THE LOCK-OUT EFFECT OF THE U.S. WORLDWIDE TAX SYSTEM

INTRODUCTION

NDER THE U.S. WORLDWIDE TAX SYSTEM, U.S.-

domiciled multinational ﬁ rms pay U.S.

income taxes on foreign earnings when

such earnings are repatriated. Deferral of U.S.

taxation until repatriation creates an incentive for

U.S. multinational ﬁ rms to postpone, temporarily

or permanently, repatriating their foreign earnings

from low-tax countries. This incentive is com-

monly referred to as the “lock-out effect.” We

investigate the lock-out effect in the context of

the American Jobs Creation Act of 2004 (the Act).

The Act became law on October 22, 2004, and

there were two primary rationales for its passage.

The first was the repeal of the extraterritorial

income exclusion that had been ruled an illegal

export subsidy by the World Trade Organization.

The second policy rationale for the Act was to

provide a general economic stimulus. The fol-

lowing quotes capture the proponents’ logic for

supporting the Act as a means of stimulating the

U.S. economy:

“Multiple studies show my repatriation provision

could bring $400 billion back into our economy

and create upward of 600,000 jobs in America in

2005,” U.S. Representative Phil English (R-PA), a

member of the House Ways and Means Committee,

who drafted the bill.

“Today more than at any time in our history, we

operate in a global economy. This vote for the Act is

about ﬁ xing our international tax law and providing

much needed tax relief for businesses to help cre-

ate jobs,” U.S. Representative David Wu (D-OR).

“This bill provides tax relief for American busi-

nesses to further fuel economic growth and job

creation,” U.S. Representative Jo Bonner (R-AL).

Most signiﬁ cant among the economic stimulus

provisions of the Act were a deduction for U.S.

domestic production income and a 1-year tax

holiday for repatriations of foreign earnings. This

study evaluates effects of the repatriation tax holi-

day on the lock-out effect of the U.S. worldwide

tax system.

The tax holiday provides an interesting setting

to test the lock-out effect as the Act permits ﬁ rms

to exempt (for one taxable year) 85 percent of the

income that would have otherwise been recognized

on the repatriation of eligible foreign earnings (U.S.

Treasury Department, 2005). The 1-year window

to repatriate under the Act is deﬁ ned either as the

year of the American Jobs Creation Act of 2004 or

the year following the Act (e.g., for calendar year

taxpayers, the eligible year is either 2004 or 2005).

There is also a ﬁ nancial reporting consequence

associated with the lock-out effect. For ﬁ nancial

reporting purposes, Accounting Principles Board

Opinion No. 23 (APB 23) provides an opportunity

to avoid booking U.S. taxes on foreign earnings that

are not anticipated to be repatriated. Speciﬁ cally,

if the foreign earnings are reinvested in a foreign

subsidiary indeﬁ nitely, the earnings may be desig-

nated as permanently reinvested offshore (PRE).

Because the PRE classification is a necessary

condition to defer the recognition of U.S. taxes on

foreign earnings for ﬁ nancial reporting purposes,

we use PRE as a proxy for the amount of foreign

earnings subject to the lock-out effect.

To investigate the lock-out effect, we develop

and test three sets of hypotheses around the imple-

mentation of the Act. First, we expect that the

cash holdings and the repatriation tax savings are

positively associated with the ﬁ rms’ level of PRE

in the year prior to the tax holiday. We ﬁ nd that the

level of PRE is positively associated with the tax

savings associated with the deferral of repatriation.

We also expect and ﬁ nd that the cash holdings are

positively associated with the level of PRE prior

to the tax holiday.

Regarding our second set of hypotheses, we

expect and ﬁ nd that the change in PRE is posi-

tively associated with the ﬁ rm-speciﬁ c change in

repatriation tax rate during the holiday. This result

supports the existence of a lock-out effect induced

by the U.S. tax system. We also ﬁ nd that the change

in PRE is positively associated with the change in

THE LOCK-OUT EFFECT OF THE U.S. WORLDWIDE TAX SYSTEM:

AN EVALUATION AROUND THE REPATRIATION TAX HOLIDAY

OF THE AMERICAN JOBS CREATION ACT OF 2004

Roy Clemons, Florida Atlantic University

Michael R. Kinney, Texas A&M University

102

ANNUAL CONFERENCE ON TAXATION

cash holdings. This result is consistent with De

Waegenaere and Sansing’s (2008) theoretical pre-

diction that ﬁ rms that have reached their optimal

level of investment in foreign operating assets

accumulate foreign earnings as ﬁ nancial assets until

they can be repatriated at a more advantageous tax

rate (e.g., during a tax holiday).

Regarding our third set of hypotheses, we expect

and ﬁ nd that the change in a ﬁ rm’s PRE following

the holiday period is positively associated with the

change in the ﬁ rm’s repatriation tax rate from the

holiday to the post-holiday period. Firms in our

sample increased PRE in the aggregate by approxi-

mately $88 billion in the year following the tax hol-

iday. This ﬁ nding suggests that the lock-out effect

immediately reappears in the year following the

tax holiday. However, contrary to expectations, the

change in PRE is not associated with the change in

cash holdings in the year following the tax holiday.

One potential explanation for this result is that our

proxy for cash holdings is based on multinational

ﬁ rms’ worldwide cash holdings. Therefore even if

ﬁ rms are increasing their foreign cash holdings in

the year following the Act, the increases may be

offset by decreases in their domestic cash holdings

in the year following the Act. More speciﬁ cally,

spending the repatriated cash may extend into the

year following repatriation.

This study makes several contributions to exist-

ing literature. First, it documents the existence of

a lock-out effect for U.S. multinational ﬁ rms. Sec-

ond, it provides empirical support for De Waegen-

aere and Sansing’s (2008) theoretical model which

predicts that ﬁ rms with mature foreign operations

accumulate foreign earnings offshore in ﬁ nancial

assets until those earnings can be repatriated at

a more advantageous tax rate (e.g., during a tax

holiday). Third, it documents a positive relationship

between the magnitude of the lock-out effect and

the tax cost associated with repatriation.

The ﬁ ndings of this study provide information

useful to academic researchers, regulators, and

policy makers. Academic researchers will ﬁ nd

this study useful in discerning how global ﬁ rms’

cash holdings are associated with their worldwide

taxation. This study links the theoretical predic-

tions of De Waegenaere and Sansing (2008) with

the empirical ﬁ ndings of Foley et al. (2007) to

suggest that ﬁ rms operating in low tax countries

will accumulate their foreign earnings as cash once

they have reached their optimal level of investment

in foreign operating assets. Regulators will also

ﬁ nd this study helpful in assessing the responses

of U.S. multinational ﬁ rms to the U.S. worldwide

tax structure and possible remedies to economic

distortions caused by the lock-out effect.

