress says that companies don’t have to pay tax on actively earned profits from their foreign subsidiaries as long as they keep the money permanently reinvested outside the U.S. in subsidiaries that are organized as foreign corporations. Each year the parent companies state in their 10-Ks how much money is stored in that category. For 30 big companies, the profits kept abroad grew 560 percent, to $740 billion, from the end of 2000 to the end of 2010, SEC filings show.

2004 Holiday Results

The temporary holiday passed in 2004 was supposed to shrink the pile. It allowed companies to repatriate profits attributed to their foreign operations at a 5.25 percent tax rate instead of the usual 35 percent. (Companies get a credit for foreign tax already paid.)

According to the Internal Revenue Service, $362 billion came back to the U.S., of which $312 billion was eligible for the reduced tax rate. The amount repatriated was 45 percent of the total held abroad at the end of 2004. In one of the more extreme repatriations, Hewlett-Packard Co. (HPQ) brought back $14.5 billion, almost all of the $15 billion that it had abroad, SEC filings show.

Incentive to Wait

In the long run, though, the holiday was rife with unintended consequences. Research by Northwestern’s Brennan indicates companies rationally concluded that if they were granted one special one-time tax break, they might very well be granted another. That gave them the incentive to attribute even more of their profits to foreign operations, like a shopper waiting for an end-of-season sale. By the end of 2006 the total “permanently” reinvested abroad had exceeded the 2004 peak. It has continued to grow since.

Business did indeed lobby for seconds soon after its first helping of tax relief. In 2009, just five years after the 2004 break, Congress debated giving another one as a stimulus-bill amendment sponsored by Democratic Senator Barbara Boxer of California and Republican Senator John Ensign of Nevada. The amendment was defeated 42-55 on the floor of the Senate as anti-business sentiment swept the nation after the financial crisis.

Lobbying Campaign

Cutting taxes on big businesses that stow profits abroad is never going to be an applause line for candidates on the campaign trail. Then again, it doesn’t have to be. All business has to do is get a bill through Congress and signed by the President using carefully targeted contacts, not billboards and airtime. To that end, the pro-holiday coalition has quietly assembled an all-star lobbying and communications team heavy on Democratic representation, as if to counter the impression that tax relief for big business is solely a Republican objective.

The team’s chief communications strategist is Anita Dunn, the Democratic media consultant who served as President Barack Obama’s interim communications director during his first year in office. Politico.com first reported her involvement on March 4. Dunn runs strategic communications and public relations for SKDKnickerbocker, a new firm created from the merger of Washington’s Squier Knapp Dunn Communications and New York’s Knickerbocker Consulting.

The lead lobbyists are former Representative Jim McCrery of Louisiana, who was the ranking Republican on the House Ways and Means committee, and Jeffrey A. Forbes, the former chief of staff to Senate Finance Chairman Max Baucus, the Montana Democrat.

Obama Shift

The pro-holiday message has gained traction, at least a little. As Bloomberg News reported on Feb. 11, Obama’s consistent pledge to “end tax breaks for companies that ship jobs overseas” disappeared from his stump speech after Republicans won the House in November and Obama began talking with executives about a corporate tax code overhaul.

In his State of the Union address, Obama even proposed cutting the corporate tax rate while simultaneously closing loopholes. Treasury Secretary Timothy Geithner has expressed openness to some kind of repatriation-tax holiday as long as it’s linked to “comprehensive” tax reform.

The economics of a holiday, however, are less pliable than the politics. While many economists agree there’s something wrong with a tax code that induces companies to keep profits abroad when they could be more efficiently deployed in the U.S., fewer say that a one-time tax break is the right remedy.

Take Federal Reserve Chairman Ben Bernanke. The coalition’s talking points include what sounds like a plug from him in congressional testimony March 2.

Bernanke, Zandi

“As you know,” Bernanke said, “I’ve suggested looking at the corporate tax code, and one aspect of it is the territoriality provision. If you were to allow firms to bring back cash, you know, from abroad without additional taxation or limited additional taxation, there might be more incentive for them to bring it home and use it domestically.”

On closer reading, it’s apparent that Bernanke wasn’t talking about a one-time holiday but about changing the method of taxation to a territorial system, in which only profits earned in the U.S. are taxed. The same goes for a December quote cited in the talking points from Mark Zandi, chief economist of Moody’s Economy.com: “The (repatriation) proposal is a reasonable, albeit very modest, idea.” Says Zandi now: “At this point I don’t think I would go down that path” of a stand-alone tax holiday. “It makes much more sense to fold it into broader tax reform.”

Economic Argument

Even on theoretical grounds the tax holiday is debatable. Cutting taxes can stimulate the economy if it adds to companies’ incentives to invest and expand. But the holiday, as a break on profits that have already been made, wouldn’t improve incentives, says Edward D. Kleinbard, former chief of staff of the Joint Committee on Taxation, who is a professor at the University of Southern California’s Gould School of Law in Los Angeles.

To build the economic case for a holiday, the coalition cites several studies, including two from 2003 and 2008 by Allen Sinai, president of the consulting firm Decision Economics, which predicted their impact based on an econometric model. The studies -- sponsored by the American Council for Capital Formation, which favors lower corporate taxes -- didn’t consider the outcome of the 2005 repatriation.

Share Buybacks

Some analyses that did showed disappointing results. The 2005 repatriation “did not increase domestic investment, employment, or R&D,” but did boost share buybacks, concludes a forthcoming Journal of Finance article by Illinois’ Dharmapala, C. Fritz Foley at Harvard Business School and Kristin J. Forbes at the Massachusetts Institute of Technology Sloan School of Management.

One anecdote makes the point acutely: Hewlett-Packard, even as it was pulling its $14.5 billion home from abroad, announced plans in 2005 to reduce its workforce by 14,500.

