Late last year, when it became clear that Dell was considering building a computer assembly plant in North Carolina, it was offered several inducements to make the move, including $242m in tax credits and property tax breaks. At about the same time, the Texas-based global computer company was promised another financial windfall for its investment, this time from the federal government in the form of US jobs creation legislation.
The legislation, a mammoth overhaul of the US corporate tax system, included a one-time opportunity for US firms with overseas operations to repatriate their profits at a reduced tax rate of 5.25%, compared with the typical US corporate rate of 35%. Called the US Homeland Investment Act, lawmakers hoped that it would prompt US companies to invest directly in their own locale, instead of an overseas market. Among other advantages, this boon for US firms – which have long chaffed under the double taxation of foreign earnings repatriated back to the US – allows for liberal uses of the repatriated money. For example, it can be used to make an acquisition, to pay wages or to pay down corporate debt.
“The thinking was that we are in new phase of the economy and this act would be a good way to encourage investment,” explains Tom Stringer, a tax partner in the international tax practice of BDO Seidman.
If Dell is any indication, the act has been a fabulous success. Dell will be able to bring about $4.1bn in foreign earnings back to the US, according to spokesperson Colleen Ryan. Of that, $100m will be used for the construction, capital expenditures and employee training at the new Winston-Salem facility. The rest will be applied to domestic research and development (R&D), and capital expenditures in its manufacturing facilities in Tennessee and Texas.
But is Dell truly an indicationthat the legislation will shift US direct investment back to its own shores?
At face value, Dell’s North Carolina plant is the embodiment of foreign investment agencies’ worst nightmare. Not only would the act make US sites more competitive than lower-cost locations overseas, according to this thinking, but it also would endanger current investment in foreign countries.
Few believe that the act will cut foreign investment by US firms to any great degree. Although most firms are examining the benefits of the one-time tax break, which can be applied for either FY2004 or FY2005, it is not an easy decision for them to make. For one thing, a site selection analysis can entail months if not years of study. Nor is the act itself entirely investment friendly: it is still uncertain whether and how US companies can apply credits for foreign taxes paid on the profits repatriated under this act, for instance.
Despite Dell’s investment, analysts say that it is still unclear what, if any, impact the law will have on direct investment in the US or whether it will affect US investment in foreign markets.
“It is far too early to determine all that,” says Mr Stringer. “Yes, companies are looking into the options. But this tax break is only one factor out of many that must be weighed up.”
The textbook case
In theory, taking advantage of the new law should be a simple decision. Business proponents have long charged that US companies are often subject to double taxation of the same income.
Unlike many European countries, the US does not base its tax code on a territorial system – allowing income to be taxed in the jurisdiction in which it was earned – but taxes the income of a US firm once the money is repatriated to the US, even if it has already been taxed by a foreign government. Providing foreign tax credits – that is, crediting taxes that a US company has paid to a foreign government – does provide some relief but it is a cumbersome process and often US firms are not credited the full amount.
The result has been that US companies tended to keep their foreign-sourced earnings abroad, using them to fund new operations or expand existing ones.
A study conducted by Allen Sinai, president and chief global economist at Decision Economics, estimates that between $265bn and $406bn of US corporate income could be repatriated under the act. It could also lead to the creation of up to 666,000 new US jobs.
The act is best suited for US companies with large offshore earnings that have cash requirements in the US, or at least heavier requirements than they have in foreign locales, says Emily Parker, a tax partner at Thompson & Knight and former deputy chief counsel of the US Internal Revenue Service. “Pharmaceutical companies are especially well positioned to benefit from it,” she says.
Since the beginning of the year, a number of pharmaceutical companies have either announced plans to repatriate profits or are considering doing so. Among them are Schering-Plough (which says it could bring back $9bn), Johnson & Johnson ($11bn), Eli Lilly ($8bn) and Pfizer ($29bn).
Other multinationals, such as Intel, Hewlett-Packard and Dell, are also poised to reap substantial benefits, according to statements that executives have made in the past 90 days in earnings calls.
Many of these statements, though, stop short of explaining what will be done with the funds if they are repatriated. Dell, with its investment plan already formulated and awaiting approval from its board of directors, appears to be one of the few exceptions to the rule.
3M, for example, which generates about 60% of its sales outside the US and can repatriate $800m under the law, has said it might use the funds to expand R&D. “There are a lot of different options open to us and we are currently examining all of the possibilities,” says 3M spokesperson Jackie Berry.