The next section discusses background research

and motivates our hypotheses. The third section

explains our sample selection and research design.

The fourth section discusses descriptive statistics

and results and the ﬁ fth section concludes.

BACKGROUND AND HYPOTHESES DEVELOPMENT

The Dividend Repatriation Tax Holiday

Internal Revenue Code section 965, part of the

American Jobs Creation Act of 2004, allowed U.S.

multinational ﬁ rms to temporarily repatriate earn-

ings from their foreign subsidiaries at a reduced

effective tax rate. For one taxable year, ﬁ rms could

deduct 85 percent of the repatriations of eligible

foreign earnings -- thereby incurring a maximum

effective tax rate of 5.25 percent (i.e., 15 percent

of 35 percent) on qualifying repatriations (U.S.

Treasury Department, 2005). Firms could elect the

1-year holiday period as the last tax year beginning

before the date of the enactment of AJCA (October

22, 2004) or the ﬁ rst taxable year beginning after

that date. Therefore, all repatriations under the

tax holiday were completed by October 2006.

The following sections discuss the lock-out effect

and the incentives created by the Act in greater

detail.

The U.S. Tax Treatment of Foreign Earnings

and the Lock-Out Effect

Under the U.S. worldwide tax system, U.S.

multinational corporations defer paying U.S. taxes

on the earnings of their foreign subsidiaries until

those earnings are repatriated to the United States.

Upon repatriation, the U.S. parent is allowed a

credit against U.S. taxes for foreign taxes paid on

the repatriated earnings; and, as the foreign tax

rate decreases, the U.S. tax due upon repatriation

increases. Thus, when the subsidiary is located in a

low-tax jurisdiction, the U.S. tax savings associated

with a non-repatriation strategy are substantial. As

long as the foreign earnings of U.S. multination-

als are not repatriated, no U.S. tax is assessed

on such earnings. Firms effectively make their

foreign earnings exempt from U.S. taxes by hold-

ing them offshore permanently. This opportunity

for indeﬁ nite deferral of the incremental U.S. tax

NATIONAL TAX ASSOCIATION PROCEEDINGS

assessed on repatriation of foreign earnings creates

the lock-out effect.

Prior Literature and Hypotheses

Prior empirical literature provides evidence that

the U.S. tax system creates a lock-out effect and

suggests that repatriation decisions are very sensi-

tive to the taxes that are due when foreign earnings

are repatriated. Altshuler and Newlon (1993) evalu-

ate tax return data and conclude that a 1 percent

higher repatriation tax burden is associated with

a 1.5 percent reduction in amount repatriated. To

isolate the effect of taxes on repatriation decisions,

Desai et al. (2001), examine both afﬁ liates that

face U.S. repatriation taxes and branches that do

not face U.S. repatriation taxes. Using Bureau of

Economic Analysis data from 1982 to 1997, they

ﬁ nd that when afﬁ liates face a 1 percent increase

in repatriation taxes they decrease dividend repa-

triations by 1 percent, whereas branches do not

exhibit this pattern. Desai et al. (2001) conclude

that repatriation taxes reduce dividend repatriations

by approximately 13 percent noting that “these

effects would disappear if the U.S. were to exempt

foreign income from taxation.” (p. 829)

The statutory U.S. tax rate assessed on repatria-

tion is reduced by the tax rate assessed by foreign

tax authorities in jurisdictions from which the

repatriations originate. Thus, ceteris paribus, the

lower the tax rate in the foreign jurisdictions, the

greater is the net tax rate applied to the repatria-

tions. Logically, the magnitude of the lock-out is

positively associated with the magnitude of the

ﬁ rm-speciﬁ c net tax rate applied to repatriations.

We state our expectations formally in our ﬁ rst

hypothesis expressed in the alternative form:

Hypothesis 1a: The level of foreign earnings

designated as permanently reinvested (PRE) is

positively associated with the net repatriation

tax rate existing prior to the tax holiday for ﬁ rms

repatriating under the Act.

Hartman (1985) argues that the strength of the

lock-out effect is a function of the rates of return

that can be earned on new investment in the United

States versus the foreign country. To develop his

theoretical model, Hartman assumes that the U.S.

taxation of income earned in low-tax foreign

countries is inevitable and that repatriation taxes

will not inﬂ uence the decision of when to repatriate

the earnings. Hartman demonstrates that an after-

foreign-tax dollar in repatriated earnings generates

cash ﬂ ows for the parent ﬁ rm of

(1)

−

where t is the U.S. tax rate, and is assumed to be

larger than the foreign tax rate, t*. In deciding

between reinvesting foreign earnings abroad and

repatriating, the ﬁ rm will compare the after-tax

return associated with each option. If a firm

reinvests its foreign earnings for n years, it will

accumulate the following:

(2)

)

]

(

−

⎡

⎣

⎢

⎡

⎣

⎤

⎦

⎥

⎤

⎦

(

where r* is the pre-tax return in the foreign country

and is taxed by the foreign jurisdiction each period

at t*. Eventually, the funds will be repatriated to the

United States and taxed at the U.S. rate, t.

Alternatively, if the foreign earnings are repatri-

ated immediately, the ﬁ rm will earn:

(3)

[(

)]

(

−

⎡

⎣

⎢

⎡

⎣

⎤

⎦

⎥

⎤

⎦

(

−

(

where r is the pre-tax return in the United States.

Comparing equations (2) and (3) reveals that the

level of U.S. taxation of foreign earnings will not

affect the decision between foreign reinvestment

and repatriation. The U.S. tax costs associated with

repatriations in equation (1) are incurred regardless

of whether one reinvests the earnings abroad or

repatriates them. Hartman’s (1985) model shows

that earnings should be reinvested in the location

that provides the greatest expected after-local-tax

rate of return, irrespective of the taxes owed upon

repatriation to the United States.

Hartman’s (1985) ﬁ ndings hold if foreign earn-

ings are reinvested in operating assets, but Scholes

et al. (2008) suggest that if the foreign income

generated from operating assets is reinvested in

ﬁ nancial assets, then the length of deferral of U.S.

repatriation taxes does matter. Foreign subsidiaries

that have reached their optimal level of investment

in operating assets may indeﬁ nitely defer repatria-

tion to avoid the U.S. tax liability. These ﬁ rms will

likely accumulate excessive amounts of ﬁ nancial

assets, such as cash and marketable securities, in

their foreign subsidiaries.

Consistent with Scholes et al. (2008), Foley et

al. (2007) argue that ﬁ rms’ cash holdings increase

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when their foreign tax rates are less than U.S. tax

rates. The authors’ ﬁ ndings suggest that foreign

subsidiaries in relatively lower tax jurisdictions

hold higher levels of cash than other foreign sub-

sidiaries of the same ﬁ rm.

