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Risk and Section 965 Repatriation

The sheer complexity of the repatriation process can affect business operations, financial performance, and financial reporting, both now and in the future.
Celina Rogers, CFO Research Services
October 20, 2005

The new section 965 of the Internal Revenue Code, enacted as part of the American Jobs Creation Act of 2004, offers companies a one-time opportunity to repatriate profits earned overseas with greatly reduced tax consequences. But the saving — in many instances, the effective tax rate on repatriated funds can be reduced from 35 percent to 5.25 percent — is not without risks.

That was one theme to emerge from a discussion between leading finance executives, tax practitioners, and editorial staff from CFO Research Services, who gathered in July to discuss the repatriation provisions in section 965. Participants observed that section 965 poses risks to business operations, financial performance, and financial reporting, both now and in the future, stemming from the sheer complexity of the repatriation process.

Repatriation under section 965 can be as complex, in many cases, as a merger or acquisition, participants agreed. This complexity arises, in part, from the fact that repatriation requires the involvement of many functional areas of the business — ranging from the finance and tax departments to human resources and corporate communications. The sheer number of transactions required to find the cash — as well as the corporate governance exercise of causing controlled foreign corporations (CFCs) to pay a dividend, also contributes to the complexity of the undertaking. Attendees strongly suggested that companies still considering a repatriation under section 965 should accelerate their actions to execute this time-consuming series of transactions. The CFO of one manufacturing company that has successfully executed a repatriation noted that her company's treasury and tax departments were already studying the possibility of repatriation when section 965 went into effect in October 2004.

While the complexity of the undertaking created work for finance and operating teams, perhaps more importantly, the breadth and scope of repatriation decisions and transactions introduced new risks to their businesses. Several attendees mentioned the risk that the IRS would take a contrary view of the tax treatment at some point in the future, but they also cited risks to the company's operating and financial position at home and overseas. And while no particular process or framework emerged as the single "right way" to approach section 965 repatriation, the theme of complexity and the risks it creates echoed throughout the discussion:

Qualifying funds. To qualify for the section 965 dividends-received deduction, the U.S. parent must receive the funds in cash. While the CFC may borrow the funds, the statute constrains certain intragroup borrowing; ideally, a third-party lender might certify by letter that the CFC is able to borrow the cash on its own (without relying, for example, on the credit or collateral of its corporate parent). These and other regulatory and borrowing constraints required repatriating companies to unwind and rebuild complicated structures to find funds appropriate for repatriation. The treasurer of a telecommunications equipment company that recently repatriated approximately $100 million (although not under section 965, due to the company's particular tax situation) explained that his company solved this problem by revamping its international treasury and capital structures before undertaking its repatriation activities — not only to locate pockets of available overseas cash, but also to assess its needs for cash abroad.

Planning for repatriation as part of a broader corporate strategy. Roundtable attendees unequivocally agreed that companies should undertake repatriation in pursuit of a broader corporate strategy, not as a limited, tactical move to gain more favorable tax treatment. This meant, for most companies, that planning for repatriation involved assessing a company's need for cash both at home and abroad to fund organic growth plans, pay down debt, or make acquisitions. To do so, finance teams examined their subsidiaries' capital requirements and operating positions in foreign countries and markets — all the while keeping in mind the impact repatriation would have on each unit's ability to conduct business going forward.

Executing the transactions. Finance executives reported that executing a repatriation under section 965 required a vast series of transactions. To ensure that the process went smoothly, companies engaged a wide range of internal stakeholders in the United States and overseas — including the obvious players, such as finance and tax personnel and business unit managers, and less obvious players, such as HR and corporate communications groups. The CFO of a manufacturing company explained, for example, that the HR staff at her company helped to ease difficult transitions in the company's overseas operations connected to repatriation. HR, she said, also helped the company decide how to take advantage of labor arbitrage opportunities as it considered how to set its international operating profile going forward. And, as several attendees pointed out, bringing money home under a statute entitled the American Jobs Creation Act created public relations pressure that corporate communications groups were often called upon to handle — particularly when the activities funded by repatriated cash seemed, on the surface at least, to have less to do with creating jobs than with improving the company's financial and operating footprint.


