Tax Man Wipes Out Killer Bees

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So the Internal Revenue Service has shut down the Killer B, the tax shelter that has helped fuel the stock buyback programs of many companies with foreign earnings, proving once again that the first rule of Tax Shelter Club is “Do Not Talk About Tax Shelter Club.”
The Killer B, named for a provision of the tax code governing certain corporate reorganizations, was a tax-shelter scheme that was well-known among lawyers and corporate accountants. It’s use was thought to be fairly common among corporations with substantial foreign earnings. Essentially, companies employed it as a way of repatriating foreign profits for the benefit of shareholder without getting hit by US corporate taxes. Surprisingly, however, the Internal Revenue Service seems only to have learned of it when IBM publicly disclosed that it had employed the shelter in connection with a recent stock repurchase. And once it got word of the Killer B, the IRS acted quickly to shut it down.
[After the jump: How the Cold War gave birth to the Killer B.]

A Corporate Tax Marshall Plan.
The Killer B arose in response to a Kennedy-era law that imposed corporate taxes on profits earned by US companies from foreign operations. While not unique to the US, this kind of extra-territorial taxation is rare. Most other countries impose taxes only on profits earned within their borders. And this contrast in tax policies created a new problem: since foreign countries taxed profits earned within their borders and the US taxed profits earned by US companies everywhere, US companies faced the threat of getting taxed by both the US and the countries where the profits were earned. Of course, double taxation of this sort would be unfair to US businesses, putting them at a distinct competitive disadvantage with foreign companies. To avoid double taxation Congress provided for tax credits for taxes paid abroad.
But Congress also created another tax exemption, one that needs a bit more of an explanation. It allowed companies to defer paying taxes on foreign profits that are not repatriated to the US. This single provision essentially transformed the corporate tax on foreign earnings into a repatriation tax. Why would the US adopt a tax code penalizing companies for bringing profits home? The answer lies in the politics of the Cold War and globalization. Part of the US strategy against communism involved encouraging US companies to invest abroad, providing much needed capital to European and developing nations and enmeshing foreign economies with the US. It also encouraged foreign countries to open their markets to the US in hopes that money earned their would remain there. In effect, the repatriation tax was a subsidy to the economies of countries that opened themselves US business. Think of it as a Marshall Plan for globalization.

Irrational Investing.

Like most subsidies, the repatriation tax leads to substantial inefficiencies. Trapping profits abroad limits the investment choices of the companies making the profits. Some times companies simply opt to keep cash on their balance sheet. Investments that might not otherwise be rational become much more attractive when the alternative is getting hit with a 35 percent corporate tax. And as corporate taxes around the world have declined—the US currently has the second highest corporate tax rate in the developed world—the value of tax credits for foreign taxes has declined. To avoid paying more than a third of their profits in taxes, companies sometimes over-invest or mal-invest in overseas operations and markets. Revenues from the repatriation tax were small because so few companies repatriated foreign profits.
This was powerfully demonstrated when the US adopted a temporary measure to encourage repatriation of profits after the attacks of September 11, 2001. In order to boost a flailing economy, Congress created a sort of amnesty for repatriation, taxing repatriated profits at a low 5.25% rate. To encourage them to repatriate the money immediately, Congress put a tight sunset provision on the tax reduction. Not surprisingly, many companies did repatriate profits while this window was open. So much money was repatriated that tax revenues actually increased despite the lower rate.
But the window closed, and this lead to the popularity of the Killer B. The simplest way to think about it is as a work-around to allow companies to repatriate funds to shareholders without paying the tax. IBM provides a nice example of how it worked. As part of a recent buyback, IBM used a foreign subsidiary to repurchase shares through foreign exchanges. The subsidiary then used the shares of IBM to satisfy intercompany indebtedness to its parent. Because the subsidiary was sending stock rather than money to its parent, the repatriation tax wasn’t triggered. (Investors might want to take note that IBM’s desire to repatriate the money is arguably a vote of no-confidence about the future of the global economy.)
After IBM disclosed the practice, the IRS acted swiftly passed rules advising companies that it would consider this use of stock as a repatriation. The Killer B is dead.

A Lost Opportunity.

The IRS hates tax shelters and the public is generally suspicious of them. But the Killer B was not about wealthy individuals shielding income from the tax man. It freed up capital trapped abroad, reduced incentives for inefficient foreign investment and encouraged returning capital to shareholders through stock repurchases. Without the Killer B, companies will have less of an incentive to repurchase their stock. A less hasty decision by the IRS—or, even better, a serious deliberation by lawmakers and the public—may have concluded that the Killer B should remain. It may have even resulted in a repeal of the repatriation tax altogether if lawmakers were forced to confront the question of whether we still need this Cold War relic.