De Waegenaere and Sansing (2008) suggest that

ﬁ rms owning foreign subsidiaries that have reached

their optimal level of investment in operating assets

and that are operating in low-tax countries are more

likely to designate their foreign earnings as PRE

and hold these earnings in the foreign subsidiary

as ﬁ nancial assets. The following example illus-

trates the argument of De Waegenaere and Sansing

(2008). This example is borrowed from Bryant-

Kutcher et al. (2007). Assume that a foreign sub-

sidiary of a U.S. multinational invests an amount,

K, in foreign operating assets generating pre-tax

cash ﬂ ows (and earnings) according to the func-

tion f(K) = 0.20(K) – 0.001(K

), so that increased

investment increases earnings, but at a decreasing

rate. Assume that the ﬁ rm has an after-tax discount

rate equal to 4 percent, that the U.S. corporate tax

rate is 35 percent, and that the after-U.S.-tax risk-

free rate is 3.25 percent, which implies a pretax

risk-free rate of 5 percent. The ﬁ rm faces a foreign

tax rate,

, which is less than 35 percent. In this

case the ﬁ rm should continue to reinvest in foreign

operating assets until the optimal investment level,

K*, is reached, where (1 –

)f ′(K*) = 4 percent.

That is, the ﬁ rm should keep investing in foreign

operating assets until the marginal after-foreign-

tax return on additional investment is equal to the

ﬁ rm’s discount rate.

Further assume that two ﬁ rms, H and L, are

operating in two foreign countries with differing

tax rates. The tax rate of Country H is 25 percent

and the tax rate of country L is 15 percent. Based

on these foreign tax rates and the fact that f ′(K) =

0.20 – 2(0.001)K, ﬁ rm H will continue to reinvest

in foreign operating assets until K = 73, since (1

– 25%) f ′(73) = 4%, ﬁ rm H’s discount rate. K of

73 will generate a before-tax return each year of

f(73) = 0.20(73) – 0.001(73

) = 9.27. Alternatively,

ﬁ rm L will continue to reinvest in foreign operating

assets until K = 76, because (1 – 15%) f ′(76) = 4%,

which is ﬁ rm L’s discount rate. Operating assets of

76 will generate a before-tax return each year of

f(76) = 0.20(76) – 0.001(76

) = 9.42.

De Waegenaere and Sansing (2008) study the

optimal repatriation strategy for a ﬁ rm that has

reached investment level K* and will therefore

stop reinvesting future foreign earnings in foreign

operating assets. Firms that have reached K* face

two choices; they can either begin to repatriate all

future earnings as a taxable dividend to the U.S.

parent paying gross U.S. taxes at a 35 percent rate,

or reinvest the after-foreign-tax earnings in foreign

ﬁ nancial assets that earn the risk free rate.

De Waegenaere and Sansing (2008) suggest that

the optimal repatriation strategy depends on the

relative size of (1) the after-foreign-tax risk-free

rate, and (2) the ﬁ rm’s discount rate. Let R equal the

risk-free-rate and r equal the ﬁ rm’s discount rate.

The repatriation decision depends on the relation-

ship between r and R(1 –

). If the discount rate

is greater than the after-foreign-tax risk free rate,

so that r > R(1 –

), the optimal decision is to

repatriate all future earnings as a taxable dividend

to the parent and to incur the 35 percent (gross) U.S.

tax. Using the example of ﬁ rms H and L, assume

that ﬁ rm H, with a foreign tax rate of 25 percent,

generates $20 of pretax foreign earnings, resulting

in $15 of after-tax earnings. Repatriations yield $13

to the U.S. parent after U.S. tax. Since the ﬁ rm has

reached its optimal level of investment in operating

assets, if it retains the $15 abroad, it can reinvest

only at the 3.25 percent after-U.S.-tax risk-free rate.

This investment yields a perpetuity of 0.49 with a

present value of 0.49/0.04 = $12.19, which is less

than $13. Thus, the optimal policy for ﬁ rm H is to

repatriate all future earnings from foreign operating

assets as a taxable dividend to the U.S. parent.

Alternatively, if the discount rate is less than

the after-foreign-tax risk-free rate,

so that r <

R(1 –

), ﬁ rm value is maximized if the foreign

earnings are held abroad in ﬁ nancial assets. This is

the optimal decision despite the fact that the future

earnings from the ﬁ nancial assets will be subject

to tax at the 35 percent U.S. tax rate. Now, assume

that ﬁ rm L, with a foreign tax rate of 15 percent,

generates $20 of pretax foreign earnings, resulting

in $17 of after-tax earnings. Repatriation yields $13

after U.S. tax to the U.S. parent. Retaining the $17

abroad and reinvesting at the 3.25 percent after-

U.S.-tax risk-free rate yields an annual perpetuity

of 0.55 with a present value of 0.55/0.04 = $13.81,

which is more than $13. Therefore, the optimal

policy for ﬁ rm L is to reinvest all future earnings

from foreign operating assets in foreign ﬁ nancial

assets and not repatriate the foreign operating

earnings until a lower tax rate can be obtained for

repatriations.

NATIONAL TAX ASSOCIATION PROCEEDINGS

Based on the preceding examples, ﬁ rms will

reinvest foreign earnings in foreign operations

until they reach their optimal level of investment

in foreign operations, K*. All else equal, only after

reaching K* will ﬁ rms begin to accumulate foreign

earnings in ﬁ nancial assets. The lock-out effect is

evidenced by accumulation of foreign earnings in

ﬁ nancial assets. Therefore, as implied by the theo-

retical model from De Waegenaere and Sansing

(2008) and the empirical ﬁ ndings of Foley et al.

(2007), we hypothesize the following:

Hypothesis 1b: The level of foreign earnings

designated as permanently reinvested is positively

associated with the level of cash holdings (ﬁ nancial

assets) prior to the tax holiday for ﬁ rms repatriating

under the provisions of the Act.

Hartman’s (1985) theoretical model assumes

that the tax costs of repatriations are time invariant;

therefore, his model does not consider effects of a

temporary change in the tax costs of repatriations.

In the presence of the tax holiday provided by the

Act, equations (2) and (3) in Hartman’s (1985)

model, presented earlier, will no longer drop out

(Clausing, 2005). Therefore, whether the tax holi-

day was anticipated or not, ﬁ rms experiencing the

lock-out effect of the U.S. worldwide tax system

have an incentive to repatriate more funds during

the tax holiday than they would prior to or after

the tax holiday. Therefore, we hypothesize the

following:

Hypothesis 2a: For the year of repatriation, the

change in foreign earnings designated as PRE is

positively associated with the change in the net

repatriation tax rate.

