Tax reform is now history, and taxpayers expect big changes in the taxes they pay over the coming year. Even as Americans have come to terms with the most obvious changes in the tax laws as a result of reform efforts, such as declines in individual and corporate tax rates, they're only now starting to parse through some of the more complex parts of the bill to see what impact they'll have.
One of the most important changes in tax reform governed the treatment of multinational corporations with extensive foreign operations. U.S.-based companies had held trillions of dollars in offshore businesses in order to take advantage of tax deferral opportunities that existed under previous law. To their credit, lawmakers chose not to implement one-time patches that have had mixed success in past years. Instead, they made major changes to international taxation that essentially forced multinationals to bring back their overseas assets .
How the new rules work
Tax reform changed the way that entities known as deferred foreign income corporations get taxed. Previously, such entities could generally defer taxation until they paid dividends to related U.S. corporations, triggering taxes at corporate income tax rates.
Section 14103 of the tax reform bill forces companies generally to increase their taxable income by the amount of deferred foreign income they had accumulated after the 1986 tax changes. However, the effective tax rate on that deemed taxable income is less than the new corporate tax rate. The legislation does so by offering a deduction to offset that increased taxable income. Mechanically, the amount of the deduction is engineered so that the company pays a 15.5% effective tax rate on cash held overseas. Any accumulated foreign income that exceeds the cash balance -- for instance, that has been invested in equipment or other capital assets -- gets a larger deduction to make the effective tax rate 8%.
This combination of income and deductions happens regardless of what the companies actually do with their overseas assets. That's the secret of its success in spurring Apple (AAPL -0.48%) and many other businesses with extensive holdings in related international entities to bring back assets to their U.S. operations.
Why past efforts failed
The latest tax reform effort isn't the first time that the federal government has tried to get companies to bring capital back to their domestic business entities. What changed, though, is that past efforts were voluntary in nature, and although some companies took advantage of them, others held out for the potential for a better future deal.
In 2004, Congress passed what became known as a repatriation tax holiday, offering a deduction that lowered the effective tax rate on money moved back from foreign corporations from 35% to 5.25%. Yet results were mixed, with 842 out of roughly 9,700 businesses with foreign subsidiaries bring money back to their U.S. parents, according to an IRS study of tax data. That resulted in a total of $362 billion in repatriated funds, $312 billion of which qualified for the lower rate, but that was only a small fraction of the foreign assets that existed at the time. Moreover, only about 5% of corporations reported repatriating the maximum amount of assets allowed under the provision.
Companies benefiting from the 2004 repatriation holiday also didn't take such visible steps to link investment in the U.S. to their tax break. Opponents of the measure noted later that the companies that brought back the most money through repatriation still cut jobs and spent less on research and development. That led Congress to reject calls for a subsequent holiday, instead pushing them toward the more extensive reform of foreign taxation generally.
Hold companies accountable
The provisions of tax reform collect tax revenue on overseas holdings regardless of whether companies actually repatriate their assets. Although many companies have already announced their plans to bring back money to the U.S., complicated interactions between the tax systems of the foreign countries involved and the new U.S. system will take time to understand fully. That could lead to delays in implementation.
Still, the clear implication among those who support the tax reform bill was that companies that fail to take visible measures to demonstrate their repatriation of funds through U.S. investment will get the disapproval of the measure's proponents. That won't stop companies from returning some of their tax windfall to shareholders through dividends and stock buybacks, but it will at least make them think about the ramifications of their decisions to a greater extent than they did in the past.