Abstract
We examine whether repatriation tax liabilities affect bond pricing using four settings: (1) pricing on a new bond issuance, (2) pricing changes around the American Jobs Creation Act of 2004 (AJCA), (3) pricing changes around the 2016 US election, and (4) pricing changes around the Tax Cuts and Jobs Act of 2017 (TCJA). The preponderance of evidence suggests that bondholders incorporate expected repatriation taxes into bond prices. However, this evidence appears concentrated around the 2004 AJCA (which created a repatriation tax holiday) and the 2016 US election (which unexpectedly increased the likelihood of a reduction in repatriation tax rates), arguably the strongest two experiments of the four. Around the 2016 US election, we find cross-sectional evidence suggesting that the positive relation between returns and repatriation tax liabilities is strongest for firms for firms that likely faced greater borrowing distortions due to repatriation taxes and for repatriation tax liabilities specifically on foreign cash. We do not find evidence that bondholders price repatriation tax liabilities on foreign earnings that have been reinvested in operating assets, suggesting that they do not price all repatriation tax liabilities equally. Overall, our results are consistent with lenders pricing when these liabilities are causing distortions in firms’ borrowing decisions and when they are more likely to be paid.
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Notes
For example, in its 2014 10-K filing, Yum Brands states, “If we experience an unforeseen decrease in our cash flows from our US businesses or are unable to refinance future US debt maturities we may be required to repatriate future international earnings at tax rates higher than we have historically experienced.”
A concurrent working paper by Ma, Stice, and Wang (2020) examines the relation between repatriation tax liabilities on current year earnings and interest rates on bank loans. We discuss important differences between our research question and research design and the research question and design of Ma et al. (2020) in Section 2.2.
“Trump Fan Wins $124,000 Betting on Election Victory,” by Alanna Petroff, CNNMoney, November 9, 2016.
Details of the actual and proposed corporate tax changes related to the AJCA, 2016 US election, and TCJA are outlined in Appendix A.
Broadly, the GILTI inclusion proxies for intangible income using foreign income less 10% of foreign tangible assets.
We note that the scope of APB 23 (1972) is broader than the unremitted earnings of foreign subsidiaries and applies to all book-over-tax basis differences if a firm has the ability to demonstrate that the potential deferred tax liability will be avoided indefinitely.
Indeed, in a more recent study, Ayers et al. (2015) find that 77% of firms either fail to disclose the tax liability on PRE or state that it is impracticable to calculate. We also note, however, that the economic magnitude of PRE has increased dramatically since the sample in Collins et al. (2000), so it is unclear to what extent equity investors continue to view the “impracticable to calculate” designation as a credible signal that the repatriation taxes are unlikely to be paid during our sample period.
Altshuler, Newlon, and Slemrod (1993) find that US multinational firms with parents in tax loss positions paid out little dividends to the US parent in relation to their income and assets. Altshuler et al. (1993) point out that although domestic operating losses eliminate the tax liability on repatriated earnings, any foreign tax credit also cannot be taken currently and must be carried forward. During their sample period, firms could carry net operating losses back three years and forward 15 years, whereas the foreign tax credit could be carried back two years and forward only five years. Thus, firms likely prefer a net operating loss carryforward over a foreign tax credit carryforward causing them not to increase their repatriations of foreign earnings in loss years. Similarly, Power and Silverstein (2007) find evidence that a small subset of firms appear to take advantage of repatriation during loss periods but the majority of firms repatriate less when they are in a loss position rather than more. The authors conclude that the desirability of net operating loss carryforwards over excess foreign tax credits drives this result, consistent with Altshuler, Newlon, and Slemrod (1993). During our sample period, the net operating loss deduction can be carried back two years and forward 20 years, whereas the foreign tax credit can be carried back only one year and carried forward only 10 years.
Specifically, if a firm retains control of the assets it transfers to a special purpose entity (SPE), it must treat the transaction (i.e., the transfer of assets to the SPE for cash) as a borrowing and recognize a liability on the balance sheet; for the portion of assets over which the firm does not retain control, the transaction is recognized as a sale. Like operating leases, firms can structure the contracts in these transactions to appear as though they have no control over the transferred assets, which may be inconsistent with the economic substance of the transaction.
The sample ends on December 22, 2017, in order to exclude debt issuances following the TCJA enactment. In untabulated analysis, we examine the 185 debt issuances between the 2016 presidential election and the TCJA enactment and find similar inferences.
We note, however, that inferences are similar if we instead use a three-day window from (0, +2) or if we use the window (+1, +3) under the assumption that information about the passage of the AJCA was released after the bond market closed.
