Barriers to Mobility: The Lockout Effect of U.S. Taxation of Worldwide Corporate Profits

John R. Graham – Duke University, Michelle Hanlon – University of Michigan, Terry Shevlin – University of Washington


In a frictionless world, capital would flow freely across countries. Within multinational firms, capital would be allocated across divisions, regardless of the location of those divisions, to maximize marginal product and firm value. In reality, tax laws create barriers to capital mobility. Taxes also create incentives for firms to expend resources in an effort to avoid or minimize capital taxes. In this paper, we investigate whether, how, and to what extent taxation distorts the mobility of capital within firms.

In particular, we survey tax executives to examine their firm’s response to the one-time dividend received deduction in the American Jobs Creation Act of 2004 (AJCA). The AJCA granted a temporary dividends received deduction of 85 percent of the extraordinary dividend from foreign earnings repatriated back to the U.S., which effectively reduced the rate of tax on the repatriated dividends to 5.25 percent (15 percent*35 percent statutory tax rate; we provide more details about the Act below). This dramatic rate reduction was a temporary change in the tax price of dividend repatriation and thus provides an ideal setting to study the incentives firms face when deciding whether to repatriate earnings back to the U.S. and the effects of U.S. tax policy on capital mobility.  Most estimates of the amount of dividends repatriated under the provisions of the AJCA exceed $300 billion (Redmiles, 2007).

Hartman (1985) concludes that if the repatriation and U.S. taxation of foreign earnings is inevitable (and this is a crucial assumption) and tax rates are a known intertemporal constant, then U.S. repatriation taxes do not affect the decision of mature firms to either reinvest funds abroad or repatriate them home. The only factors that matter in Hartman’s (1985) model are the after-local-tax rate of return (rf) and the home country, or domestic, after-tax rate of return (rd).

However, Hartman (1985) does not incorporate 1) cases where firms can use tax planning strategies to return the money at a low U.S. tax rate, 2) the effects of a temporary tax price change like the one-time DRD granted in the AJCA of 2004, or 3) any tax rate uncertainty.

Empirically, prior research suggests that firms retain a large share of their earnings abroad when faced with a high tax upon repatriation.  For example, Hines and Hubbard (1990) analyze 1984 tax return data and report that a one percent decrease in the repatriation tax is associated with a four percent increase in dividend payments by foreign subsidiaries in a sample of U.S. multinationals. Further, Desai et al. (2001) using Bureau of Economic Analysis (BEA) data of dividend repatriations for foreign subsidiaries conclude that repatriations are sensitive to repatriation taxes (in contrast they find that repatriations from foreign branches which are not subject to the repatriation tax are not sensitive to the tax, mitigating concerns of time varying changes in repatriations due to other non-tax factors). They infer from their data that repatriation taxes reduce aggregate dividend payouts by 12.8 percent. In addition, Foley et al. (2007) hypothesize that the repatriation tax cost is a reason that firms hold significant amounts of cash, an empirical observation previously explained by the existence of transaction costs and precautionary motives.  They report evidence consistent with their prediction—firms that face higher repatriation tax burdens hold higher levels of cash, hold the cash abroad, and hold the cash in affiliates that would trigger high tax costs when repatriating earnings.

Furthermore, there is anecdotal evidence that firms incur non-tax costs to avoid repatriation taxes, indicating these taxes are important. For example, in 1993 Apple Computer Inc. (now Apple Inc.) filed a $500 million shelf offering.

The company stated they were considering the debt offering to pay for new research and development facilities. Analysts at the time noted that it was an unusual offering because Apple had more than $1 billion in cash on hand and no long- term debt obligations. The investor relations spokesperson for Apple, Bill Slakey, responded that Apple was reluctant to draw on the cash reserves because much of the cash was outside the U.S. and repatriating those assets would produce a significant tax bill.1  In this same article analysts discussed the difficulties of high technology firms obtaining debt, indicating the debt was costly, but apparently less costly to Apple than bringing cash home from overseas.

