Will Tax Reform Really Strengthen the Dollar Too Much?

Posted: Dec 19, 2017 2:01 PM
Will Tax Reform Really Strengthen the Dollar Too Much?

As of this writing, the much-anticipated Republican tax reform plan looks like a done deal. For those concerned about the future strength of the US dollar, the corporate “tax holiday” included in the plan is the most interesting factor. In order to encourage international corporations to return assets to the United State, Republican lawmakers have elected to reform the infamous American international tax system.

Under the current system, American corporations that have cash kept overseas are subject to the United States’ unique system of taxation, which discourages repatriation by taxing companies twice: once one the profits they make overseas, and again when they return those profits to the U.S. The US is one of the only major economies to practice this system of taxation. In addition, the US has the highest nominal corporate tax rate in the world, at 35%; well above the global average of 22%(the new intended rate is 21%). A high corporate tax rate discourages companies from bringing back profits made overseas into the U.S. A company may have made, for instance, $30bn in Ireland, which has a corporate tax rate of 12%. Why would that company then take those $30bn from Ireland into the U.S., where it would then be taxed for repatriation, in addition to being taxed at nearly 3x the rate for profits made in the U.S.?

The Republican plan is to eliminate the practice of double taxation by replacing system that has led to these problems, replacing the US double taxation system with a “territorial” system; but one that will “protect the U.S. tax base by taxing at a reduced rate and on a global basis the foreign profits of U.S. multinational corporations.”

The proposal in this GOP tax plan that is likely to have the largest impact on the dollar in the foreseeable future is the tax holiday, which offers companies the opportunity to bring earnings back to the U.S. at a one-time heavily reduced rate. In theory, the repatriation holiday should lead to a large rise in the dollar.

President Trump’s administration is not the first to try to encourage repatriation of the $2.5tn dollars stuck overseas. The Bush Administration attempted the same, in 2004.

The American Jobs Creation Act was passed by the Republican-controlled House in October of that year. The law allowed U.S. companies to repatriate profits produced overseas at a one-time tax rate of 5%. The intention was for the repatriated profits to be invested in job-creation projects in the US, and so there were strict regulatory guidelines on the use of these funds.

 Issues with American Jobs Creation Act

The potential of the Act to strengthen the dollar was undermined immediately by seemingly strict and uncertain regulatory rules, not clarified by the IRS until the next year. According to TaxHistory.org:

“[S]ection 965(b)(4) created the most controversial and flexible limitation in the dividends qualifying for the DRD. This stipulation required that the USS claiming the DRD invest the full amount of the dividend in the United States, in accordance with a domestic reinvestment plan (DRIP) adopted before the payment or the dividend. The DRIP was required to be approved by the management of the USS, including the CEO and the board of directors, making it subject to Sarbanes-Oxley requirements.”

The regulations surrounding the law indicated that repatriated funds would be highly limited in their application. For several months, corporations that would otherwise intend to repatriate were in uncertain regulatory territory. Then, in January of 2005, the IRS explained that corporations would also have to allocate investments to the measure of the original repatriated profits, pretax:

“For example, if a USS received a dividend of $100,000 that qualifies under section 965 for the DRD and pays taxes on the nondeductible amount of $15,000, in addition to $10,000 in foreign withholding taxes, the USS must reinvest the complete amount of $100,000, even though it will receive only $90,000 in cash before U.S. taxes are assessed.”

This was a further barrier to potential repatriation. For the first few months after the passing of the American Jobs Creation Act, repatriation was essentially discouraged.

In addition, this first IRS clarification in January of 2005 did not outline specific requirements for investment of repatriated funds.

It wasn’t until February of 2005 that there was some news incentivizing repatriation. The IRS issued a notice then making it clear that the definition of “investment” under the Act was broad, essentially allowing corporations to use repatriated funds for a variety of purposes, outside the original stipulations of “jobs creation.” Again, from TaxHistory.org:

“Finally, permitted and non-permitted investments were made explicit in Notice 2005-10. However, the permitted investments were sufficiently broad as to provide only a small number of excluded uses of the dividend. Those excluded uses were the payment of executive compensation, and ‘a USS group’s payment to its shareholders of dividends, for return of capital, or in the redemption of stock,’ thus specifically excluding share repurchases. The permitted uses of the dividend, however, included such broad categories as ‘financial stabilization’ of the USS, compensation to existing employees, worker hiring and training, infrastructure and capital investment, advertising and marketing, acquisition of intangible property, payments to contractors within the United States, pension funding, and anything deemed to reduce the ‘financial constraints’ on the USS group’s U.S. operations. That range of permissible investments, then, made it quite simple for a USS group to meet its reinvestment requirement without adjusting its corporate strategy.“

Further complicating the situation, after a corporation repatriated the profits for FY 2004 or 2005, they would then have 2-year period in which to allocate the funds.

Impact on the Dollar

  1. October 22nd 2004: Passage of American Jobs Creation Act. January 13th 2005: IRS notice clarifying that repatriated funds would have to be invested at pre-tax rates. Discourages repatriation.
  2. February 7th 2005: IRS notice clarifying broad investment stipulations. Encourages repatriation.
  3. September 2005: End of FY for some companies, meaning corporations would have to have repatriated at this point.
  4. December 2005: End of FY for some companies.

Compare the dates on the chart to repatriation-relevant events in the same period. There does not seem to be a meaningful correlation between these events. Annotation #4, the IRS notice clarifying that companies could “invest” repatriated funds broadly, precedes a sudden and steep decline in the dollar. But that event is one that encouraged repatriation, which according to the hypothesis should precede a rise in the dollar. The dollar rises somewhat at the end of FY 2005, which was the deadline for repatriation. But there’s little correlation earlier on, when the actual repatriation events were taking place.