Inferences are similar if we use (+1, +4).
Inferences are similar if we use (+1, +3).
The deferred tax liability recorded for non-PRE UFE is grossed up by the statutory tax rate and not the differential rate between the statutory tax rate and the foreign effective tax rate because firms record their deferred tax liability separately from their foreign tax credit (Donohoe, McGill, and Outslay 2012). In untabulated analysis, inferences are similar if non-PRE UFE is grossed up by the differential rate between the statutory tax rate and the foreign effective tax rate.
When five years of data is unavailable, we use three years of data. When three years of data is unavailable, we use one year of data. Alternatively, requiring five years of data does not change the inferences made.
Because of the small sample, industry fixed effects are omitted given that their inclusion reduces to firm fixed effects and eliminates the variation in our measure of repatriation costs. Instead, the results presented include industry random effects (Maas and Hox 2004, 2005). Inferences are similar if random fixed effects are omitted (untabulated).
Control variable descriptive statistics for the AJCA and TCJA samples are omitted for brevity.
Given that Ma et al. (2020) document a positive association between an estimate of repatriation costs on current year earnings and private bank loan spreads, in an untabulated test we add the interaction Foreign Earn * Repat Rate. This interaction more closely approximates the Ma et al. (2020) measure of repatriation costs. Specifically, they measure repatriation costs as the higher of zero or pre-tax foreign income, multiplied by the US statutory tax rate less any foreign taxes, scaled by total assets. The measures are complementary to each other and allow for an understanding of how bondholders discriminate between current and long-term repatriation costs. Consistent with the Ma et al. (2020) results, we find a positive association between current period repatriation costs (Foreign Earn * Repat Rate) and the cost of debt (Spread). This suggests that bondholders charge higher rates for firms with current estimated repatriation costs but do not appear to change their rates for long term repatriation costs. Additionally, these results suggest that different measures, rather than differential information between bondholders and private lenders (Rajan 1992), likely drive the difference between our results and Ma et al. (2020).
The coefficient on UFE * Repat Rate is significantly different in column 3 compared to columns 1, 2, and 4, with the greatest p value being 0.067 among the three comparisons. The coefficient on UFE * Repat Rate is not significantly different across columns 1, 2, and 4.
α3*(0.135*0.163)
Wagner et al. (2018) examine stock returns around the 2016 US election and observe either insignificant or negative returns for their measure of PRE. We note that an important difference between our design and theirs is that we calculate the estimated taxes on unremitted foreign earnings, not just the foreign earnings amount. In addition, we include all unremitted foreign earnings in our estimate, not just UFE that is designated as PRE. This is an important distinction because President Trump also spoke repeatedly throughout the campaign about raising trade barriers between the US and some foreign countries to bring jobs back to the US. Consequently, the amount of either UFE or PRE proxies not only for potential repatriation taxes but also for the extent of a firm’s foreign operations. The (sometimes) negative coefficient on PRE observed in Wagner et al. (2018) is consistent with equity investors’ concerns about potential trade barriers outweighing the benefits of a potential reduction in repatriation taxes for stock returns. Column 3 documents a negative and significant coefficient on the UFE main effect. This result is consistent with Wagner et al. (2018) and also suggests that the positive and significant estimated coefficient on the UFE * Repat Rate interaction is not simply due to firms with more extensive foreign operations having more positive bond returns around the election.
The coefficient on UFE * Repat Rate is significantly different in column 1 compared to columns 2–4, with the greatest p value being less than 0.01 among the three comparisons. The coefficient on UFE * Repat Rate is not significantly different across columns 2–4.
The one-time repatriation rates of 12 and 5% for foreign cash and operating assets, respectively, were included in the introduction of the TCJA (https://taxfoundation.org/2017-tax-cuts-jobs-act-analysis/). While President Trump proposed a 10% rate for one-time repatriation (during the campaign), the Tax Reform Task Force Blueprint proposed by House Republicans proposed rates of 8.75 and 3.5% for foreign cash and operating assets, respectively (https://abetterway.speaker.gov/_assets/pdf/ABetterWay-Tax-PolicyPaper.pdf). The enacted TCJA bill included one-time repatriation rates of 15.5 and 8% for foreign cash and operating assets, respectively.
It is also possible that bond investors react negatively to the details of the GILTI income inclusion or the base-erosion and anti-abuse tax (BEAT).
