It is quite common for U.S. corporations with foreign functional entities to leave cash overseas until an American tax holiday makes it advantageous to convert it to U.S. dollars. Unfortunately, corporates may actually expose themselves to a high degree of FX volatility, whether they realize it or not.
The problem with holding foreign cash
Numerous factors—particularly corporate-friendly tax environments in Ireland, Switzerland and the Netherlands—have driven many U.S. corporations to open euro-functional foreign entities. Those entities, naturally, collect their profits in euros. The problem, however, lies not in what form the profits take, but what happens to them after they arrive.
The intricacies of accounting rules make it seemingly attractive to simply hold the euros as is, with the hope of Congress enacting a 2004-style repatriation tax holiday. That event—which has subsequently become quite the political hot button—saw taxes on repatriated foreign profits temporarily reduced to 5.25 percent, resulting in more than $300 billion being returned to the United States.
Partisan efforts to institute another such holiday have been largely stymied in Congress, and in the meantime, many corporations continue to stockpile considerable amounts of foreign profits overseas. Combined with recent currency volatility, such a scenario has the potential to create very large problems.
To wit: Euro-denominated profits accumulated and held in euros during 2014 suffered a 20 percent decline in value. More recently, the pound sterling has plunged 20 percent this year, most of that decline in a single week in June, around the Brexit vote. Unfortunately, many corporations have not taken steps to hedge against such volatility, leaving not insubstantial amounts of cash exposed completely to sudden dips (and gains).
Making these drops in cash value particularly insidious is the fact that, for many corporations, they remain buried in financial statements; gain/loss is typically accounted for in the cumulative translation adjustment (CTA) account, a subset of other comprehensive income (OCI). When the financials are examined, the sheer import of the problem is easy to miss.
What should treasurers do?
Treasury professionals are ultimately tasked with shoring up a company’s economic health. That means addressing real-world risks, not simply accounting issues. Clearly, the aforementioned scenario qualifies. How can the exposure be mitigated?
Examine your foreign entity structure, including functional currency. Each company should use the anticipated structural changes that tax is likely to instigate as an opportunity to review functional currency. Should USD functional entities be considered? And should foreign cash be converted to USD more quickly?
Deploy net investment hedging strategies to keep the USD value of the foreign cash constant on a global basis if you decide that cash should continue to be held overseas in foreign currency. Such strategies are not free—there are trading costs and professional fees to take into account—but they are largely effective in eliminating the kind of massive swings the euro and pound have seen in recent years.
Remember, the fact that something isn’t hitting the P&L doesn’t mean it’s not happening. The drop in value of foreign currency represents a real impact on the overall value of a company, whether it’s reported in OCI or P&L. Evaluate the risk in your corporation’s cash balances, consider and recommend appropriate responses, and draft policies to reflect your conclusions. The alternative is to stick your head back in the sand.