In addition, a calculation of the Federal Funds rate against the dollar also does not indicate that the repatriation act of 2004 had a significant impact on the dollar not explained by rising rates.

Here is a chart of the underlying data of the Fed Funds against the USD, showing a positive correlation – as one would expect – between the Fed Funds rate and dollar strength.

Below is a chart of the “residual,” which shows to what extent the rise in the USD is not explained by a rise in the Federal Funds rate. Theoretically, if repatriation had a positive effect on dollar strength, the residual would be positive, and react accordingly to events that encourage repatriation. However, the passing of the law in October 2004 is followed by a decline in the residual (what's left over after you account for the rise in interest rates).

If you compare this chart to the list of relevant dates of repatriation, you’ll see – with the exception of September 2005 – that these events have little-to-no bearing on the change in the residual. Again, the relevant dates:

  1. October 22nd 2004: Passage of American Jobs Creation Act. January 13th 2005: IRS notice clarifying that repatriated funds would have to be invested at pre-tax rates. Discourages repatriation.
  2. February 7th 2005: IRS notice clarifying broad investment stipulations. Encourages repatriation.
  3. September 2005: End of FY for some companies, meaning corporations would have to have repatriated at this point.
  4. December 2005: End of FY for some companies.


The notion that repatriation has a significant positive effect on dollar strength is not supported by the example of The American Jobs Creation Act. The extent to which the dollar rose in the relevant period is adequately explained by the rise in interest rates.

As for the Republican repatriation plan, Bloomberg wrote this earlier in 2017, prior to the announcement of the official plan:

“To the world’s second-biggest currency trader, any boost to the dollar would be equally insignificant this time around. The Fed will be near the end of the current tightening cycle in about two years, just about when the overseas cash would be returning home, blunting its already marginal impact, said John Normand, JPMorgan’s head of foreign-exchange, commodities and international rates research.”

Another issue with determining the potential effect of the new tax holiday is the unknown quantity of the extent to which overseas profits have already been “dollarized.” For repatriation to have a strengthening effect on the dollar, the overseas profits that would be repatriated would have to be in foreign currencies, or foreign-currency denominated assets. If a large portion of those profits are already in dollars or dollar-dominated assets, the effect of repatriation on the dollar could be muted.

Again, from Bloomberg:

“The problem is most of that hoard may already be held in the U.S. currency […] Yet at Apple Inc., with the most overseas cash among S&P 500 members, more than 90 percent of its $216 billion stash is in the U.S. currency, according to former employees who had direct knowledge of the matter and asked not to be identified. For Microsoft Corp., the second-largest holder of cash abroad, dollar- denominated bonds alone make up 66 percent of total cash, securities filing shows. The data suggest that even if Trump is able to follow through with a tax amnesty similar to the one-time, 10 percent holiday he’s proposed, its effects on the world’s reserve currency would be minimal.

‘None of this information is explicitly disclosed, but most of the money is already in dollar-denominated securities,’ said Richard Lane, a senior analyst at Moody’s Investors Service. ‘All else being equal, there shouldn’t be direct impact on the dollar.’”

That analysis was based on a speculative repatriation, before an exact plan was announced. The official plan involves other complications.

An argument in favor of the “high impact on dollar” hypothesis is that this is not just a tax holiday; in theory, it’s an entire reform package that will discourage keeping profits offshore in the first place.

In fact, to call it a tax “holiday” is questionable: the repatriation act described in the Republican tax plan is mandatory. Companies are required to repatriate assets, with an allotted 8-year window to do so. The American Jobs Creation Act, by contrast, did not require repatriation, and companies were allotted two years in which they could repatriate. Theoretically, the mandatory nature of the tax holiday would lead to a greater impact on the dollar, but the 8-year window with which to do so could blunt the immediate impact on the dollar.

The rates for repatriation also differ: in the House version of the bill, liquid assets are taxed at 15.5%, and illiquid assets are taxed at 8%. The initial House plan called for rates 8.75% and 3.5% respectively.

Another factor to consider is that the repatriation tax holiday has been in consideration for over a year. Its potential effects may have already been priced in to the dollar. Support for this notion can be found in the response of the dollar to the tax plan. The DXY, an index of the dollar against 6 other major currencies, has been down since Trump’s inauguration. It rose substantially in anticipation of the initial tax reform announcement, going from a low of 91.9 on September 22nd, to a high of 93.97 on the 26th, the day of the announcement. But the DXY fell on the 28th, down to 93.2. As of December 19th, the DXY is down 8.4% from the start of the year.

The variable response of the dollar could indicate that whatever impact repatriation would have was largely priced in earlier in 2017, when investors were confident that a tax holiday – among other things – would be passed.

In addition, the tax plan has been announced and will go into effect during a monetary tightening cycle. The Federal Reserve intends to continue gradually raising interest rates through 2018, meaning the potential impact of repatriation on the dollar will likely be felt amid a rising interest rate environment, as happened with the American Jobs Creation Act.

The situation is at least as complicated as it was in 2004: there are several unknown quantities that could significantly change the outlook of the dollar.

As for the example of the American Jobs Creation Act, while it does not refute the notion that repatriation will strengthen the dollar, it does not support it. The rise in the dollar in that period was mostly explained by interest rate hikes. The new GOP tax proposal could in theory be broader- reaching than the American Jobs Creation Act, or it could be narrower.

The example of the 2004 tax holiday might indicate that the dollar impact of repatriation is lower than conventional wisdom would assume; however, there are factors in the recent tax bill that should encourage dollar strength. As was the case during the Bush administration, the ultimate impact of the tax holiday on the dollar will continue to be highly uncertain until after regulatory guidelines are made clear.