We acknowledge that one downside of using the election setting for this analysis is the possibility that bondholders were reacting to campaign promises that were unrelated to repatriation taxes. We note, however, that our model controls for effective tax rates and other measures of tax avoidance, so it is unlikely that our results can be attributed to differences across firms in tax avoidance or to aspects of expected tax reform that are unrelated to repatriation taxes.
Ideally, we would only capture domestic debt due within the next five years rather than all debt due. The mixing of foreign and domestic debt adds noise to this measure.
The analysis in columns 1 and 2 is limited to the firms reporting foreign cash because we need this disclosure to calculate domestic cash.
As an additional untabulated analysis, we partition the sample based on noninvestment/investment grade firms and find evidence that the positive relation between bond returns and repatriation costs is the most positive for noninvestment grade firms with the lowest domestic cash balances. In other words, the positive reaction to a reduction in repatriation costs is seen in the group of firms most affected by borrowing distortions created by repatriation costs (i.e., firms that are financially constrained/have low domestic cash).
We do not restrict the sample to cash-only acquisitions for two reasons. First, using a mix of cash and stock can still result from managers overspending foreign cash. Second, the sample is too limited for cash-only acquisitions.
We acknowledge that these cross-sections are measured with noise (e.g., we only include firms that make an acquisition). However, acquisition behavior is one type of large investment that is possible to disaggregate into its domestic and foreign parts.
We note that the proposed one-time repatriation tax in congressional Republicans’ proposal was lower for UFE held in operating assets than for UFE held in cash, which could lead to firms with a greater portion of UFE invested in operating assets having more positive returns than firms with UFE held in cash, because the reduction in the repatriation tax they would have to pay is larger. On the other hand, President Trump’s proposal did not make a distinction in the taxation of UFE based on composition of cash versus operating assets, so it was unclear at the time of the election which proposal would become law.
As an illustrative example, if a firm has $1000 of UFE with 80% designated as PRE and a foreign tax rate of 15%, of the $800 in UFE designated as PRE, the firm will disclose this amount as $680, which reflects the after-foreign tax amount. To arrive at the estimate of UFE designated as PRE, we would need to gross-up the disclosed $680 by 1 minus the foreign tax rate of 15% ($680/(1–0.15)). The firm would also accrue a deferred tax liability for the portion of UFE not designated as PRE equal to $200*0.35 = $70. Additionally, it would separately record a deferred tax asset for the related foreign tax credit ($200*0.15 = $30). Thus, to arrive at an estimate of the amount of UFE not designated as PRE, we take the disclosed DTL and gross it up by the US statutory rate ($70/0.35) to arrive at $200. Adding together the grossed up PRE amount of $800 and the grossed up non-PRE amount of $200, we arrive at UFE of $1000.
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Acknowledgements
We are grateful for helpful comments received from an anonymous referee, Jennifer Blouin (editor), John Campbell, James Chyz, Brant Christensen, Fabio Gaertner, Kerry Inger, Tom Omer, Richard Price, Terry Shevlin, Bridget Stomberg, Steve Utke, Ryan Wilson and workshop participants at Oklahoma State University, the University of Arkansas, the University of Nebraska – Lincoln, the University of Oklahoma, and the 2016 ATA midyear meeting. We thank Burch Kealey for providing assistance with DirectEdgar, and Alissa Beattie for research assistance.
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Appendices
Appendix 1
1.1 Corporate tax changes around the AJCA, 2016 US election, and the TCJA
1.1.1 Panel A: Corporate Tax Changes Related to the AJCA. Footnote 34
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US MNCs can repatriate extraordinary dividends from their controlled foreign corporations (CFCs) at an effective 5.25% rate of tax during a two-year period following the year of the law’s enactment through an 85% dividends received deduction.
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These extraordinary dividends are limited to the greater of $500 million or either the amount of PRE according to the US firm’s balance sheet as of June 30, 2003, or 35% of the specific tax liability attributable to PRE.
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US MNCs could specify which dividends qualified for the deduction, because dividends qualifying for the deduction were not eligible for the foreign tax credit.
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The Extraterritorial Income Exclusion regime was repealed effective January 1, 2005, with two years of transition relief in 2005 and 2006.
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Provides a deduction of 9% of income generated from domestic production activities, which was phased in from 2005 to 2010.
1.1.2 Panel B: Proposed Corporate Tax Changes Related to the 2016 US Election. Footnote 35
President Donald Trump:
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A one-time 10% tax on the deemed repatriation of all corporate profits held offshore.
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Reduce the corporate tax rate from 35% to 15%.
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Eliminate the corporate alternative minimum tax.
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An election to immediately expense all capital investment for firms engaged in US manufacturing. However, firms making the election will no longer be able to deduct interest expense.
