Overcomplicated corporate tax policies in the US are distorting financing decisions
How much cash does one company need? According to Apple, $97 billion seems plenty. At the company’s shareholder meeting last week, Apple’s CEO Tim Cook conceded that the company had more cash than needed to run operations. But barring a large acquisition or an unexpected dividend payout, Apple will continue its upward cash trajectory. The company, which ended 2011 with $97.6 billion in cash, is on course to pass the $100 billion mark for cash holdings. In the previous two quarters, the company’s cash reserves grew by $21 billion.
Apple isn’t an isolated case. For the past few years, non-financial companies have been accumulating large piles of cash, driven by lack of good investment opportunities and fear of another recession. Leading this race for cash, by a wide margin, are technology firms. The top eight technology companies by market size, collectively hold around $320 billion in cash reserves. Microsoft has $51 billion in the bank, while both Cisco and Google have more than $45 billion squirreled away.
There are good reasons why companies in knowledge-based industries such as technology and life sciences, need large cash balances. The most valuable assets for the firms are intellectual capital such as people or algorithms. Valuing these intangible assets can be difficult. Knowledge-based firms also compete in a volatile environment, where a new smartphone or social-media platform can render the product obsolete. A comfortable cash cushion, allows these companies to weather market movements while focusing on innovation. Indeed, previous research has shown that knowledge-based industries lose up to 80% of their enterprise value in times of financial distress, while companies with more tangible assets such as energy, lose only 10% on average.
And yet, the numbers seem excessive. Consider Apple. The company has zero debt and its operating expenses last quarter were $3.6 billion. A $97.6 billion cash buffer is overly conservative. Google’s debt-to-equity ratio is a benign 7%. The reason for this stockpile isn’t financial prudence but tax avoidance. Apple has stashed $64 billion of its cash offshore. The top eight technology companies have around $210 billion or, 66%, of their cash overseas. Microsoft and Cisco have close to 90% of their cash outside the US.
These numbers are symptomatic of broken tax system. At 35%, America has one of the highest corporate tax rates in the world. But there is a large variance among businesses in the effective tax rate, due to countless loopholes and exceptions. For instance, transfer pricing - the mechanism by which multinational firms assign a price to the sale of goods and services among subsidiaries - can be manipulated to recognize profits in low-tax havens. By deferring overseas profits, firms can avoid paying any taxes. Most technology firms indefinitely defer the foreign income, preferring to reinvest overseas, rather than repatriate. Ironically, most of the overseas earnings are held in dollar denominated assets such as US Treasury bills.
Of course, one could argue that these companies are maximizing value by exploiting market distortions. But these tax dodging schemes can hurt shareholders. For one, cash rich managers have the temptation to make bad investment decisions. A strong justification for Microsoft’s $8.5 billion acquisition of Skype and HP’s $10.3 billion acquisition of Autonomy was that these deals were financed with overseas profits. While cheap cash may have made these companies attractive, did it trump other business factors?
Focusing on tax policies can also skew financing decisions. Most of the technology companies have large operating costs in the US. Domestic earnings do not fully cover these costs. But rather than use the overseas profits, companies prefer to issue debt to fund ongoing operations. Thus companies are levering up domestically even as they lobby for a repatriation tax holiday. While the large technology companies have room to grow their debt, it could impact their ability to react to business slowdown. It also isn’t clear if the strategy of investing overseas cash in low-yielding assets is the right one. Without many investment opportunities outside the US, shouldn’t the companies return the cash to shareholders and let them make investment decisions?
To be sure, America’s tax code needs reform. However any substantial changes to the US tax code appears unlikely until the presidential elections are over. Until then companies must recognise that building up cash mountains solely to avoid taxes may lead to inefficient financing and investment decisions. Returning the profits to shareholders through dividend payout may be the best use of the cash.