The Tax Cuts and Jobs Act (TCJA) of 2017 modified several aspects of corporate income tax rules, including a key change to the treatment on foreign-generated earnings. Preliminary results from the authors’ investigation suggest the TCJA was successful because large corporations “repatriated” a large portion of their cash held overseas. The analysis shows that the TCJA increased the tax burden for U.S. companies with substantial foreign earnings while reducing the tax burden for those with mostly U.S.-based earnings. Investment activity as measured by capital expenditures showed no significant change after implementation of the TCJA whereas share repurchases increased substantially, suggesting that repatriated overseas cash was not needed for investment purposes as was claimed by the TCJA’s proponents.
In 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law, representing the most significant changes to U.S. tax policy in the last 30 years. With the potential for such broad impact, it was no surprise that the TCJA received significant attention in the popular press prior to its passage. Proponents of the TCJA emphasized the act’s potential economic benefits, such as lower taxes and increased investment, while largely ignoring the negative economic impact of certain provisions, such as new taxes on foreign-generated earnings kept overseas. The claimed benefit of lower taxes for U.S. companies was of particular interest, in part because the following announcement by Apple, Inc. in the Wall Street Journal appeared to directly contradict this perception:
Apple on Wednesday announced it would make a one-time mandatory tax payment of $38 billion related to unrepatriated offshore cash holdings under the new U.S. tax law. That equates to 15% of its $252.3 billion offshore cash pile, broadly in line with the 15.5% tax rate required by the new law.” [Tatyana Shumsky, ‘Apple’s Tax Payment Could Set off Repatriation Trend; Changes in U.S. tax regime mandate companies pay tax on offshore cash; raising specter of repatriation,’ Wall Street Journal(Online), Jan 2018]
Understanding this apparent contradiction was the author’s primary motivation for the present study. Other claimed benefits, such as the repatriation of “trapped” offshore cash and increased investment in the United States, are also of interest in evaluating the effectiveness of the TCJA. As Warren Buffett stated prior to the TCJA’s implementation:
American corporations and private investors are today awash in funds looking to be sensibly deployed. I’m not aware of any enticing project that in recent years has died for lack of capital. (“Repatriating Multinationals’ Foreign Profits Wouldn’t Likely Boost Private Investment,” Center on Budget and Policy Priorities, October 12, 2017)
The claimed benefits of the TCJA can now be evaluated by examining the relevant financial measures around the TCJA’s enactment and thereby provide insights on business behavior affecting future tax policy proposals.
The S&P 500 was selected for analysis because it represents approximately 82% of U.S. equity market value, and companies in the index collectively generate approximately 40% of their sales outside the United States. Apple was analyzed because it represents a large portion of the S&P 500 and was significantly affected by the TCJA in an unexpected way (based on initial perceptions of the TCJA’s advertised tax benefits). The authors’ strategy is to investigate whether changes in certain accounting measures proxies for companies’ behavior are consistent with the TCJA’s original advertising (e.g., capital flows into the United States, lower U.S. corporate taxes, and more U.S. capital investment).
This article presents preliminary evidence suggesting that the TCJA greatly accelerated “repatriation” of overseas cash for the S&P 500. However, much of the cash claimed to be held overseas was already invested in the United States, and “repatriation” resulted in significant economic costs to companies through new “deemed repatriation” taxes that were not offset by reduced taxes on U.S. earnings. The analysis shows that taxes are actually flat to increasing for the S&P 500 and significantly increasing for Apple under the TCJA. This effect is concentrated in companies with foreign operations. Businesses with mostly domestic operations did benefit from lower U.S. corporate income taxes once the TCJA’s lower tax rates became effective in 2018.
Together, these results suggest that the TCJA implemented a “stick” approach, rather than a “carrot” approach, to economically penalize U.S. companies with overseas operations and thus, incentivize/coerce these firms to relocate their operations back to the United States. Effectively, the TCJA shifts a large portion of the corporate tax burden from U.S. companies with domestic operations to U.S. multinationals, through “deemed repatriation” taxes on all income earned overseas since 1986 and other new annual taxes on certain types of foreign earnings. The claimed benefits of increased U.S. investment do not seem to have materialized after implementation of the TCJA either. The study found only modest increases in capital expenditures, consistent with historic trends, while share repurchases increased significantly over the same period, suggesting companies’ preference for returning capital to shareholders.