A long lead time
Scot Butcher, a tax partner in the international tax practice of BDO Seidman, is not surprised at the ambiguity. “The bill just passed at the end of October. Deciding whether to repatriate the income or not can take months. Companies will need an even longer lead time to decide what they want to do with it once they do repatriate it,” he says.
Some companies may conclude that profit repatriation does not align with their corporate goals. Jim McGeever, CFO of California-based software company NetSuite, has examined the act and decided not to repatriate profits. “We are expanding in Europe and need the money there to fund operations,” he says.
Companies that want to take advantage of the act will find that in some areas it is frustratingly vague. This is a result of behind-the-scenes tinkering when the respective US House and US Senate bills went to committee to be reconciled. The main area of uncertainty is the issue of foreign tax credits and the manner in which they can be applied under the Homeland Investment Act. For some companies, this uncertainty has sidelined the entire decision.
Another problem is finding the cash to bring back. Companies may have invested their profits in portfolio holdings or spent it on new equipment or plant upgrades. A subsidiary could not, for example, get a loan using its parent to guarantee the debt because the US tax authorities would view this as the debt of the parent company. The act states that the parent cannot fund what would amount to a dividend back to itself. Nor can the parent lend the money to the subsidiary directly.
For these reasons, Hank Gutman, principal in charge of the federal tax legislative and regulatory services group at the Washington national tax practice of KPMG, believes that the act is more likely to result in the sale of European securities held by US companies. “Some companies might cash out investments to bring back the money,” he says.
Assuming that enough US companies eventually decide to take advantage of the law – whether to fund new direct investments in the US or to pay down domestic debt – few observers believe that US direct investment overseas will be adversely affected to any great degree.
“Site selection is rarely just about taxes,” says Mr Butcher. “A company will first look at the quality of the workforce, for example, and the available utilities and what the roads are like and if its main customers and suppliers are located nearby.”
Dell considered all of these factors as it made its decision, says spokesperson Michelle Blood. “There were a number of reasons why we selected North Carolina,” she says.
Most observers, though, were surprised to see Dell make the level of investment that it did in the US. “Pound per pound, the US is a more expensive place to manufacture and operate,” says Mr Stringer. “It costs a premium to access our market.”
The Homeland Investment Act was undoubtedly an inducement for the computer maker, but most investment professionals are convinced that the generous package of incentives the state and local authorities put together for Dell was the deciding factor. “Right now, the way our tax system is structured, a lot of site selection decisions are driven locally instead of federally, even with this new act taken into account,” says Mr Butcher.
New legal and legislative developments, though, may change this.
Top among these is a Sixth Circuit US Court of Appeals decision made last autumn by a three-judge panel and reaffirmed in January at a hearing with all 12 judges. The original decision found that the use of investment tax credits as state incentives was a violation of the interstate commerce clause in the US Constitution. The case, which arose from a challenge to the incentives that Ohio granted to DaimlerChrysler to build a Jeep plant, has serious implications for the use of state tax incentives throughout the country, according to Messrs Butcher and Stringer.
“The decision basically said that anything that pits one state against another is not permitted,” says Mr Stringer.
As it stands, the ruling affects investment in Ohio, Michigan, Kentucky and Tennessee, narrowly limiting the type of incentives that can be offered to firms. Also, the decision could easily be cited by other circuit courts should similar lawsuits be filed. The US Supreme Court is considering whether it will hear the case.
There appears to be a growing backlash against the multi-million dollar packages that many states offer in return for direct investment. In North Carolina, a state senator recently filed a bill that would require the state and local governments to provide details about incentives proffered to a company once a decision was announced. This was a direct response to the stealth and speed that many lawmakers felt characterised the incentives offered to Dell.
Ironically, these measures – should they prove successful – could propel federal incentives such as the US Homeland Act to the forefront of companies’ planning. “If the worst happens, the feds may soon be the only game in town for companies,” says Mr Stringer.
The Homeland Investment Act is a one-time tax incentive. However, many observers believe that it may be extended, despite the passive reluctance of the US Treasury and even, some say, the president himself to grant this tax holiday the first time around.
More tax holidays?
“Somebody once said that there is no such thing as a one-time offer in Washington,” says Mel Hiscox, senior vice-president of the Welsh Development Agency in New York. “If it happened once, it can happen again.”
Should that prove to be the case, foreign locales would have little trouble competing for US investment, according to Mr Hiscox. “It might even stimulate overseas investment,” he says. “Repatriation of profits has always been an issue for US companies considering investing in the UK and has made more than a few think twice about setting up shop. This law would do away with that.”