Foreign subsidiaries of U.S. firms distributed more than $300 billion in dividends to their parent companies during the “tax holiday” created by the American Jobs Creation Act of 2004 (AJCA). But the true value of this short-term achievement must be considered in the light of its long-term effects, according to Thomas J. Brennan, an associate professor of finance at the Kellogg School of Management. His recent analysis shows that in the years since the holiday, the earnings returned from foreign subsidiaries to the United States have been largely offset by increased new investment of foreign earnings overseas.

Furthermore, when Congress enacts a temporary tax holiday, it can have a permanent conditioning effect on corporate behavior, Brennan points out. Corporate decision-makers salivate for the next goodie that lawmakers are willing to serve up, and they arrange their affairs accordingly. In his research, Brennan found that an increased amount of the cash stashed overseas seems to have been relabeled as being permanently invested overseas. Relabeling funds is an expedient way for companies to prepare for a future repatriation tax holiday without substantially changing their behavior.

“The possibility of a future holiday leads to an incoherent kind of system. We say that we have a tax on foreign earnings when they come back to the U.S., but it is really very ineffective,” Brennan says.

Luring Money Back Home
Currently, he explains, profits made by a foreign subsidiary of a U.S. company are taxed in the foreign jurisdiction, and usually no tax is due in the United States until a dividend is paid from the subsidiary to the parent. This may motivate companies with subsidiaries in low-tax jurisdictions to keep foreign earnings abroad. In addition, any sums permanently reinvested in the foreign subsidiary can avoid not only current U.S. taxation but also the reporting of a deferred tax liability for financial accounting purposes. These taxation and accounting rules have provided part of the motivation for U.S. companies to keep an enormous amount of cash overseas.

The intent of Congress in passing the AJCA was to lure some of this money back stateside. The AJCA temporarily reduced the tax rate on repatriated dividends by 85 percent. In the short term, the $300 billion in repatriated funds makes it look as though Congress accomplished its goal.

However, the long-term data tell a different tale. Using statistical regression techniques, Brennan analyzed publicly available data about the post-AJCA overseas investment behavior of corporations that repatriated large amounts of cash under the Act. He found that these firms have increased the quantity of foreign earnings that they permanently reinvest abroad (Figure 1). Permanently reinvested earnings of the sample firms increased annually from about $100 billion in 1998 to about $400 billion just before the repatriation period. Subsequent to the repatriation window, permanently reinvested earnings for the sample firms steadily increased until they totaled about $600 billion in 2008.



Figure 1. Aggregated permanently reinvested earnings (PRE) for firms in the sample, 1998–2008. Repatriated funds placed in the column corresponding to the 2005 fiscal year.

Brennan explains that the problems illustrated by the AJCA are part of a bigger problem in the overall approach to corporate taxation. “This set of laws is badly dysfunctional in a way that is highlighted by the escapade of the 2004 repatriation and the subsequent machinations by corporations in response to it,” he says. 

Other Options for Taxing Foreign Earnings
Various alternative approaches could be taken to taxation of foreign earnings, according to Brennan. One would be simply not to tax income that is earned in foreign countries, ever. This is the approach taken by most of the rest of the industrialized world. Brennan says that the current approach in the United States—referred to as worldwide taxation—used to be shared by many other countries, but gradually everyone changed except the United States. He notes, “It is hard to know what the right solution is, but it is interesting that the U.S. is out of step with the rest of the world right now.”

At the other extreme, the nation could impose an immediate tax on foreign earnings, with no deferral. However, this approach would put U.S. companies at a competitive disadvantage when operating internationally. Brennan says there are various compromise approaches Congress could take if it wants to find a middle ground. For example, foreign income could be taxed on a permanent basis at a reduced rate without deferral. He notes that this approach would remove the incentive to keep money invested overseas.

Brennan points out that the data on money repatriated under the AJCA provides a unique opportunity to study corporate behavior. “It is very rare that you have hundreds of billions of dollars moving around and then have the opportunity to see what the companies did with it.”

Partially in response to that data, Congress is trying to tailor its proposals a little more narrowly this time, according to Brennan. “Lawmakers must exercise care in weighing not only the short-term intended consequences but also the long-term behavioral changes induced by the prospect of future holidays. In the case of the AJCA tax holiday, these long-term effects were substantial and perhaps outweighed the short-term benefits, resulting in a net policy failure—at least to the extent that the policy goal was the long-term net return of foreign earnings to the United States.”

Congress is presently under pressure from the corporate community to provide another tax holiday, Brennan says. He believes that even if legislators learn from the mistakes made in the AJCA, the bottom line is that they should not enact additional tax holidays. “They should just make up their minds about how they want to tax foreign earnings, or not tax them. Then have that be the rule permanently.”

Related reading on Kellogg Insight

Big Tax Breaks Beget Small Investments: Why the American Jobs Creation Act lowered taxes but failed to spur domestic investment

Driven Offshore: An unintended consequence of Sarbanes-Oxley