Given the assumptions of Hartman’s (1985)

theoretical model no lock-out effect exists. But, the

theoretical model of De Waegenaere and Sansing

(2007), presented earlier, demonstrates that once

ﬁ rms reach their optimal level of investment in

foreign operating assets, K*, they may accumu-

late subsequent earnings in financial assets in

their offshore subsidiaries to avoid paying U.S.

repatriation taxes.

De Waegenaere and Sansing (2008) also model

ﬁ rms’ behavior around tax holidays that occur in a

stochastic fashion. The authors argue that because

operating assets are costly to liquidate, all repa-

triations under a tax holiday must be in the form

of ﬁ nancial assets. De Waegenaere and Sansing

(2008) demonstrate that ﬁ rms experiencing the

lock-out effect will accumulate ﬁ nancial assets in

their low-tax foreign subsidiaries to avoid paying

U.S. repatriation taxes. Furthermore, the authors

argue that only ﬁ rms that have accumulated ﬁ nan-

cial assets will have the cash required to repatriate

signiﬁ cant amounts of foreign earnings that have

accumulated abroad due to the lock-out effect.

In summary, only ﬁ rms that have accumulated

ﬁ nancial assets due to the lock-out effect of the

U.S. tax system will have the ability to repatriate

signiﬁ cant amounts of foreign earnings under the

one-time tax holiday. Accordingly, we hypothesize

the following:

Hypothesis 2b: The change in foreign earnings

designated as PRE is positively associated with

the change in cash holdings in the year of the tax

holiday for ﬁ rms repatriating under the Act.

In the year following the tax holiday, we expect

that the lock-out effect will be reestablished as

the net tax rate for repatriations reverts to the rate

prior to the holiday. Also, as argued by Clausing

(2005), granting one tax holiday will cause ﬁ rms

to anticipate future tax holidays and they will no

longer view the normal tax rate as permanent; ﬁ rms

may thus defer repatriations in the hope of future

tax holidays. We expect the strength of the lock-out

effect will be positively associated with the change

in the net tax rate from the holiday to post-holiday

period. Therefore, we hypothesize the following:

Hypothesis 3a: The change in foreign earnings

designated as permanently reinvested is positively

associated with the change in the net repatriation

tax rate in the year following the tax holiday for

ﬁ rms repatriating under the Act.

De Waegenaere and Sansing (2008) demonstrate

that ﬁ rms repatriating during the tax holiday accu-

mulated ﬁ nancial assets in their low-tax foreign

subsidiaries prior to repatriation. They then sug-

gest that, “because at a tax holiday accumulated

ﬁ nancial assets can be repatriated at the lower

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repatriation tax rate, the expectation of a future tax

holiday may affect the ﬁ rms’ choice to reinvest its

foreign earnings from operating assets in ﬁ nancial

assets or to repatriate them as a dividend.” (p. 11)

Following this logic, subsequent to the repatriation

tax holiday we expect ﬁ rms will have an increased

incentive to defer the repatriation of ﬁ nancial assets

because of their expectations of tax holidays reoc-

curring in the future. Therefore, we hypothesize

the following:

Hypothesis 3b: The change in foreign earnings

designated as permanently reinvested is positively

associated with the change in cash holdings in the

year following the tax holiday for ﬁ rms repatriating

under the Act.

SAMPLE SELECTION AND RESEARCH DESIGN

Sample Selection

We hand collect annual ﬁ nancial statement data

for U.S. multinational ﬁ rms that repatriated under

the tax holiday of the Act. We identiﬁ ed these ﬁ rms

through two primary sources. First, we identiﬁ ed

ﬁ rms that disclosed repatriations under the Act in

their ﬁ nancial statements by searching the EDGAR

database utilizing the following search string [(10Q

or 10K) and (foreign earnings repatriation) w/25

(American Jobs Creation Act of 2004)]. Second,

we identiﬁ ed ﬁ rms that repatriated under the Act

using the Lexis-Nexis Business Wire and News

Wire and Google searches using the key words

“foreign earnings repatriation” and “American Jobs

Creation Act of 2004.” This search identiﬁ ed 378

ﬁ rms that repatriated under the Act.

Fiscal years 2004 through 2006 provide a win-

dow to evaluate repatriation actions during the tax

holiday. For the sample of repatriating ﬁ rms, we

collect permanently reinvested earnings data (PRE)

for ﬁ scal years 2004 through 2006 from income tax

footnotes in annual reports. We exclude observa-

tions not disclosing an amount for PRE for years

t – 1, t, t + 1, where t is the year of repatriation;

this information is needed to compute the pre- to

post-Act change in PRE. As previously noted, the

PRE classiﬁ cation is a necessary condition to defer

the recognition of U.S. taxes on foreign earnings

for ﬁ nancial reporting purposes. The level of PRE

may be considered a proxy for the upper-bound

of the amount of earnings locked out due to the

U.S. tax system. To ensure that we are capturing

ﬁ rms experiencing the lock-out effect, we limit

our sample to ﬁ rms that have PRE greater than or

equal to the amount of earnings repatriated under

the Act.

Finally, we delete observations lacking

data sufﬁ cient for models we use for hypothesis

testing.

After imposing all sample screens, there are 213

ﬁ rms that have the required data to test H1a and

H1b in ﬁ scal year 2004, 210 ﬁ rms available to test

H2a and H2b in ﬁ scal year 2005, and 193 ﬁ rms

available to test H3a and H3b for ﬁ scal year 2006.

Research Design – Determinants of PRE

Prior to the One-time Tax Holiday

We test H1a and H1b using the following ordi-

nary least squares regression in Model 1.

PRE

t–1

Repatriation tax rate

t–1

Cash holdings

t–1

Size

t–1

Foreign Income

t–1

U.S. Income

t–1

Capex

t–1

Research & Development

t–1

Book-to-market

–

Share Repurchases

–

PRE equals the level of permanently reinvested

earnings scaled by total assets in the year prior to

repatriation, t – 1. The value of PRE is hand-col-

lected from the ﬁ rms’ ﬁ nancial statement footnotes,

and total assets are obtained from the Compustat

annual database (Data 6).

On the right-hand side, Repatriation tax rate

proxies for the net U.S. tax liability associated

with the earnings classiﬁ ed as PRE. We obtain

footnote disclosures that provide both the U.S.

tax liability recorded during the tax holiday and

the corresponding amount of foreign earnings

repatriated during the tax holiday. During the tax

holiday, ﬁ rms received an 85 percent reduction in

the normal U.S. tax liability for repatriated earn-

ings. Therefore, the U.S. tax rate associated with

the repatriations during the tax holiday equaled the

recognized U.S. tax liability divided by the foreign

earnings repatriated under the Act. For example if

a ﬁ rm recorded a U.S. tax liability of $5.25 associ-

ated with a $100 repatriation, the ﬁ rm’s repatriation

tax rate is 5.25 percent. Also, the tax recorded for

the holiday repatriation allows us to infer the tax

rate for repatriations in non-holiday years. A ﬁ rm

recording a 5.25 percent tax rate for the holiday

repatriation would have incurred a 35 percent tax

NATIONAL TAX ASSOCIATION PROCEEDINGS

rate on the repatriation (i.e., 5.25 percent divided by

15 percent) in non-holiday years. H1a predicts that

the level of foreign earnings designated as PRE is

positively associated with the repatriation tax rate

prior to the tax holiday. Thus, we expect a positive

and signiﬁ cant coefﬁ cient on Repatriation tax rate.

