Trapped Foreign Earnings are Hurting US Multinationals in the Debt Markets

What to do with foreign earnings held abroad is a controversial subject today and was a frequent part of the debate leading up to the 2016 US presidential election. US multinationals now hold over $2 trillion dollars in cash in foreign countries. These foreign profits (held as cash) are not taxed until they are ‘repatriated’ to the US (i.e., transferred back home to the US for domestic use). Heated debate surrounding this controversy centers on either 1) taxing the foreign profits of US companies, regardless of when they transfer these profits back to the US or 2) holding a ‘tax holiday’ where these foreign earnings can be brought back to the US over a certain time period at a significantly reduced rate. President Bush declared a tax holiday, and many academic studies have investigated whether this tax holiday achieved the objectives originally conceived. It is not straightforward to identify exactly how repatriated cash was spent in the US (the stated objective of the Bush administration was to create new American jobs), but most academic studies have concluded that not as many jobs were created as originally hoped. 

Today we face the same set of arguments that led to the Bush tax holiday, but the dollar amounts are much larger. Companies that rely heavily on intangible assets (eg patents, trademarks, IP) are able to take the most advantage of the tax laws that allow the indefinite deferral of tax on foreign profits, hence companies like Apple, Google, and Microsoft are mentioned most as the benefactors of the current tax regime. The benefits of deferring tax, potentially forever, are clear; but less is known about the costs that accompany this benefit. Our study investigates one of these costs, specifically the costs that companies incur in the form of less favorable debt contracts. A key factor driving the debt contracting costs of foreign profits held abroad relates to the uncertainty about whether a borrower will need to access these funds in the future (and whether there will be another tax holiday). If a company is required to repatriate the foreign earnings (because of an unexpected domestic expense) they will pay a steep tax cost. We explore how lenders view repatriation costs and shed light on the current debate. 

Specifically, in our study we examine the effect of earnings repatriation taxes on bank loan contracting. We find that banks charge U.S. multinationals a higher loan spread when their tax cost of foreign earnings repatriation is high. This effect is more pronounced for firms with recent poor accounting performance and for those that are financially constrained. Our results are robust to a difference-in-differences research design using The American Jobs Creation Act of 2004 as an exogenous shock. The results also suggest that repatriation costs are associated with an increase in the likelihood of lenders requiring collateral and including more financial covenants in loan contracts. We also find that high repatriation costs increase the likelihood that a firm will borrow from foreign banks. The effect of earnings repatriation taxes is different from an overall tax avoidance effect, and our evidence is consistent with the effect operating mainly through agency and information risk channels. Overall, the study contributes to our understanding of the effect of US tax system on the bank loan contracting for U.S. multinational firms. 

Zhiming Ma is an Assistant Professor at Peking University, Derrald Stice is an Assistant Professor at Hong Kong University of Science and Technology and Danye Wang is a PhD student at New York University.