USD repatriation boost: Less than meets the eye in the short run – Westpac

Richard Franulovich, Research Analyst at Westpac, points out that the Republican-led congress is approaching the final stretches of a major US tax overhaul and the tax treatment of US corporate earnings held offshore - estimated at about $2.6trn - has been a major focus for the tax bill's authors.

Key Quotes

“The House and Senate plans contain differences in many areas that need to be ironed out but their provisions for the treatment of offshore earnings are closely aligned.”

“With key details now at hand we assess that any short term boost to the USD is likely to be much smaller than the 2005 tax repatriation holiday. Planned long term changes to the way foreign earnings are taxed however will nevertheless exert significant longer term impacts for USD liquidity in offshore vs domestic markets and the USD.”

“Key details

• The tax plan calls for a “deemed” repatriation of deferred foreign earnings. The Senate plan sets a 14.5% tax on liquid assets and 7.5% on non-liquid holdings, while the House plan calls for 14% and 7% respectively. This is a one-time transition tax.
• Thereafter the House and Senate plans both shift the US to a territorial tax system, ending the practice of taxing global income, to be achieved via a tax exemption for income/dividends paid from the overseas subsidiary to the US parent.”

“2017/18 vs 2004/05 tax holiday

• The 2004 Homeland Investment Act triggered about $300bn in repatriation the following year. Back then US corporates were entitled to a material tax deduction on dividends  from their foreign subsidiaries, reducing the effective tax on these earnings to 5.25%. That structure produced a strong voluntary incentive to repatriate earnings, boosting the USD (though the Fed was also boosting the USD by raising rates at the time).
• The current plan does not produce the same clear incentive for a wave of repatriation in the short run. US corporates are “deemed” to have repatriated earnings, making them subject to a mandatory tax obligation, payable over eight years, regardless of whether they repatriate the foreign earnings or not. The “deemed” nature of the repatriation essentially separates the tax obligation from the underlying income source. In the extreme the tax obligation could be paid out of domestic earnings, or a small portion - the tax owed - could be repatriated. The structure implies that we are less likely to see a repeat of the 2005 tax holiday that produced periodic bouts of corporate demand for the USD.”

“Earnings already in USD

• Given the different approach to taxing accumulated overseas earnings comparisons with 2005 are probably moot. That said, US balance of payments data shows US corporates have retained about $200bn-$300bn in earnings offshore every year data since the 2005 holiday. That amounts to a $2.6trn stock, heavily concentrated in the tech and pharmaceutical industries. By contrast US corporates accumulated about USD1trn offshore between 1990-2004. About $300bn in repatriation was attributed to the 2005 tax holiday implying about 30% of the stock was repatriated.
• A similar ratio applied to the current $2.6trn overseas holding implies $780bn in repatriation. But much of that is denominated in USD, blunting any FX impact. Many observers note 75% to 80% maybe be USD denominated. In some cases, notably Apple, filings show 90% is in USD. If 80% of repatriated earnings are in USD there could be  $155bn+ in FX flows into the USD (i.e. 20% in foreign currency * $780bn). But, the true USD impact may prove much smaller due to the deemed nature of the repatriation plan. The 2004/05 plan offered a large tax deduction on voluntarily repatriated earnings. The mechanics of the current proposal are different.”

“Where will offshore earnings be deployed?

• The notion that tax changes will boost physical investment by unleashing earnings sitting idle overseas is shaky. Overseas earnings are taxed when they are invested in "US property" such as US real estate, US based operations and the US stock of the parent company but there are broad exemptions including holding many securities such as US fixed income instruments unrelated to the parent company and bank deposits. Much of the $2.6trn in earnings may be offshore technically for tax purposes but is effectively in the US, invested in Treasurys and corporate bonds.
• Many corporates deploy their offshore cash "synthetically", issuing debt in the US to fund share buybacks. Indeed the debt raised could have funded CAPEX.
• Altogether, changes to the way the existing stock of earnings overseas are taxed are unlikely to create any truly meaningful impact on the USD thanks to; 1) the deemed nature of the repatriation; and 2) the fact that much is already USD denominated. That said, US corporate holdings of US Treasury and corporate debt will likely suffer at the expense of increased equity buybacks and special dividend payments.”

“The long run

• The tax plan also incorporates a shift to a territorial tax system via a 100% deduction for dividends from foreign sources. This is where the tax plan could have a meaningful long term impact on the USD and USD liquidity. The current tax system creates a strong incentive for corporates to keep earnings overseas, leaving their overseas entities flush with USD liquidity – much more than operational needs warrant – and their US operations relatively more leveraged.
• The planned shift to a territorial tax system effectively ends the tax driven motivation for running up cash balances offshore and running a relatively more leveraged domestic US operation.
• These large cash balances offshore create relatively higher demand (and thus supply) for quality rated liquid USD instruments offshore. That will change as the US transitions to a territorial tax system. Offshore dollar funding markets will face increased pressure.
• The diminished incentive to hoard earnings overseas for tax purposes implies that at the margin US corporates are likely to have more ongoing long term demand for USD than otherwise too, even allowing for the fact that the vast majority of offshore cash holdings are already USD denominated (>85%).”