Our expectation stated in H1b is that the magni-

tude of foreign earnings designated as PRE is posi-

tively associated with the level of cash held prior

to the tax holiday. To test whether the magnitude

of PRE is positively associated with cash holdings,

we calculate cash holdings following Foley et al.

(2007). Cash holdings is the natural logarithm of

the ratio of cash to net assets (deﬁ ned as total assets

minus cash). Using Compustat annual data, cash

holdings is calculated as the natural log of (data

item 1/(data item 6 – data item 1)). H1b predicts

the magnitude of foreign earnings designated as

PRE is positively associated with cash holdings

prior to the tax holiday.

Other right-hand side variables are included as

controls. Size is the log of total assets (data item

6) and is included to control for unspeciﬁ ed size

effects. Foreign income is equal to pretax foreign

income scaled by total assets (data item 273/data

item 6) and, U.S. income is equal to U.S. pretax

income scaled by total assets (data item 272/data

item 6). These variables are included to control for

the effects of foreign and domestic proﬁ tability

on PRE. Capex is equal to capital expenditures

scaled by total assets (data item 128/data item 6)

and is included in Model 1 as a proxy for current

growth. Research & Development is equal to

R&D expense scaled by total assets (data item 46/

data item 6) and is included as a control for future

growth. Book-to-market is equal to book value

scaled by market value of equity (data item 60/

(data199*data25)) and is also included in Model 1

to control for a ﬁ rm’s growth opportunities. Finally,

we include Share repurchases, ((data item 115 –

(data item 130 – data item 175))/data item 6), as a

control for the motive to hold cash offshore. More

speciﬁ cally, if as shown in prior research (Blouin

and Krull, 2009; Clemons and Kinney, 2008) ﬁ rms

signiﬁ cantly increase share repurchases in the

year of repatriation, it would suggest that the cash

repatriated under the Act was not needed to fund

domestic growth opportunities and that the cash

was held abroad to avoid the associated U.S. tax

liability on those foreign earnings consistent with

arguments of De Waegenaere and Sansing (2008)

and Desai et al. (2001).

Research Design – Determinants of the Change in

PRE in the Year of the One-time Tax Holiday

To test H2a and H2b we estimate Model 2 using

ordinary least squares:

ΔPRE

ΔRepatriation tax rate

ΔCash holdings

ΔShare Repurchases

Size

ΔForeign Income

ΔU.S. Income

ΔCapex

ΔResearch & Development

Book-to-market

where ΔPRE equals the change in permanently

reinvested earnings from the year prior to the

tax holiday (t – 1) to the year of the tax holiday

(t) scaled by total assets. The values of PRE are

hand-collected from the ﬁ rms’ ﬁ nancial statement

footnotes, and total assets are obtained from the

Compustat annual database (Data 6).

We investigate whether ΔPRE is associated with

ΔRepatriation tax rate, which is a proxy for the

reduction in the net U.S. tax liability during the

tax holiday. Based on ﬁ nancial statement footnote

disclosures, we obtain both the U.S. tax liability rec-

ognized under the tax holiday and the corresponding

amount of foreign earnings repatriated under the tax

holiday. The U.S. tax liability recognized by ﬁ rms

repatriating under the tax holiday is 15 percent (i.e.,

an 85 percent reduction under the Act) of the U.S.

tax liability that would have been recorded by the

ﬁ rms absent the tax holiday. Because the tax holi-

day liability is 15 percent of the non-holiday tax

liability, our proxy for the non-holiday tax liability

is the recognized holiday tax liability divided by

15 percent. ΔRepatriation tax rate is the difference

between the holiday and non-holiday net tax rates

and represents the tax savings on repatriations

during the tax holiday. H2a predicts that ΔPRE is

positively associated with ΔRepatriation tax rate

in the year of the tax holiday for repatriating ﬁ rms.

Therefore, we expect a positive and signiﬁ cant

coefﬁ cient for ΔRepatriation tax rate.

We also investigate whether ΔPRE is associated

with ΔCash holdings in the year of the tax holiday.

ΔCash holdings is the change in cash balance from

the year prior to the tax holiday (t – 1) to the year

of the tax holiday (t) scaled by total assets. H2b pre-

dicts that ΔPRE is positively associated with ΔCash.

Thus, we expect a positive coefﬁ cient for ΔCash

holdings. Finally, we expect that ΔPRE is negatively

associated with ΔShare Repurchases. Finding such

102

ANNUAL CONFERENCE ON TAXATION

a result would further support De Waegenaere and

Sansing’s (2008) prediction that ﬁ rms accumulate

cash in their foreign subsidiaries because they do

not have domestic investment opportunities that

provide a return superior to the foreign risk free rate.

We also include control variables in Model 2.

Size controls for unspeciﬁ ed size effects. ΔForeign

Income and ΔU.S. Income control for the effects

of changes in foreign and domestic proﬁ tability.

ΔCapex, ΔResearch & Development, and Book-to-

market are included in Model 2 to control for ﬁ rms’

current and future growth opportunities.

Research Design – Determinants of the

Change in PRE in the Year Following the

One-time Tax Holiday

We test H3a and H3b by estimating Model 3

using ordinary least squares regression in the year

following the tax holiday:

ΔPRE

t+1

ΔRepatriation tax rate

t+1

ΔCash holdings

t+1

ΔShare Repurchases

t+1

Size

t+1

+ Β

ΔForeign Income

t+1

ΔU.S.Income

t+1

ΔCapex

t+1

ΔResearch & Development

t+1

Book-to-market

t+1

ΔPRE is the change in permanently reinvested

earnings from the year of the tax holiday (t) to the

year following the tax holiday (t + 1) scaled by total

assets. We investigate whether ΔPRE is associated

with the return to normal repatriation tax rates in

the year following the tax holiday. We calculate

ΔRepatriation tax rate from the year of the tax

holiday (t) to the year following the tax holiday

(t + 1). H3a predicts that ΔPRE is positively

associated with ΔRepatriation tax rate in the year

following the tax holiday for ﬁ rms repatriating

under the Act.