The United States has a well-established history of using tax policy to motivate the economic activity of individuals and businesses. There have been many policy changes implemented over the years, with the TCJA being the most recent. Although many provisions in the TCJA affected individuals and businesses, this article focuses on the TCJA’s provision on taxing repatriated foreign earnings of U.S. multinationals. The most similar tax policy to the TCJA’s repatriation provision was enacted in 2004 and provided U.S. multinationals with a “repatriation tax holiday” that allowed these companies to repatriate foreign earnings at a temporarily reduced tax rate. The voluntary nature of the 2004 repatriation tax provision makes any comparison to the TCJA’s involuntary “deemed repatriation” tax provision inappropriate.
The reduction of the top U.S. corporate income tax rate from 35% to 21% may be the most well-known change implemented by the TCJA, but another key aspect of the act is the new tax treatment on foreign-generated earnings by U.S. companies. Prior to the TCJA, U.S. companies paid no income tax on foreign-generated earnings until they were repatriated, if ever. TCJA rules now require U.S. firms to pay taxes on all permanently reinvested foreign earnings not previously repatriated, going back to 1986, and the TCJA now taxes U.S. firms’ foreign-generated earnings annually.
The new tax provision is described as a “deemed repatriation” tax because the provision assumes that any foreign earnings still held overseas are repatriated to the United States from the foreign tax jurisdiction, although there is no requirement for U.S. companies to actually “repatriate” their foreign earnings to the United States. In addition, there are three provisions that now tax U.S. multinationals’ foreign earnings annually: global intangible low-taxed income (GILTI); foreign derived intangible income (FDII); and base-erosion and anti-abuse tax (BEAT) provisions. In total, foreign earnings-related provisions are expected to generate $600 billion in incremental U.S. tax revenue over the next 10 years. GILTI and BEAT are expected to generate $112 billion and $150 billion in additional U.S. tax revenue, respectively, over this period. “Deemed repatriation” is expected to generate $339 billion over the next 8 years.
Although reducing the U.S. corporate tax rate could certainly be considered a positive economic development, the TCJA’s new rules for taxing U.S. businesses’ foreign earnings creates significant new U.S. tax liabilities for any companies that were not planning on bringing these earnings back to the United States.
In the following sections, several analyses are presented with information related to performance, taxes, and other relevant accounting measures that help provide insights on the aggregate effects of the TCJA on the S&P 500 collectively. The data presented is aggregated across all firms constituting the S&P 500 in a given year and is provided by Calcbench.com. The analyses separate the S&P 500 into two groups of companies: one group that reported having foreign earnings overseas as of fiscal year end 2016, and another that did not report having foreign earnings overseas for the same period. Apple was examined in depth because it was a proponent of the TCJA’s new tax rules on foreign earnings and rationalized its support with reference to some of the act’s claimed economic benefits. Certain comparisons also refer to Dollar General Stores because it is a member of the S&P 500 that maintains almost all of its operations in the United States.
Repatriation of Overseas Cash
The first analysis presented below compares aggregate reported amounts for unremitted (or permanently rein-vested) foreign earnings and overseas cash for all companies that composed the S&P 500 during 2007–2018. The first two years, 2007–2008, of data in Calcbench have limited coverage across firms, but are included in the analyses in the interest of full disclosure. Focusing on 2017–2018, Exhibit 1 shows significant decreases in the balances of overseas cash and unremitted foreign earnings consistent with significant “repatriation” since the implementation of the TCJA. Prior to 2018, Exhibit 1 shows increasing balances of overseas cash consistent with the reluctance of U.S. companies to repatriate foreign earnings.
The same metrics for Apple indicate that the company “repatriated” substantially all of its overseas cash as of its September 30, 2018, fiscal year end. An important point to consider is that “repatriation” in the context of the TCJA is not simply a company transferring cash from overseas bank accounts into U.S. accounts. Apple’s cash was mostly invested in the United States prior to implementation of the TCJA; thus, it was not actually “trapped” overseas. The following two excerpts explain this situation:
Multinationals’ foreign profits are often portrayed as “trapped” offshore and unable to work in the U.S. economy, but a large portion is already in U.S. banks, held in U.S. dollars, or invested in U.S. Treasury bonds or U.S. corporate securities. (‘Repatriating Multinationals’ Foreign Profits Wouldn’t Likely Boost Private Investment’, Center on Budget and Policy Priorities, October 12, 2017)
Nearly all of the $2.6 trillion [of permanently reinvested foreign earnings] is already invested in the U.S. … As Apple, Inc. states in its annual report: The Company’s cash and cash equivalents held by foreign subsidiaries are generally based in U.S. dollar-denominated holdings…. Microsoft’s annual report states that more than 90 percent of its $124 billion in deferred cash was invested in U.S government and agency securities, corporate debt, or mortgage backed securities. Those examples are typical. (Adam Looney, “Repatriated earnings won’t help American workers—but taxing those earnings can”, Brookings Institute, October 25, 2017)
Contrary to the perception that U.S. multinationals with foreign operations have kept their profits overseas, much of the cash earned overseas was effectively invested in the United States already. In Apple’s case, the company was required to pay taxes of $38 billion on the earnings that generated this “overseas” cash to remove restrictions on its use. Because Apple had no expectation of paying taxes on its foreign-generated earnings prior to the TCJA, any tax payment arising from the TCJA is economically equivalent to a significant transfer of wealth from Apple shareholders to the U.S. Treasury.
