The Tax Cuts and Jobs Act (TCJA), passed in late 2017, enacted significant reforms to the Federal Income Tax Code, including lowering the corporate income tax rate on previously deferred foreign earnings.
U.S. multinational corporations who previously deferred their foreign earnings will now pay an incentivized 15.5 percent for cash and cash-equivalent assets and 8.0 percent for non-cash assets—down from a full 35 percent on the former tax code. How will this change impact corporate site selection decisions?
A market inefficiency
As discussed in Part Two, the TCJA moved the U.S. from a worldwide tax system to a territorial tax system, meaning U.S.-based multinational corporations will now pay income taxes levied only against U.S. earnings as opposed to all earnings.
The former worldwide system had a provision which allowed multinational companies to hold foreign earnings offshore for years and defer paying the full U.S. tax. This avoidance strategy created a market inefficiency as foreign earnings were being reinvested and/or stockpiled offshore instead of being returned to the U.S. parent company.
Multinationals were incentivized to only bring back as much income as could be offset by excess foreign income tax credits generated by paying taxes in higher-tax countries. With the U.S. previously having this highest statutory tax rate of developed countries, foreign earnings would sit for years in offshore tax havens until enough foreign tax credits were generated to cover the tax difference.
The TCJA ends this loophole by its change to a territorial system and incentives the return of this foreign earnings bubble by including a lower corporate income tax rate that will encourage more multinational corporations to invest money back in the U.S.
Deferring foreign earnings meant less U.S. investment
The former tax code created an enormous disparity in tax payments for companies withholding foreign earnings. Among S&P 500 firms, approximately $2.8 trillion in foreign earnings had been deferred, with the technology industry holding $978 billion and the healthcare/life sciences industry holding $582.9 billion.
Here is a breakdown of deferred foreign earnings by industry. You’ll find the most profitable U.S. firms were among the largest holders of deferred foreign earnings:
This very significant market inefficiency meant there was less capital available for U.S. parent companies, and ultimately less wages paid to U.S. workers.
Because the TCJA corrects a significant loophole that enabled companies to temporarily avoid paying income taxes, an estimated $339 billion in new federal corporate income taxes is expected to be collected over the next decade. Ultimately, it is up to the multinationals to determine how best to outlay their foreign earnings but the TCJA potentially could result in a one-time infusion of cash back to the United States.