We also investigate whether ΔPRE is associated

with ΔCash holdings in the year following the

tax holiday. We calculate ΔCash holdings as the

change in cash from the year of the tax holiday

(t) to the year following the tax holiday (t + 1)

scaled by total assets. H3b predicts that ΔPRE is

positively associated with ΔCash holdings in the

year following the tax holiday. Thus, we expect a

positive coefﬁ cient on ΔCash holdings. In addition

to the variables of interest, Model 3 includes the

same control variables as Model 2 to control for

size effects, and growth factors.

DESCRIPTIVE STATISTICS AND RESULTS

Descriptive Statistics

Table 1 summarizes the industry composition

of the repatriating ﬁ rms in our sample. Firms in

manufacturing industries represent 73 percent of

the sample. Service companies comprise the second

largest group of repatriating ﬁ rms (8 percent of the

sample), and retail companies and ﬁ nancial service

companies are the next largest groups of repatriat-

ing ﬁ rms (representing 5 percent and 6 percent of

the sample respectively).

Table 2 presents descriptive data for those repa-

triating ﬁ rms having sufﬁ cient data available to

Table 1

Industry Distribution of Firms Repatriating under

the American Jobs Creation Act of 2004

SIC Code # of Firms:

1000-1999 Mining and Construction 5

2000-2999 Manufacturing 54

3000-3999 Manufacturing 101

4000-4999 Transportation, Communication, Electric, Gas 6

5000-5999 Wholesale, Retail 12

6000-6999 Financial, Insurance, Real Estate 13

7000-7999 Hotel, Services 18

8000-8999 Services 4

9000-9999 Public Administration 1

NATIONAL TAX ASSOCIATION PROCEEDINGS

calculate each speciﬁ c metric.

We do not winsorize

or otherwise transform the raw data reported in

Table 2; hence, some means are heavily inﬂ uenced

by outliers. We provide medians, minimum, and

maximum values as well as the standard error for

each variable for the data items so that the inﬂ uence

of outliers can be inferred.

The per-ﬁ rm average amount repatriated under

the Act was approximately $1 billion, and the aver-

age repatriation equaled 9 percent of total assets.

The median repatriation amount was $152 million

and equaled 6 percent of total assets. The sample

ﬁ rms are large and have substantial foreign opera-

tions. Average total assets were $31.5 billion, and,

on average, foreign income amounted to 5 percent

of the ﬁ rm’s total assets.

The data in Table 2 show sample ﬁ rms had a

mean U.S. effective tax rate of 33 percent and a

mean foreign tax rate for repatriated earnings of 7

percent. Absent the tax holiday, ﬁ rms would have

recognized an average U.S. tax liability of approxi-

mately $264 million on the repatriated earnings

(i.e., (.33 - .07)*1,014), but under the tax holiday

the liability was only $40 million, representing an

average U.S. tax savings of $224 million per ﬁ rm.

On average, research and development expense

represented 4 percent of total assets, and the aver-

age book-to-market ratio was .41. Consistent with

prior research (De Waegenaere and Sansing 2008;

Foley et al. 2007), the data in Table 2 suggest that

ﬁ rms were investing some foreign earnings in cash.

On average, ﬁ rms were holding cash equal to 28

percent of net assets compared to cash holdings

of 10 percent of net assets for all other Compustat

ﬁ rms — which is consistent with a lock-out effect.

The mean and median ratio of cash to PRE was

2.88 and 0.81 suggesting cash constituted a large

percentage of PRE.

Results – Determinants of PRE

Prior to the Tax Holiday

Table 3 presents the results from estimating

Model 1 which is intended to identify determi-

nants of PRE in the year prior to the tax holiday.

Consistent with H1a, we ﬁ nd a positive and sig-

niﬁ cant association between the level of PRE and

Repatriation tax rate (p-value < 0.00, one-tailed

test). This result suggests that, as a ﬁ rm’s U.S. tax

Table 2

2004 Descriptive Statistics

Firms Repatriating under the American Jobs Creation Act of 2004

Variable Mean Std. Dev. Min. Median Max.

Repatriations

Repatriations 1,014 3,210 1 152 37,000

Repatriations/total assets 0.09 0.09 0.00 0.06 0.50

Permanently reinvested earnings (PRE)

PRE 1,802 4,675 4 367 51,600

PRE/total assets 0.17 0.14 0.00 0.13 0.67

Cash/PRE 2.88 10.19 0.01 0.81 120.60

Tax attributes

Effective tax rate (ETR) 0.33 0.78 -1.92 0.30 10.50

Foreign tax rate (FTR) 0.07 0.09 0.00 0.03 0.35

Firm characteristics

Size (total assets) 31,512 145,929 78 3,066 1,484,101

Foreign income/total assets 0.05 0.04 -0.05 0.04 0.17

Research and Development/total assets 0.04 0.04 0.00 0.02 0.19

Book-to-market ratio 0.41 0.21 0.01 0.37 1.11

Cash holdings (cash/net assets) 0.28 0.46 0.00 0.13 2.85

($ amounts in millions)

102

ANNUAL CONFERENCE ON TAXATION

Table 3

Determinants of the Level of PRE in the Year Prior to the Tax Holiday Estimated Using OLS

Variables Predicted Sign Coefﬁ cient t-statistic p-value

Intercept ? 0.173*** 3.28 0.00

Size ? -0.010*** -2.41 0.02

Foreign Income ? 1.766*** 7.87 0.00

U.S. Income ? -0.342*** -2.03 0.04

Capex ? 0.099 0.38 0.70

Research & Development ? 0.061 0.28 0.78

Book-to-market ? 0.040 0.90 0.37

Cash Holdings + 0.025*** 7.31 0.00

Repatriation tax rate + 0.200*** 6.49 0.00

Repurchases ? 0.103 0.71 0.48

Adjusted R-square = 40%

*** indicates signiﬁ cance at the 5 percent level or better for a one-tailed test when a prediction is made and a

two-tailed test when no prediction is made.

Model 1: PRE

t–1

Size

t–1

Foreign Income

t–1

U.S. Income

t–1

Capex

t–1

Research &

Development

t–1

Book-to-market

t–1

Cash holdings

t–1

Repatriation tax rate

t–1

Share Repurchases

t–1

Variable deﬁ nitions:

PRE = Permanently reinvested earnings scaled by total assets

Size = Log of total assets

Foreign Income = Foreign pretax income scaled by total assets

U.S. Income = U.S. pretax income scaled by total assets

Capex = Capital expenditures scaled by total assets

Research & Development = R&D expense scaled by total assets

Book-to-market = Book value scaled by market value of equity

Cash holdings =

Log of cash scaled by net assets, where net assets = total assets – cash

Repatriation tax rate = Tax rate related to repatriation of foreign earnings

Share Repurchases = Share repurchase scaled by total assets.

