Is A Tax Holiday On The Way?

By Stephen D. Simpson, CFA | June 21, 2011 AAA

To say that the United States has some strange corporate tax rules would a bit like saying that Michael Jordan knew how to play a little basketball. One of the byproducts of the byzantine U.S. tax structure is that many corporations are forced to keep large amounts of cash in their overseas subsidiaries instead of bringing it home and paying taxes on it to the U.S. Treasury. With nearly $1.4 trillion in U.S. corporate earnings sitting overseas, investors may begin to hear more debate about whether Congress should, or will, pass some sort of tax holiday bill to allow corporations to bring this money home.

TUTORIAL: Financial Statements

The Last Holiday Was a Mixed Blessing
One of the arguments for tax holidays is that U.S. corporations can repatriate their cash and use it to expand their businesses and hire workers. It's a nice theory, but it does not always (or perhaps even "often") work that way. A similar repatriation holiday was passed in 2004 under the Bush administration, inside the American Jobs Creation Act of 2004. While 800 companies took advantage in 2004 and 2005, the National Bureau of Economic Research (a non-partisan non-profit economics research organization) reports that 92% of the money repatriated was paid out as dividends and stock buybacks. (Read about how these strategies saved even more taxes; check out A Breakdown Of Stock Buybacks.)

It is an open question, then, whether another tax holiday would be any different. Companies have been accumulating cash and gorging on cheap debt, but have not shown any particular inclination to make big investments in capacity expansion. If hundreds of billions of dollars came in from overseas, how likely is it that the money would go to new workers and new equipment as opposed to new buybacks?

Of course, there is the counter-argument that dividends and share buybacks can be reinvested in capital formation (giving new companies the money to expand) or simply spent. Unfortunately, that may be a hard sale in the current environment. While it may be possible to construct a repatriation holiday that would proscribe or penalize companies from simply distributing the cash, it would almost certainly lead to a knock-down fight between Congress and the President.

A Big Deal For Tech and Energy Companies
Looking at those companies with some of the largest balances of undistributed earnings, there is a large number of tech companies. Apple (Nasdaq:AAPL), for instance, has $12.3 billion in such earnings (versus its market capitalization of $292 billion). Cisco (Nasdaq:CSCO) comes in at close to $32 billion (compared to a market cap of about $84 billion), while Google (Nasdaq:GOOG) and Hewlett-Packard (NYSE:HPQ) tally up over $17 billion and nearly $22 billion, respectively. Of course, this is not just a tech phenomenon. Investors may imagine that companies with large overseas businesses would have a great deal at stake here, and they would be right. Major energy player Apache (NYSE:APA), for instance, has over $19 billion in undistributed earnings, while Coca-Cola (NYSE:KO) and Exxon Mobil (NYSE:XOM) have $21 billion and $35 billion at stake, respectively. (Learn more in Financial Statements: Long Lived Assets.)

The Bottom Line: How Much Will It Move the Needle?
While these numbers on undistributed earnings seem large, and they are, they may not be as significant to valuation as it would initially seem. Many analysts simply tally up a firm's net cash and add that to their discounted cash flow estimates. It is relatively rare to see those analysts adjust the figures for the taxes that the firm would encounter in repatriation, so it could be argued that many firms with large overseas cash balances have inflated price targets to begin with (or the market is already pricing in an eventual tax holiday).

On the flip side, there is evidence that cash on the balance sheet does not drive stock price action nearly to the extent that actual dividend declarations and buyback announcements do. With that in mind, investors should keep an eye on this debate about repatriation tax. There are legitimate debates about whether this money really can (or will) be used to fuel economic growth, but investors who view themselves as co-owners of these companies should have a vested interest in when and how they will have access to this cash. (Learn the basics to finding the numerical worth of a company you want to invest in. Read Fundamental Analysis: A Brief Introduction To Valuation.)

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