“Given that the last holiday did not result in repatriating firms increasing investment levels, it seems the burden is on the advocates of another holiday to explain why things would be different this time,” Dharmapala said in an interview.

Sinai, of Decision Economics, stands by his research: “I’m quite sure there were some jobs created,” he said. Hewlett-Packard declined to comment.

Subpart F

Legal tax avoidance intensified after World War II, as the U.S. dominated the world economy. Companies with newly established foreign operations had fresh opportunities to shift income. The Kennedy Administration worried that the flow of dollars out of the country was jeopardizing U.S. adherence to the gold standard. In 1962, Congress passed Subpart F of the Internal Revenue Code, which reduced companies’ ability to keep foreign profits out of reach of the U.S. tax authorities by “deferring” taxation in overseas vehicles. Subpart F didn’t lock the door.

As is often the case in Washington, the scandal isn’t what’s illegal -- it’s what’s legal, in this instance tax-avoidance systems with names like the Double Irish and the Dutch Sandwich. As detailed in a Bloomberg Businessweek investigative story last May, Forest Laboratories Inc. (FRX), which makes the antidepressant Lexapro, sells almost 100 percent of its drugs in the U.S. and cuts its U.S. taxes dramatically by attributing the bulk of profits to a law office in Bermuda.

Similarly, Google reduced its income taxes by $3.1 billion over three years by shifting income to Ireland, then the Netherlands, and ultimately to Bermuda. Microsoft has used a similar arrangement. Records in the Cayman Islands and Ireland show that Facebook is setting up such a structure too.

Profits Rise Faster

The clearest evidence that companies are carefully managing where they report their taxable profits is that earnings overseas have grown faster than sales abroad. In 2008, large U.S. pharmaceutical companies reported about 80 percent of their pretax profits overseas, up from about a third a decade earlier, according to Martin A. Sullivan, a contributing editor to the trade journal Tax Notes and a former U.S. Treasury tax economist. Those companies’ foreign sales grew more slowly during that period: to 52 percent of revenue from 38 percent.

The very success of tax-avoidance strategies is what motivates the push for a holiday. U.S. multinationals have an embarrassment of overseas riches, more than they can use. If they bring profits home, they must pay the difference between the U.S. tax rate and what they have already paid abroad. That would sting: From 2007 through 2009, Google reported an average tax rate of 2.4 percent on the earnings it claims overseas. If Google and others can get the repatriation rate down to 5.25 percent as in 2005, the pain will be more tolerable. (In 2005, tax-planning strategies helped lower the average tax paid on repatriated funds to just 3.7 percent, according to the Joint Committee on Taxation.)

New Tax Code

Critics of a proposed repatriation break complain that it would reward companies that have aggressively shifted profits into tax havens. “This is the system they bought into,” USC’s Kleinbard says. “Now they present (paying tax on) the fruits of their success as some kind of a hideous punishment.”

There’s broad agreement that, if done right, corporations and the federal government would benefit far more from a new tax code than a tax holiday. Many multinationals, including companies on both sides of the holiday debate -- such as Cisco and United Technologies -- want the U.S. to adopt a territorial system similar to that used by most of the rest of the world. Under such a system, the U.S. would largely stop trying to go after companies’ worldwide income and instead mostly tax profits earned in the U.S., whether by U.S.-based or foreign-based companies. The only other sizable countries that still use a system like the one in the U.S. are Chile, Israel, Mexico, Poland and South Korea. Supporters of territorial taxation include the bipartisan National Commission on Fiscal Responsibility and Reform created last year by Obama.

Territorial System

A pure territorial system has its own disadvantages. Because it doesn’t tax companies’ foreign income, it amps up the gains from shifting income to low-tax jurisdictions. So it works only if accompanied by close supervision and rules against gaming the system. Most developed countries, including Germany and Australia, have regulations to curb this sort of gaming, meaning that their systems, while opposite in concept to that of the U.S., are not all that different in practice.

Lowering the U.S. tax rate on all earnings, foreign and domestic, from 35 percent is a high priority of business groups. Thanks to loopholes, what companies actually pay as a percentage of their income is around 30 percent. That’s roughly the same as in several large industrialized countries in Europe and lower than the effective rate reported by Japanese companies, according to recent research by Kevin S. Markle of Dartmouth’s Tuck School of Business and Douglas A. Shackelford of the University of North Carolina’s Kenan-Flagler Business School.

More Generous

The American system works out to be more generous than that of other countries for some companies, says David S. Miller, a partner at Cadwalader, Wickersham & Taft in New York. Consider this: A U.S. company that pays a lot in high-tax Germany can apply the resulting credits against profits repatriated from a zero-tax location like Bermuda.

One proposed change in the tax code would allocate profits between countries the way most U.S. states with a corporate income tax do, using hard-to-fudge measures like employment or sales in each jurisdiction. If a company had 90 percent of its employees in the U.S., the IRS would tax 90 percent of its profits. Simple, but few multinationals are in support.

In Washington, framing the debate is everything. John Chambers and others frame the repatriation-tax holiday as something for nothing -- jobs for the unemployed, dividends for shareholders, tax payments for the Treasury. But the free lunch isn’t really free. If companies are once again given a big tax break on profits they’ve kept abroad, they’ll be induced to steer even more of their income offshore. That’s a frame that puts the repatriation holiday in a decidedly unflattering light.

To contact the reporters on this story: Peter Coy in New York at pcoy3@bloomberg.net or; Jesse Drucker in New York at jdrucker4@bloomberg.net or i97.

To contact the editors responsible for this story: Josh Tyrangiel at jtyrangiel@bloomberg.net or; Gary Putka at gputka@bloomberg.net or

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