Foreign Cash: Taxes, Internal Capital Markets, and Agency Problems

Jarrad Harford is the Paul Pigott-PACCAR Professor of Finance at Foster School of Business, University of Washington; and Cong Wang is Professor of Finance at China Europe International Business School. This post is based on a recent article forthcoming at the Review of Financial Studies by Professor Harford, Professor Wang, and Kuo Zhang, Assistant Professor of Finance at School of Economics & WISE, Xiamen University.

U.S. multinational corporations park trillions of dollars of cash in low-tax jurisdictions to avoid the taxes associated with repatriating their foreign earnings. Company filings to the SEC for fiscal year 2016 show that some of the largest multinational companies, such as Apple and Microsoft, held over 90% of their cash reserves abroad. While keeping foreign earnings outside the U.S. can bring tax savings to shareholders, it may also hurt firm value through financing frictions and potential agency problems arising from the use of foreign cash. In our new article, Foreign Cash: Taxes, Internal Capital Markets, and Agency Problems, we investigate the shareholder value implications of parking large amounts of cash abroad.

We manually collect the amounts of foreign cash reserves for a sample of firms in the S&P 1500 index that disclose such information in their 10-K filings. Using a value-of-cash model, we find that the marginal value of a firm’s cash declines as the proportion of its total cash that is held abroad (foreign cash ratio) increases. This result suggests that investors place a discount on firms’ cash that is trapped overseas. We also examine the economic magnitude of this discount and find that a one standard deviation (0.29) increase in the foreign cash ratio is associated with a reduction of the marginal value of cash by $0.31. This large economic impact goes beyond the repatriation tax cost a firm would incur when bringing its foreign cash back to the U.S. To provide a more complete picture of the sources of the foreign cash discount, we next investigate the potential real consequences of stockpiling cash abroad.

Specially, we examine two more potential channels through which foreign cash holdings reduce the marginal value of cash. One is the domestic underinvestment problem. Firms facing large repatriation tax costs are generally unwilling to use their foreign cash to fund domestic investment and would have to raise money from external capital markets. But when the cost of external financing is high, the likelihood of firms abandoning positive NPV projects in the domestic market goes up, leading to a domestic underinvestment problem. To empirically test this conjecture, we construct a model to estimate the expected level of a firm’s domestic investment and find that firms with a greater portion of cash overseas indeed are more likely to underinvest in the domestic market. Notably, this domestic underinvestment problem only exists when a firm faces a higher cost of borrowing.

To provide more evidence on the potential disruption of the internal capital market, we also estimate a firm’s domestic investment-cash flow sensitivity and show that its domestic investment is only sensitive to the domestic cash flows while insensitive to the foreign cash flows. More importantly, the sensitivity of domestic investment to domestic cash flows is more pronounced for high foreign cash ratio firms. Further, we show that cash reserves are less useful in mitigating the negative impact of the recent financial crisis on corporate investment when a large portion of these reserves are offshore. Given this finding, we also investigate the tradeoff between underinvestment and repatriation. We find that firms facing a domestic cash flow shortfall are more likely to repatriate cash, but only when the tax cost of doing so is relatively low. Taken together, these findings suggest that holding substantial cash abroad impairs the functioning of a firm’s internal capital market and reduces financial flexibility at the parent company, leading to underinvestment problems in the domestic market.

The other potential real consequence of parking large amounts of cash abroad is the overinvestment problem in the foreign market, as the use of foreign cash is often subject to less monitoring from directors and shareholders. This is because foreign operations are often associated with a lower level of transparency due to organizational and financial complexity, while a foreign division’s long geographic distance from corporate headquarters makes on-site visits more difficult and time-consuming. To test the foreign overinvestment hypothesis, we examine how the market reacts to the announcements of firms’ foreign capital expenditure and acquisition decisions. We find that firms with a higher proportion of cash held overseas experience significantly lower abnormal returns when they announce foreign capital expenditure plans or acquisitions.

To establish causality, we investigate how the passage of the American Jobs Creation Act of 2004 (AJCA) affects the foreign cash valuation discount. The passage of AJCA in 2004 serves as an exogenous regulatory shock that significantly reduced firms’ repatriation tax costs during the tax holiday. We find that the foreign cash valuation discount exists during the periods before and after the tax holiday, but is significantly attenuated during the tax holiday. These results suggest that shareholders alter their perceptions towards undistributed foreign cash and that their concerns over parent firms’ liquidity conditions in the domestic market and the agency problems associated with the use of foreign cash are mitigated when foreign cash can be repatriated in a tax-efficient way.

Overall, our findings indicate that holding cash abroad has real economic consequences at the firm-level and should have important policy implications as they add to the debate on the efficiency of the current U.S. tax system.

The complete article is available for download here.

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