NATIONAL TAX ASSOCIATION PROCEEDINGS

liability due upon repatriation of foreign earnings

increases, so does the amount of foreign earnings

classiﬁ ed as permanently reinvested offshore. This

result supports H1a and the existence of a lock-out

effect induced by the U.S. tax system.

Consistent with H1b, we ﬁ nd a positive and

signiﬁ cant association in Table 3 between the pre-

holiday level of PRE and Cash holdings (p-value

< 0.00, one-tailed test). This result provides addi-

tional evidence that ﬁ rms were experiencing the

lock-out effect prior to the tax holiday as some

earnings were held offshore in cash rather than

operating assets, consistent with the predictions

of De Waegenaere and Sansing (2008).

Not surprisingly, we also find that Foreign

Income is signiﬁ cantly and positively associated

with PRE (p-value < 0.00, two-tailed test), and U.S.

Income is signiﬁ cantly and negatively associated

with PRE (p-value < 0.04, two-tailed test). These

results indicate that ﬁ rms generating relatively

higher levels of foreign income have a greater

capacity to accumulate earnings offshore.

Results – Determinants of the Change in PRE

in the Year of the Tax Holiday

Table 4 presents the results from estimating

Model 2, in which we identify determinants of

the ΔPRE in the year of repatriation. Consistent

with H2a, we ﬁ nd a positive and signiﬁ cant asso-

ciation between ΔPRE and ΔRepatriation tax rate

(p-value < 0.00, one-tailed test). This result is

consistent with a pre-Act lock-out effect, and the

Act reducing the lock-out incentive. The evidence

in Table 4 strongly suggests that, all else equal,

ﬁ rms experiencing the lock-out effect repatriated

their earnings when the lock-out incentive was

signiﬁ cantly reduced.

Consistent with H2b, we ﬁ nd a positive and

signiﬁ cant association between ΔPRE and ΔCash

holdings in the year of repatriation (p-value < 0.02,

one-tailed test). Consistent with the predictions of

De Waegenaere and Sansing (2008), this ﬁ nding

suggests that ﬁ rms released the excess cash from

their foreign subsidiaries during the tax holiday.

Together, these ﬁ ndings support H2a and H2b

and suggest that ﬁ rms repatriating under the Act

previously accumulated foreign earnings as cash

offshore to avoid paying U.S. income tax that

would be due upon repatriation of the earnings

(i.e., the lock-out effect). Also, we ﬁ nd that the

ΔPRE is negatively associated with the ΔShare

Repurchases (p-value < 0.01, one-tailed test) in

the year of repatriation during the tax holiday.

Consistent with the predictions of De Waegenaere

and Sansing (2008), this result suggests that ﬁ rms

deferred repatriation prior to the tax holiday due

to the lock-out effect; however, the use of the

repatriated cash also suggests a lack of investment

opportunities in the United States.

Results – Determinants of the Change in PRE

in the Year Following the Tax Holiday

Table 5 presents the results from estimating

Model 3 to identify the determinants of ΔPRE in

the year following the holiday. Consistent with

H3a, we ﬁ nd a positive and signiﬁ cant association

between ΔPRE and ΔRepatriation tax rate (p-value

< 0.02, one-tailed test). Consistent with the predic-

tions of prior research (Clausing, 2005; Gravelle,

2005; De Waegenaere and Sansing, 2008) this

result suggests the tax holiday encouraged ﬁ rms to

subsequently revert to retaining foreign earnings

abroad (i.e., behaving consistent with the lock-out

effect). Post-Act, not only do these ﬁ rms avoid

current U.S. tax by not repatriating, but the ﬁ rms

also have an added incentive (i.e., they now attach

a higher probability to additional tax holidays in

the future) to wait for a more favorable repatria-

tion tax rate.

Contrary to H3b, the coefficient on ΔCash

holdings in the year following repatriation is not

signiﬁ cantly different from zero (p-value 0.24, one-

tailed test). However, our proxy for cash holdings

is based on multinational ﬁ rms’ worldwide cash

holdings. Therefore even if foreign cash holdings

increase as expected, such increases may have

been offset by domestic cash holding decreases

in the year following repatriation. For example,

ﬁ rms may still be spending the cash in year t + 1

repatriated under the Act in year t.

With respect to our other control variables, we

ﬁ nd that ΔForeign Income is signiﬁ cantly and

positively associated with ΔPRE (p-value < 0.00,

two-tailed test). This result indicates that ﬁ rms

generating higher levels of foreign income have a

greater capacity to accumulate earnings offshore.

We also ﬁ nd, consistent with the lock-out effect,

that a ﬁ rm’s Book-to-market ratio is negatively

associated with the ΔPRE in the year following

the Act.

102

ANNUAL CONFERENCE ON TAXATION

Table 4

Ols Regression of 2004 to 2005 Changes in Permanently Reinvested Earnings (PRE) for Firms

Repatriating under the Tax Holiday on Changes in the Motives for PRE

Variables Predicted Sign Coefﬁ cient t-statistic p-value

Intercept ? -0.095*** -3.04 0.00

Size ? 0.005 1.48 0.14

Book-to-market ratio ? 0.047 1.87 0.06

Change in Foreign Income ? 0.393 1.32 0.19

Change in U.S. Income ? 0.281 1.46 0.15

Change in Capex ? 0.596 1.58 0.12

Change in Research & Development ? 1.044*** 2.58 0.01

Change in Cash Holdings + 0.017*** 4.13 0.02

Change in Repatriation tax rate + 0.206*** 7.40 0.00

Change in Share Repurchases - -0.110*** -2.36 0.01

Adjusted R-square = 25%

*** indicates signiﬁ cance at the 5 percent level or better for a one-tailed test when a prediction is made and a

two-tailed test when no prediction is made.