Potentially even more costly, a few years later Apple considered merging or selling itself to Sun-Microsystems because its “financial condition was worsening” and noted that its board may have “decided a merger is the best way to save the company, which is facing a cash crunch to pay future restructuring charges and an upcoming debt payment.” An analyst from Brown Brothers Harriman said that although Apple had $1.1 billion in cash, most of it was in foreign subsidiaries.  He stated “if they were to draw it out it would be subject to taxation.  It’s liquid, but it’s like drawing money from a 401K (retirement plan) or something.” 2

In contrast, there is evidence that firms tax-plan to bring the money back to the U.S. in ways that avoid the U.S. tax, and thus the repatriation tax should not result in a substantial lockout of foreign earnings (e.g., “triangular” strategies described below from Altshuler and Grubert, 2003). There is also much anecdotal evidence that firms avoid taxes in general (Drucker, 2008; GAO 2008).3

We contribute to the literature by asking over 400 tax executives at firms with foreign source earnings about their firm’s response to the one-time DRD in the AJCA of 2004.  Our survey approach allows us to examine issues that are difficult to examine using traditional archival or theoretical methods. For example, we ask the tax executives to describe 1) the sources of funds repatriated (was it from cash?), 2) the uses of funds repatriated (were there projects in which they previously felt they could not invest because they felt the funds were locked out of the U.S.?), 3) the costs incurred to avoid repatriating earnings prior to the tax amnesty under the AJCA (were they borrowing instead of using earnings from foreign subsidiaries?), among other questions.

Data on these issues are difficult to obtain without the use of a survey.  For example, most financial statement data are worldwide and not provided by geographic segments (under the current accounting rules).  As a result, activities in the U.S. versus foreign jurisdictions cannot be easily discerned (e.g., did firms shift investment from foreign jurisdictions to the U.S.?).  In addition, as we describe below, the AJCA did not require the specific tracing of funds nor that the spending of the funds be incremental spending on “permitted uses.”  Thus, because cash is fungible, archival data cannot delineate between what the repatriated funds were used for and what the cash “freed up” by the repatriated funds was used for.  We directly ask executives to distinguish between these two types of funds in our survey questions.  Using archival data does have some benefits, however, such as the availability of a larger sample and the use of reported, audited financial statement data (or data collected elsewhere such as perhaps the BEA).  Thus, we view our results as triangulating the data from the archival studies.

Our survey data indicate that on average over 60 percent of the repatriations came from cash holdings.  This result is consistent with the observations in Foley et al. (2007) that large cash balances are held overseas to avoid the tax. When the tax rate was reduced significantly, the firms brought the cash back to the U.S.  The reported uses of the cash brought back to the U.S. are wide ranging but generally consistent with uses explicitly permitted by Congress, e.g., U.S. capital investment, the hiring and training of U.S employees, and U.S. research and development. In addition, firms report that the two most common uses for cash “freed up” by the repatriated cash were paying down domestic debt and repurchasing shares, as one would expect in an efficient market (additional cash does not create new investment opportunities).  This result sheds light on the empirical finding (in Blouin and Krull (2008) for example) that firms used the repatriated cash for share repurchases, which the authors point out is not a “permitted use” of the funds.  The more detailed data from the survey reveal that to a large extent the firms used the cash from the repatriations for permitted uses and used “freed-up” cash to repurchase shares.

This distinction is important given the writing in the AJCA and subsequent guidance from the Internal Revenue Service (described in detail below).  Surprisingly, the third highest ranking use of freed-up cash was additional U.S. capital investment (36 percent of the respondents).  This result suggests that the current repatriation tax inhibits investment and that even alternative sources of financing, such as borrowing, must be too costly for some of these firms to undertake investment that they otherwise would undertake in the absence of the incremental repatriation tax (or a lower tax rate).

Finally, our survey data reveal that the most common reported action taken to avoid repatriation tax is the raising of capital via debt in the U.S., with nearly 44 percent of companies stating they had done this.  In addition, nearly 20 percent of the respondents noted that their company had invested the foreign earnings in financial assets with a lower rate of return than they could have earned in the U.S.  All of this evidence is consistent with a significant lockout effect from the U.S. tax policy that taxes the worldwide income of U.S. multinationals.

The paper proceeds as follows. The second section provides a brief discussion of taxation of foreign sourced earnings of U.S. multinationals. The third section discusses our survey approach and the sample. The fourth section presents descriptive data about the respondents, the results, and our interpretation of these results in the context of the prior literature. The final section concludes.

Full report


  1. Taken from a Dow Jones News Service article entitled “Apple Edges Toward First Bond Offer with $500 mln Shelf” by Thomas Weber.  May 7, 1993.
  2. Taken from a Reuters News Wire article entitled “Apple Talks Stalled Again Over Price” by Therese Poletti. February 7, 1996.
  3. However, the shutdown of what were known as “Killer B” transactions (through IRS Notices in 2006 and 2007) likely eliminated many of the tax planning opportunities to effectively repatriate without paying the repatriation tax.