Evidence of the TCJA’s Net Tax Consequences
Two countervailing tax effects emanate from the TCJA: 1) the reduced U.S. corporate income tax rate; 2) the “deemed repatriation” tax that taxes all foreign earnings of U.S. companies back to 1986. To obtain a better understanding of the tax effects on the S&P 500, the sample was divided into two groups based on the status of their foreign earnings. The foreign earnings group consists of the 312 S&P 500 companies that reported foreign earnings held abroad for fiscal year end 2016, whereas the non–foreign earnings group consists of the 188 companies reporting no foreign earnings held abroad as of 2016. Fiscal year 2016 was selected as the conditioning year because it was the last period prior to passage of the TCJA.
Exhibit 2 shows that current income tax expense (blue column) increased in 2017 and 2018 as compared to 2016 for the foreign earnings group. The reported percentages are calculated as the current income tax expense divided by earnings before taxes. This result implies that additional taxes from deemed repatriation more than offset any benefits from the reduced U.S. corporate tax rate for companies with foreign earnings. In addition, this effect is not obvious from reported income tax expense on the consolidated income statement, because the reduction in deferred income tax expenses obfuscates a portion of the higher current income tax expense.
In contrast to the above results, Exhibit 3 shows that companies in the non–foreign earnings group exhibit lower current income tax expense relative to earnings before taxes in all three years presented and a reduction in this measure subsequent to the TCJA’s implementation. Higher taxes for companies with foreign earnings are consistent with a significant increase in tax liabilities from the deemed repatriation provision and a real economic benefit for companies without foreign earnings due to the lower U.S. corporate tax rates.
In Exhibit 4, Apple’s 2018 current income tax expense shows a significant increase, approximately $46 billion, but the deferred income tax expense for the same period is similar in magnitude but negative, approximately $33 billion, so the two components of tax expense largely offset. This effect is masked on the income statement because the two components of tax expense are netted for presentation purposes.
The TCJA effectively forced Apple to convert its deferred tax liabilities to taxes payable through a line-item reclassification. The negative economic effects of this reclassification, however, are significant. Given consistent annual increases in Apple’s deferred tax liabilities over the last 10 years, which are primarily due to foreign earnings, it appears unlikely that these liabilities would have ever been realized as future tax payments (e.g., no expectation of cash outflows). Because the TCJA imposed significant new taxes on Apple’s foreign earnings, Apple was required to recognize that the associated deferred tax liability as of 2017 was no longer deferrable and required conversion to a tax payable in 2018, which requires future tax payments with certainty as of the TCJA’s effective date. This liability conversion and related tax payment represent an effective wealth transfer from Apple shareholders to the U.S. Treasury of approximately 5.1% of Apple’s $747.5 billion market value as of September 30, 2017. That this economic cost is unexpected is supported by more than a decade of consistent growth in Apple’s foreign earnings-based deferred tax liabilities, which would not have been realized under the old tax rules, as well as $250 billion in cash held overseas, indicating that Apple did not expect to repatriate its overseas cash.
Comparing Apple with Dollar General
Some insights can be gleaned by comparing the tax effects on Dollar General to those of Apple. Dollar General operates almost exclusively in the United States, whereas at least 60% of Apple’s operations are conducted elsewhere, based on segment disclosures in its 10-Ks; most of Apple’s pre-tax earnings therefore have been and continue to be subject to income tax rates in foreign jurisdictions.
Nearly 100% of Dollar General’s pre-tax earnings were subject to the 35% U.S. federal tax rate prior to the TCJA. The analysis below compares Dollar General’s and Apple’s effective tax rates from 2007 to 2018. As Exhibit 5 shows, Dollar General’s effective tax rate remained just above 35% until 2017, when the corporate tax rate was lowered to 21%. Apple’s effective tax rate was consistent from 2011 to 2018 because most of its operations are not in the United States and thus do not benefit much from the reduced U.S. corporate tax rate under the TCJA.