Model 2: ΔPRE

1 Size

2 ΔForeign Income

3 ΔU.S. Income

4 ΔCapex

5 ΔResearch & Development

6 Book-to-market

7 ΔCash holdings

8 ΔRepatriation tax rate

9 ΔShare Repurchases

Variable deﬁ nitions:

ΔPRE = Change in permanently reinvested earnings scaled by total assets (2005-2004)

Size = Log of total assets

ΔForeign Income = Change in foreign pretax income scaled by total assets (2005-2004)

ΔU.S.Income = Change in U.S. pretax income scaled by total assets (2005-2004)

ΔCapex = Change in Capital expenditures scaled by total assets (2005-2004)

ΔResearch & Dev. = Change in R&D expense scaled by total assets (2005-2004)

Book-to-market = Book value scaled by market value of equity

ΔCash holdings = Change in log of cash scaled by net assets (2005-2004)

ΔRepatriation tax rate = Change in tax rate related to repatriation of foreign earnings (2005-2004)

ΔShare Repurchases = Change in share repurchase scaled by total assets (2005-2004)

NATIONAL TAX ASSOCIATION PROCEEDINGS

Table 5

OLS Regression of 2005 to 2006 Changes in Permanently Reinvested Earnings (PRE) for Firms

Repatriating under the Tax Holiday on Changes in the Motives for PRE

Variables Predicted Sign Coefﬁ cient t-statistic p-value

Intercept ? 0.044*** 2.71 0.01

Size ? -0.002 -1.29 0.20

Book-to-market ratio ? -0.017*** -2.18 0.03

Change in Foreign Income ? 0.448*** 3.43 0.00

Change in U.S. Income ? 0.036 0.50 0.62

Change in Capex ? 0.227 1.38 0.17

Change in Research & Development ? 0.478*** 2.33 0.02

Change in Cash Holdings + 0.003 1.41 0.24

Change in Repatriation tax rate + 0.049*** 4.00 0.02

Change in Share Repurchases ? -0.033 -0.92 0.36

Adjusted R-square = 16%

*** indicates signiﬁ cance at the 5 percent level or better for a one-tailed test when a prediction is made and a

two-tailed test when no prediction is made.

Model 3: ΔPRE

t+1

1 Size

t+1

2 ΔForeign Income

t+1

3 ΔU.S. Income

t+1

4 ΔCapex

t+1

5 ΔResearch & Development

t+1

6 Book-to-market

t+1

7 ΔCash holdings

t+1

8 ΔRepatriation tax rate

t+1

9 ΔShare Repurchases

t+1

Variable deﬁ nitions:

ΔPRE = Change in permanently reinvested earnings scaled by total assets (2006-2005)

Size = Log of total assets

ΔForeign Income = Change in foreign pretax income scaled by total assets (2006-2005)

ΔU.S.Income = Change in U.S. pretax income scaled by total assets (2006-2005)

ΔCapex = Change in Capital expenditures scaled by total assets (2006-2005)

ΔResearch & Dev. = Change in R&D expense scaled by total assets (2006-2005)

Book-to-market = Book value scaled by market value of equity

ΔCash holdings = Change in log of cash scaled by net assets (2006-2005)

ΔRepatriation tax rate = Change in tax rate related to repatriation of foreign earnings (2006-2005)

ΔShare Repurchases = Change in share repurchase scaled by total assets (2006-2005).

102

ANNUAL CONFERENCE ON TAXATION

CONCLUSION

In this study, we evaluate the lock-out effect

of the U.S. tax system by examining ﬁ rms that

repatriated under the 1-year tax holiday for repa-

triations provided by the American Jobs Creation

Act of 2004.

Hand-collecting ﬁ nancial statement data for

a sample of ﬁ rms repatriating under the Act, we

ﬁ nd that repatriating ﬁ rms behaved in a manner

consistent with a lock-out effect. Based on the

expectations from De Waegenaere and Sansing’s

(2008) theoretical model, we predict and ﬁ nd that

ﬁ rms change their lock-out behavior around the

tax holiday. To our knowledge this study is the

ﬁ rst to evaluate the lock-out effect of the U.S.

worldwide tax system around a dramatic and

temporary change in the U.S. tax rate associated

with foreign earnings repatriations. Because theory

predicts that the U.S. worldwide tax system causes

a lock-out effect for foreign earnings, we predict

ﬁ rms retained foreign earnings offshore and accu-

mulated some of those earnings as cash prior to the

tax holiday. Likewise, we also predicted that during

the tax holiday ﬁ rms would repatriate that cash to

the United States. Furthermore, we expected that

in the year following the tax holiday ﬁ rms would

revert to the lock-out behavior.

As predicted, we ﬁ nd that ﬁ rms repatriating

under the Act accumulated foreign earnings and

held some of those earnings as cash prior to the tax

holiday. This evidence is consistent with De Wae-

genaere and Sansing’s (2008) theoretical model

which predicts that ﬁ rms repatriating under the tax

holiday accumulated foreign earnings abroad as

cash as a result of the lock-out effect. These results

are also consistent with a tax executive survey

study by Graham et al. (2008). Firms responding

to this survey indicated 75 percent of the funds

repatriated during the holiday were derived from

cash or other liquid ﬁ nancial assets.

Also, consistent with lock-out behavior, we ﬁ nd

that the changes in the ﬁ rms’ U.S. repatriation tax

rates and cash holdings during the holiday are

positively associated with the change in the level

of PRE in the year of the tax holiday. Furthermore,

consistent with prior research (Blouin and Krull,

2009; Clemons and Kinney, 2008), we ﬁ nd that

ﬁ rms repatriating under the tax holiday signiﬁ -

cantly increased their share repurchases. This result

is consistent with De Waegenaere and Sansing’s

(2008) prediction that ﬁ rms accumulating cash due

to the lock-out effect lacked domestic investment

opportunities. Finally, consistent with expectations

we ﬁ nd that the change in the U.S. repatriation tax

rates were positively associated with the change

in permanently reinvested earnings in the year

following the tax holiday, suggesting that ﬁ rms

immediately reverted to deferring the repatriation

of their foreign earnings following the holiday.

Contrary to expectations, we ﬁ nd no signiﬁ cant

association between the change in permanently

reinvested foreign earnings and the change in cash

holdings in the period following the tax holiday.

This study makes several contributions to

existing literature. First, it documents the exis-

tence of a lock-out effect for U.S. multinational

ﬁ rms. Second, it provides empirical support for

De Waegenaere and Sansing’s (2008) theoretical

model that predicts which ﬁ rms will accumulate

foreign earnings in offshore cash before and after

the tax holiday due to the lock-out effect. Third,

it documents a positive relationship between the

magnitude of the lock-out effect and the tax cost

associated with repatriation.

Notes

Once the foreign subsidiary’s Subpart F income has

been subject to U.S. tax, the income may be repatriated

to the U.S. parent without triggering any additional

U.S. tax.

Note that this applies only to operating earnings gener-

ated after the optimal investment level, K*, has been

reached. Prior to that time all operating earnings are

reinvested in additional foreign operating assets.

Although the 4 percent discount rate in the example is

always greater than the after-U.S.-tax risk-free rate of

3.25 percent, the repatriation decision depends on the

after-foreign-tax risk-free rate, which, depending on the

foreign tax rate, can be higher than the discount rate.

Deleting ﬁ rms with no permanently reinvested earn-

ings reduced our sample size to 307 ﬁ rms, deleting

ﬁ rms reporting repatriations exceeding permanently

reinvested earnings reduced the sample to 222 ﬁ rms.

All variables except Repatriations are measured in the

year prior to the tax holiday. Repatriations are taken

from the year of the tax holiday.

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NATIONAL TAX ASSOCIATION PROCEEDINGS

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