Reporting, compliance, and investor relations. Another area of concern among roundtable attendees was the potential for reporting and compliance problems. The potential for discrepancies between Form 8K — the "current report" used by most public companies to report material events and corporate changes of importance to investors — and other financial statements was particularly worrisome, said the CFO of one high-tech firm, whose company pursued section 965 repatriation early in the year. The risk of a discrepancy between 8K filings and other financial statements was heightened, the CFO continued, by Treasury Department and financial accounting guidance that fell short of executives' short-term needs. This dearth of guidance early in the year made financial statements — which include projections of future tax liability — more risky than usual for repatriating companies. As the CFO pointed out, a discrepancy between 8K reporting and other statements could have the potential of forcing a restatement. Investors were already suffering from restatement fatigue, he noted; further restatement would lead to investor-relations problems and punishment in the equity markets.

Attendees also discussed the effect of Sarbanes-Oxley on section 965 repatriation. The executives at the roundtable were not surprised to learn that a large number of material weaknesses in year one of section 404 compliance among all public company filers were tax-related. And although repatriation under section 965 is a one-time transaction, not a repeatable activity, Sarbanes-Oxley requirements still apply to controls over non-routine transactions. The scale and complexity of repatriation transactions, coupled with the potential for uneven controls over non-routine transactions, place the company and its senior executives at risk.

Managing risk while conducting business post-repatriation. The risk of an IRS challenge and of compliance and reporting failures troubled executives at repatriating companies. The U.S. Treasury Department's initial guidance on section 965, while issued quickly, left many questions about domestic reinvestment plans, tax credits, and other important points unanswered for much of the year. Although most of these questions had been settled at the time of the roundtable discussion by the first two rounds of administrative guidance (the third round had not yet been issued), finance teams acting earlier in 2005 had to make critical and far-reaching decisions despite substantial uncertainty. Meanwhile, companies that waited for outstanding questions to be settled by the Treasury Department now find themselves pressed for time, and may be forced to act quickly — a situation that inherently increases risk.

Attendees discussed several techniques to manage the risk of challenge or restatement:

Tracking funds. Section 965 requires that the dollar amount of qualifying dividends be invested in the United States according to a domestic reinvestment plan that cannot change once the dividend is paid. This plan must be made available to the IRS upon request and cannot payouts. The rules do not, however, specify strict tracking requirements for repatriated funds.

While most attendees agreed that the segregation of repatriated funds into earmarked accounts would be too time-consuming and cumbersome to yield benefits, repatriating companies made efforts to track these funds to head off any possibility of reversal while keeping their asset accounts streamlined. A treasury executive from a major pharmaceutical company, for example, explained that his company had altered its accounts payable processes to account for and track repatriated funds as they were spent. In general, attendees agreed that — while it was important to treat the need to track repatriated funds prudently — a balance should be struck between caution and flexibility to preserve the benefit of repatriating in the first place.

Monitoring future events and activities that might cause the IRS to challenge a repatriation. After completing a repatriation, companies should exercise a reasonable degree of care when engaging in activities that might trigger IRS scrutiny of the deduction taken for repatriated funds. While the activities that might draw IRS attention vary, one group of activities that attendees agreed might require an especially watchful eye during the two-year period following repatriation was mergers and acquisitions — an especially important set of considerations since many companies are planning to use repatriated cash for acquisitions.

This article is excerpted and adapted from The Broad Implications of Section 965 Repatriation, which explores how section 965 repatriation fits into broader corporate strategies, both in the near and long term. CFO Research Services and Deloitte Tax LLP developed the hypotheses for this research jointly. Deloitte Tax LLP funded the research and publication of the findings; CFO Research Services produced the final report. You may download a copy of the full report by filling out a brief form.




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