After the TCJA’s implementation, Dollar General’s current tax expense and tax paid decreased significantly, whereas Apple’s current tax expense increased significantly with the company’s taxes paid remaining relatively flat, as seen in Exhibit 6. The increase in Apple’s tax expense is primarily due to the TCJA’s deemed repatriation tax, which requires recognition in the year of implementation. Apple’s tax paid stayed relatively flat, because this new tax can be paid in installments over an eight-year period.
TCJA’s Impact on Corporate Behavior
Examining changes in aggregated cash flows for the S&P 500 around the time of the TCJA implementation provides some general clues as to how repatriated cash may have been used and whether those uses are consistent with the TCJA’s advertising. The analysis examines specific cash flow measures, such as capital expenditures, acquisitions, dividend payments, and share repurchases, to determine if there were any noticeable changes in trends subsequent to the TCJA’s implementation.
Examining the S&P 500 based on foreign earnings status shows distinct differences in uses of cash. Exhibit 7 provides a detailed view of cash uses, categorized by companies’ foreign earnings status. Cash spent on share repurchases for the foreign earnings group increased by 65% from 2017 to 2018 and represented the largest change in the use of cash. Foreign earnings companies also increased the cash spent on capital expenditures by 25% during the same period. Companies in the non–foreign earnings group modestly increased capital returned to shareholders through dividends and share repurchases with only minimal changes in cash spent on capital expenditures, which appeared to be on a consistent growth trajectory prior to the TCJA. Together, these results suggest that the foreign earnings group has been driving the increase in share repurchases and capital expenditures for the entire S&P 500 since the TCJA was enacted.
Selected Uses of Cash Flows Foreign Earnings Group vs. Non–Foreign Earnings Group, 2016–2018
Overall, it appears that corporations used their “repatriated” cash largely to repurchase shares, as well as some modest increases in investing activity. These results are not entirely unexpected, despite the TCJA’s advertising. Increased cash from operations, which is observed for the S&P 500 over this period, likely contributed to some of these increased expenditures, and it will be interesting to see how cash tax payments for “deemed repatriation” over the next eight years will affect business’ investment and financing decisions. Given the significant increase in share repurchases by companies with foreign earnings subsequent to the TCJA’s implementation, it is unlikely that S&P 500 firms had potential investment projects requiring the use of this specific cash source, because funding could have been obtained at low interest rates prior to the TCJA. The observed pattern of cash flows is largely consistent with Warren Buffett’s conclusion that there was plenty of capital available for projects prior to the TCJA; returning capital to shareholders was a logical decision by company managements in this case. Corporations’ preferred method of returning capital to shareholders appears to be through share repurchases, which can have a misperceived benefit of increasing share prices.
Many studies in the academic literature show that corporate payout policy is irrelevant from a valuation perspective. On share repurchases specifically, these are zero net present value (NPV) transactions that should not affect share price. Because cash used to repurchase shares is taken out of equity, investors are left with a smaller claim on net assets (i.e., equity) and fewer shares. From a valuation perspective, investors will now discount earnings expectations using a higher discount rate because repurchasing shares increases leverage, all else equal: liabilities remain constant while equity decreases. Assuming investors are rational, they will incorporate these factors into their share purchase or sale decisions (see Stephen H. Penman, Financial Statement Analysis and Security Valuation, 5th Ed., McGraw-Hill, 2013).
In Apple’s case, the company has steadily invested in productive assets, paid dividends (starting in 2012), and repurchased shares (starting in 2013). Since implementation of the TCJA, Apple has more than doubled its share repurchase activity, consistent with having plenty of capital for CAPX prior to the TCJA in line with Apple’s normal growth trajectory of recent years. Increased dividends in 2018 were also consistent with prior trends. Overall, from Apple’s observed cash flow activities and changes in certain key account balances, one can confidently conclude that Apple spent a lot of its repatriated cash on repurchases and not much, if any, on capital expenditures.
There is a tradeoff for any business affected by the reduced U.S. corporate tax rate and the new taxes on prior and future foreign earnings. If the present value of the tax savings on U.S. generated earnings is greater than the present value of the taxes on prior foreign earnings deemed repatriated and new taxes on future foreign earnings, the company will benefit. Any benefits will be affected by the level and distribution of U.S. versus foreign earnings. Economic benefits from the TCJA would likely be enhanced from a larger portion of a U.S. corporation’s earnings being generated domestically, although this gets very complicated with differential foreign tax rates, tariffs, and implicit after-tax rates of returns on foreign investments. These considerations are critical when evaluating corporate strategy under different tax policies.