Last year's tax reform package included massive cuts to the corporate tax rate. Some companies got immediate boosts to their bottom lines from the move, and even those that had to pay immediate taxes got offsetting benefits that should leave them well ahead in the long run.
Yet one element that largely went unnoticed in the initial discussions of tax reform centered on the provisions that apply to companies with extensive foreign operations. Although these companies will have to pay a substantial amount of tax as part of the transition to the new system, the IRS just confirmed that a strategy would be available that could dramatically reduce that bill for some -- but not all -- corporations under the new system. In particular, companies like Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) have an opportunity to take advantage of the provisions, while others like Alphabet (NASDAQ:GOOGL) (NASDAQ:GOOG) and General Electric (NYSE:GE) will miss out.
Foreign earnings and deemed repatriation
Tax reform lowered the corporate tax rate on U.S. income from 35% to 21%, but it came at a cost to multinational corporations like Apple, Microsoft, Alphabet, and General Electric. The new tax laws imposed a transition tax that effectively eliminated the deferral of foreign income that they had kept overseas. This "deemed repatriation" imposed tax regardless of whether the companies subsequently moved their overseas assets back to the U.S., or kept it outside the country.
However, the provision offered some additional tax breaks for corporations. Rather than imposing the full 21% rate on deemed repatriated earnings, the new tax law set up two classes of taxable assets. Cash held overseas would be subject to a 15.5% maximum rate of taxation, while money invested in other overseas assets would enjoy an even lower 8% tax rate. Immediately, companies that would be subject to deemed repatriation tax sought ways to invest foreign cash in assets that would qualify for the lower rate.
Winners and losers
Yet one element of this new tax break went largely unnoticed. The provision refers to the end of the last tax year that begins before Jan. 1, 2018. For companies that use the calendar year as their fiscal year -- including Alphabet and General Electric -- that simply set Dec. 31, 2017 as the date on which their aggregate foreign cash position would be determined. Since tax reform passed in late December, that gave companies only days to take steps to change their relative cash positions.
However, companies with fiscal years other than calendar years had more time. In particular, Apple and Microsoft essentially earned an extra nine months to consider ways to cut the tax, with fiscal years that don't end until Sept. 30.
Even with this language, some worried that lawmakers would take steps to close this loophole for Apple, Microsoft, and other companies in similar situations. Yet in IRS guidance, what the tax agency said was that as long as any moves were "done in the ordinary course of business," it won't look at moves from companies to reduce their tax obligations as illegal tax avoidance.
Keep your eyes open for further breaks
Some policymakers looked at this loophole as an unintended consequence of the speed with which the tax reform provisions were drafted. With the need to include the legislation in a reconciliation effort in order to avoid Senate procedural rules that would have threatened passage, lawmakers had to scurry to get the bill prepared, drafted, and ready for a vote. Yet with Congress still sharply divided, it would be challenging to produce technical fixes to glitches like this.
As a result, investors can expect Apple, Microsoft, and other companies to take steps in the coming months designed to take greater advantage of the 8% repatriation rate. Meanwhile, even though ordinary taxpayers won't directly benefit from tax breaks that go to corporations, it's entirely possible that further loopholes will emerge in the legislation that could give them some savings as well.