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Eliminate most corporate tax expenditures with an exception for the research and development credit.
House Republicans’ Tax Reform Task Force Blueprint:
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Existing accumulated foreign earnings held in cash or cash equivalents will be taxed at 8.75%. Non-cash accumulated foreign earnings will be taxed at 3.5% with the tax liability payable over an eight-year period.
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Replace the existing worldwide tax system with a territorial system featuring a 100% exemption for dividends from foreign subsidiaries.
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Reduce the corporate tax rate from 35% to 20%.
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Eliminate the corporate alternative minimum tax.
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Immediate expensing of investments in tangible (excluding land) and intangible assets.
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Interest expense will only be deductible against interest income.
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Net operating losses (NOLs) will be allowed to be carried forward indefinitely. Carrybacks of NOLs will not be permitted. Additionally, NOL carryforwards will be increased by an interest factor to account for inflation, and the NOL deduction will be limited to 90% of taxable income before considering the NOL.
1.1.3 Panel C: Corporate Tax Changes Related to the TCJA Footnote 36
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One-time repatriation tax of profits in overseas subsidiaries at 15.5% for UFE held in cash and 8% for UFE operating assets.
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The corporate tax rate was lowered from 35% to 21%.
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Converted the US from a modified worldwide tax regime to a quasi-territorial tax regime by allowing a 100% dividends received deduction from 10% or more owned specified foreign corporations.
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Also introduced the global intangible low-taxed income (GILTI) regime, a 50% deduction for foreign-derived intangible income, and the base erosion and anti-avoidance tax (BEAT).
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The corporate Alternative Minimum Tax was eliminated.
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Eliminated the net operating loss carryback, and operating loss carryforwards can be carried forward indefinitely but can only offset 80% of taxable income.
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Eliminated the domestic production activities deduction.
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Increased bonus depreciation to 100% and increased Sec. 179 expensing from $500,000 to $1000,000.
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Limited the deduction for business interest expense to 30% of adjusted taxable income plus business interest income.
Appendix 2
1.1 Variable definitions
Cost of Borrowing Measure | |
Abnormal Bond Return | The daily abnormal return (Reti,t – Retm,t) from the period (+1 to +3) where day 0 is the 2016 US election. Reti,t is the daily trade-weighted return using bond prices but not interest payments on firms’ individual debt issuances. Retm,t is the daily expected return for the matched portfolio based on debt maturity and Moody’s credit rating. |
Repatriation Cost Measures | |
UFE | Hand-collected unremitted foreign earnings. UFE is estimated as PRE (obtained from Audit Analytics) grossed-up by 1 minus the average foreign effective tax rate plus the disclosed deferred tax liability on non-PRE UFE grossed-up by the US statutory rate of 35%, all scaled by lagged total assets (AT). The foreign effective tax rate is cumulative foreign tax expense (TXFO) over the prior five years scaled by cumulative pretax foreign income (PIFO) over the prior five years. |
Repat Rate | 0.35 minus the foreign effective tax rate; 0 when the foreign effective tax rate is greater than 0.35. This variable is multiplied by 100 when used in the new debt issuance sample. |
Foreign Cash | Hand-collected foreign cash scaled by lagged total assets (AT). |
Domestic Cash | Total cash (CHE) minus hand-collected foreign cash, scaled by lagged total assets (AT). |
UFE Op. Assets | UFE minus Foreign Cash |
Other Variables | |
Downside | Negative one multiplied by the 5th percentile of daily abnormal bond returns over the prior year. |
Illiq | The negative covariance of price changes over the month prior to the 2016 election. Specifically, let ΔPitd = Pitd – Pitd-1 be the change in the natural logarithm of bond i on day d of month t, then Illiq is equal to –Covt(Pitd, Pitd + 1) |
Rating | S&P Ratings from Compustat as a count where AAA+ =1 and CCC- = 21. |
Gray Area | Equal to one for firms with an Altman (1968) Z-Score between 1.8 and 3, zero otherwise. |
Distress | Equal to one for firms with an Altman (1968) Z-Score of less than 1.8, zero otherwise. |
