A look at what will happen next in the world economies
Thursday, August 7, 2014
America's Business Puzzle: Record Debt and Record Cash
Trying to avoid tax will always come back to bite you. Aivars Lode Clocks tick for tax avoidance practice.
U.S. companies taking advantage of a widely used tax-avoidance maneuver face a ticking clock: The days of ultralow interest rates, courtesy of the Federal Reserve, are numbered.
The result is a peculiar situation in which U.S. companies simultaneously have issued record amounts of debt—both in nominal terms and as a percent of gross domestic product—and hold what appears to be record amounts of cash overseas. U.S. companies borrowed another $223 billion in the first quarter of the year.Since 2008, the Fed's easy cash policies have allowed companies to buy back stock, pay dividends and make acquisitions largely without tapping cash from overseas subsidiaries. By leaving foreign profit overseas, companies avoid the sting of the U.S.'s 35% federal tax rate on it.
"It is a perfect financial blueprint to really encourage keeping money overseas and not redeploying it back here, and to leverage up," said Fredric Reynolds, former chief financial officer of CBS and a board member of AOL Inc., AOL +1.84%Mondelez International Inc. MDLZ -1.22%and Hess Corp. HES -0.61% "You'd be criticized if you didn't."
But the technique may be on borrowed time. It is likely to lose some luster as the Fed's easy-money policies cool and Congress revisits tax rules that encourage businesses to stockpile cash overseas and even to relocate to low-tax countries.
"You've just added a huge, extra fixed cost," Mr. Reynolds says. "It's a low rate, but if your business drops 5% or 6%, making that interest payment is going to get harder."And as rates tick up, the risk accompanying all that debt rises as well. Too much debt on its own can weaken debt ratings and make investors jittery. And a crisis or a downturn—whether economic, industrywide or company-specific—could hamper a company's ability to make interest payments, or to repay or refinance the debt as it comes due.
Corporate-tax rules are already getting official scrutiny after a recent rash of corporate "inversions" in which companies merge with overseas companies to gain lower tax rates and tap offshore cash. President Obama and other administration officials have criticized inversions, and Sen. Ron Wyden (D., Ore), who heads the powerful Senate Finance Committee, has called to retroactively ending the tax benefit. He and other lawmakers also are pushing for a broader corporate-tax overhaul, though meaningful progress isn't expected before November's midterm elections.
Few corporations publicly say they are borrowing to avoid a tax hit, but analysts and economists say the dynamic is clear. "The aggressively friendly debt market is allowing companies to borrow instead of repatriate cash," says Andrew Chang, an analyst for Standard & Poor's, who describes the move as "synthetic cash repatriation."
Take Honeywell International Inc.HON +0.52% Last year the Morristown, N.J., company reported a $1.9 billion increase in foreign earnings that it says have been permanently reinvested overseas, bringing the total to $13.5 billion, up 16% from a year ago. At the same time, the company also increased its debt by 18%, or about $1.3 billion.
Honeywell Chief Financial Officer Tom Szlosek expects the company's cash and debt to be basically equal by the end of the year, a situation he describes as out of step with how industrial companies are generally run. "But when you peel it back a little bit you see that almost all of our debt is in the U.S. and all our cash is overseas," Mr. Szlosek said.
Honeywell's U.S. earnings would be sufficient to pay for dividends, buybacks and minimal capital expenditure, but not much more, he said. Yet drawing on its offshore cash would incur a "cost prohibitive" tax hit, so Honeywell instead taps the debt markets. "It would be wonderful to be able to take the cash that we have overseas and be able to use it," he said.
A spokesman for the Fed declined to comment. Federal Reserve Chairwoman Janet Yellen earlier this month deflected questions about tax policy and overseas earnings, saying it was the responsibility of Congress and the White House.
By law, the Fed considers three objectives when setting monetary policy, including interest-rate targets: controlling inflation, maximizing employment and moderating long-term interest-rates. But the unintended effects of its policies can be much more diverse. Easy money ahead of the financial crisis helped run up the price of everything from forest land to housing. This year, Fed officials have expressed concern that, in the long run, low rates may again be inflating the value of assets and encouraging risky investment decisions.
Another effect may be tax avoidance. There are no comprehensive numbers on foreign cash and liquid securities held by U.S. companies, but Moody's MCO -0.31% Analytics estimates that some $950 billion in cash is held offshore by the more than 1,100 nonfinancial companies whose debt it rates. That accounts for more than half of the record $1.64 trillion in cash held by the companies at year-end, Moody's says.
Companies have been accumulating cash at a rapid clip, doubling it since 2007, according to S&P. Meanwhile, the debt taken on by nonfinancial companies reached a record $9.6 trillion in March, up from $6.5 trillion in early 2007. The first-quarter figure set a new high since at least 1955 in both absolute terms and relative to the economy as a whole, at 57% of gross domestic product—the sixth consecutive quarterly record, according to data from Moody's.
That debt not only allows companies to keep profits untaxed overseas, it also generates interest costs that can be used to generate tax deductions at the higher U.S. rate.
But when S&P looks at corporate balance sheets it doesn't fully value cash held overseas in its ratings calculations. The ratings company discounts offshore cash by about 25% on average, an estimate of how much companies would have to pay to Uncle Sam if they brought the money to the U.S. That S&P considers corporate cash at all when measuring a company's indebtedness is itself a sign of how unusual the times are: Until recently, the company saw no need, because big borrowers rarely had big cash hoards too.
Among more than 240 companies disclosing increases in unremitted foreign earnings in 2013, those with bigger increases tended to also see bigger increases in corporate debt, according to data from research firm Calcbench.
By borrowing at home, companies can do things like buy back stock—generally done from a company's home country—without taking the tax hit to bring offshore cash to the U.S. parent.
International Business Machines Corp. IBM -1.03% increased its permanently reinvested overseas earnings by 18% to $52.3 billion last year. At the same time, the company increased its borrowing by $6.4 billion, or 19%, to $39.7 billion. IBM is in the midst of a five-year plan to repurchase $50 billion of its own stock.
Medical-device maker Medtronic Inc. MDT -0.49% had accumulated $20.5 billion in unremitted foreign earnings by the end of 2013, up 13% from the prior year. At the same time, its debt has risen 12% to $11.9 billion.
A Medtronic spokesman said the company's debt and foreign earnings change independently. Acquisitions, share repurchases and the amount of cash generated within the U.S. can affect the company's debt requirements, while similar factors affect the demand for cash outside the U.S., and the amount available after those demands are met, spokesman Fernando Vivanco said.
The company held $14 billion in cash and marketable investments in its offshore subsidiaries las year, up from $10.9 billion the prior year. Medtronic is putting some of its offshore cash to use. In June it announced plans to buy rival Covidien COV -2.03% PLC for $42.9 billion, at least in part to adopt Covidien's lower-tax corporate home in Ireland.
Rising foreign cash holdings correspond to a growing share of earnings derived from outside U.S. borders as companies expand around the globe. And the figure is rising, too. About 40% of Honeywell's sales originate outside the U.S., for example, while more than 55% of IBM's do.
And, of course, low interest rates make it a feasible strategy to borrow against those untapped profits.
"Repatriation of foreign earnings is an expensive proposition," says Robert Sicina, formerly chief financial officer at divisions of American Express Co. AXP -0.17% and Citibank. "The cash is not really usable for U.S. purposes. Your alternative is to borrow—it's a great alternative.