‘Trapped Cash’

Businessmen Shaking Hands

Are Large Companies Making Poor Acquisition Decisions as a Result of Efforts to Avoid Paying U.S. Taxes?

In their attempts to avoid paying additional taxes, many large, multinational, U.S.-based companies are making dubious foreign acquisitions that may, ultimately, be bad for business.

That’s the research finding of UConn Accounting Professor Todd Kravet, and two of his colleagues, whose work will appear in the forthcoming issue of the journal of Contemporary Accounting Research.

Their work, titled “Trapped Cash and the Profitability of Foreign Acquisitions,” has strong implications for U.S. tax policy. The results have been studied by Congressional staffers and have been noted in national reports as legislators assess existing tax structure. U.S. companies harbor some $2 trillion in “trapped cash” overseas to avoid repatriation taxes back home, and the issue is a “hot topic” in business and government.

Current U.S. reporting and tax laws create incentives for some American firms to avoid the repatriation of foreign earnings, as the U.S. government charges additional corporate taxes on these transfers. In the study, they investigate the effect of cash “trapped” overseas on U.S. multinational corporation’s foreign acquisitions. They observed firms with high levels of ‘trapped cash’ make less profitable acquisitions of foreign target firms because of those cash considerations.

Yet even Kravet was surprised by what the investigation into companies with and without “trapped cash” revealed. He and his colleagues investigated 217 substantial corporate acquisitions, which occurred between 1993 and 2012.

It appears that corporations are using “trapped cash” to acquire less appealing, less robust and poorly aligned businesses, Kravet said. Their research found that companies using “trapped cash” are sabotaging the stock prices of their corporations, as indicated by stock declines at the time of the initial acquisition announcement, as well as over the years following the acquisition.

“Our results were somewhat surprising,” Kravet said. “You would think large multinational companies would have many foreign investment opportunities. When they are holding onto cash to avoid repatriation taxes, their foreign reinvestment decisions don’t seem as successful as those companies who didn’t have such constraints.”

One example cited in the research is Microsoft’s decision in 2011 to acquire Skype, headquartered in Luxembourg, for $8.5 billion. Critics of the acquisition said that the deal, which enabled Microsoft to use “trapped cash,” was based on monetary, not business, incentives.

“Microsoft made this bone-headed deal not because it was the best fit available for the company. They made the deal because it was a tax-efficient shot in the arm. If you’re a Microsoft investor, this should scare you,” one critic said. Following the acquisition, Microsoft’s stock declined.

Kravet conducted the research, from 2011 to 2015, with two friends from his Ph.D. program at the University of Washington. Professor Alexander Edwards is a member of the management faculty at the University of Toronto and Professor Ryan Wilson teaches at the University of Oregon.

Their research was painstaking, since much of the information had to be culled from U.S. Securities and Exchange Commission filings. Only recently have companies disclosed the amount of cash they have in foreign countries. The three colleagues have presented their findings at a number of conferences, including to their peers at Columbia University, Indiana University and the American Tax Association.

One variant that supported their findings was the impact of The American Job Creation Act of 2004, which allowed firms to repatriate earnings previously harbored abroad at a temporarily decreased tax rate (just over 5 percent; down from 35 percent). The ‘tax holiday’ policy continued through 2005.

The researchers examined the profitability of foreign acquisitions before, during and after the tax holiday to better identify the effect of tax and financial reporting costs on the profitability of foreign acquisitions. What they discovered was that the questionable acquisitions disappeared during the tax holiday. “The companies holding cash were no longer making less-profitable acquisitions,” Kravet said.

“Our work has tremendous policy implications,” Kravet said. “Changing the tax policy so that it doesn’t incentivize ‘trapped cash’ could result in repatriating cash home to the U.S., with more dividends paid out to investors or in making more investments domestically.”

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