Leverage | Long-term debt scaled (DLTT) by total assets (AT). |
BTM | Book value of equity (CEQ) scaled by the market value of equity (CSHO*PRC). |
Loss | Equal to one if the firm reports income before extraordinary items (IB) below zero, zero otherwise. |
Foreign Earn | Foreign pretax income (PIFO) scaled by lagged total assets (AT) |
Domestic Earn | Domestic pretax income (PIDOM) scaled by lagged total assets (AT). |
Avg. Accruals | Equal to average accruals scaled by total assets. Accruals are measured as the difference between net income (NI) and operating cash flows (OANCF). |
Size | Natural logarithm of lagged total assets (AT). |
Cash ETR | Cash taxes paid (TXPD) scaled by pretax income (PI). Equal to zero when negative. |
Curr ETR | Income tax expense (TXT) scaled by pretax income (PI). Equal to zero when negative. |
BT | Domestic pretax income (PIDOM) minus federal taxes (TXFED) scaled by 0.35 minus state taxes (TXS) minus other income taxes (TXO) minus equity in earnings from subsidiaries (ESUB). |
DTAX | The residuals from the following regression estimated by year and industry: PERM = β0 + β1INTAN + β2ESUB + β3MII + β4TXS + β5PERM_LAG + ε. PERM is equal to PIDOM – ((TXFED/TXFO)/0.35) – (TXDI/0.35). All other variables are from Compustat. |
New Debt Issuance Measures | |
Spread | The yield of the first bond issuance for a firm per year. The spread is calculated as the difference between the yield of bond i and the associated yield of the Treasury curve at the same maturity from SDC divided by 100. |
NOL | Indicator variable equal to one if the firm has a loss carry forward, TLCF, zero otherwise. |
ΔNOL | Equal to the change in the firm’s loss carry forward from year t-2 to year t-1, scaled by lagged total assets. |
Std Cash Flow | The five-year standard deviation of the firm’s net operating cash flows, OANCF, scaled by total assets. |
PPE | Firm i’s property, plant and equipment (PPENT) scaled by total assets. |
Intangibles | Intangible assets (INTAN) scaled by total assets. |
Rating | Converted letter credit ratings associated with a bond’s issuance where AAA+ =1 and CCC- = 21 retrieved from SDC. |
Life | Maturity of bond in years. |
Callable | Indicator variable equal to one if the bond is callable and zero otherwise. |
Proceeds | The natural log of the total dollar face value of the bond issue. |
Follow | The log of one plus the number of analysts following the firm in the latest I/B/E/S consensus analyst forecast. |
Error | The analyst forecast error calculated as the difference between actual reported earnings and the latest I/B/E/S median consensus analyst forecast (reported before the earnings announcement) scaled by the value of the latest I/B/E/S median consensus analyst forecast. |
Disp | The standard deviation of analyst forecasts from I/B/E/S scaled by the absolute value of the latest I/B/E/S median consensus forecast. |
Appendix 3
1.1 Validation of repatriation cost measure
In this appendix, we validate our measure of repatriation costs by comparing it to the disclosed amount of repatriation costs.Footnote 37 One-hundred fifteen firms disclose either the deferred tax liability associated with UFE or the unrecorded tax liability on PRE. Table C1 Panel A presents descriptive statistics for our estimates and the disclosed repatriation taxes. The sample presented only includes firms that disclosed one of the repatriation tax liabilities (hand-collected). The average Repat Rate is 0.15, and the average UFE is 24% of assets. The interaction of these two variables captures total repatriation costs, and the mean is equal to 4% of assets. The Total Repat Cost Disclosed is the hand-collected amount of unrecorded taxes related to PRE plus the DTL recorded for non-PRE UFE less any foreign tax credit recorded related to non-PRE UFE, all scaled by lagged assets. Similar to our interacted measure, the average Total Repat Cost Disclosed is 3.9% of assets. Non-PRE DTL is the hand-collected DTL on non-PRE UFE minus the foreign tax credit related to non-PRE UFE, all scaled by lagged total assets. This portion averages 1.8% of assets. PRE Tax is the hand-collected disclosed amount of unrecorded DTL on PRE, scaled by lagged total assets, and averages 7.3% of assets. Table C1 Panel B presents the correlation matrix between all of these measures. P values are presented below the correlation coefficients. The correlation coefficient between the interaction UFE * Repat Rate and Total Repat Cost Disclosed is 0.92, suggesting that our estimate of repatriation costs is a good proxy for actual repatriation costs. In addition, the correlation coefficient between UFE and Repat Rate is 0.37, alleviating the concern that multicollinearity will affect the inferences made from eq. (1).
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Blaylock, B.S., Downes, J.F., Mathis, M.E. et al. Do bondholders incorporate expected repatriation taxes into their pricing of debt?. Rev Account Stud 27, 1457–1492 (2022). https://doi.org/10.1007/s11142-021-09632-6
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DOI: https://doi.org/10.1007/s11142-021-09632-6