All Eyes on Foreign Earnings

New studies shed light on U.S. multinationals&spamp;rsquo; practice of designating foreign profits as permanently reinvested.
Kathy HoffelderDecember 15, 2012

Microsoft used it to defer $14.2 billion in taxes last year. Hewlett-Packard and others used it to keep more cash in foreign holdings than they had in the United States. But although U.S. accounting rules allow it, some senators are calling for its elimination.

“It” is an accounting calculation called permanently reinvested earnings (PRE), which multinational corporations use to delay repatriation on foreign earnings and avoid costly taxation in the U.S. Under accounting standard APB 23, such corporations can designate profits earned overseas as PRE when those earnings are funneled back into the company’s business abroad.

Until now, pinpointing exactly how much is therefore lost in tax dollars each year was a fuzzy calculation at best. But an academic study published in the September/October issue of the American Accounting Association’s The Accounting Review (“Is U.S. Multinational Dividend Repatriation Policy Influenced by Reporting Incentives?”) suggests that multinationals using PRE in financial statements are repatriating 20% less to the U.S. than they would have if they had not used the calculation.

The study, which included 577 multinational corporations, was conducted by professors at the University of Oregon, the Tuck School of Business at Dartmouth College, and the Wharton School of the University of Pennsylvania.

The same authors further address the subject in a recent draft (September) of their working paper “Where in the World Are ‘Permanently Reinvested’ Foreign Earnings?” They find that fully “95% of PRE is located in affiliates that would require recognition of an expected repatriation tax expense.” The working paper looked at 10 years’ worth of financial statements and data on foreign-affiliate assets.

The stakes in using PRE can be high. If a company fails to account for its earnings abroad as PRE and instead attempts to bring the cash back into the States, it could be taxed at the corporate rate of 35%. But if the company was already in a high-tax foreign jurisdiction, the U.S. government would consider some of its liability already paid and it could pay as little as a 20% rate, depending on the jurisdiction. PRE becomes a source of public concern when companies need to use those funds in the U.S. or when they disguise any part of the earnings as something else.

Where Are the Earnings?
The studies support what many critics have been saying about the motivation to use PRE. The authors say that parent companies face pressure to consistently report strong earnings numbers, which is a reason for using PRE, since paying less in taxes can help a company look better on paper.

Lewis Kevelson, partner in the tax and business-services division of accounting advisory Marcum, sees immediate benefits to companies’ bottom lines from using the accounting designation. “In order to avoid an income tax expense on a financial statement, they take the position that the funds are being permanently reinvested to grow the business. That helps from the standpoint of keeping the profits as high as possible for financial-statement purposes,” he says.

But that may not be good news for investors in those companies. Since most multinationals account for PRE in the footnotes of financial statements, the figure can be hard to decipher. Companies report the aggregate amount of the calculation across all foreign affiliates and seldom report the expected tax liability associated with repatriating those earnings to the U.S.

“Because there’s this game that goes on, people just wonder what this label [PRE] means,” adds Dartmouth professor Leslie Robinson, one of the authors. “PRE in an ideal world is supposed to represent the investment opportunities that the firm has abroad.”

The problem, she notes, is that “investors don’t know where those earnings are or what the tax liability associated with them is.” Firms, she says, routinely say it’s too hard to estimate the tax that would be due even though multinationals must report the amount of PRE and an estimate of the repatriation tax liability in their financial-statement footnotes. Without this estimate, says Robinson, “investors have no idea how costly it is for the firm to get at its own cash.”

Send Back the Cash
Investors will likewise want to know where those funds are held, notes Robinson; if they knew PRE was left in cash, they would presumably want some of it sent back to them in the form of a dividend, she says.

The authors’ working paper found that the proportion of PRE held in cash was higher in company affiliates operating in low-income-tax jurisdictions. This is an important finding, since knowing whether PRE is held in cash rather than other assets is crucial for tax-policy reform, says Robinson. Indeed, members of Congress have harped on the notion of unused cash sitting untaxed abroad.

Politicians interested in tax reform have lately jumped on the issue, eyeing multinationals as a potentially lucrative source of tax dollars in particular. Sen. Carl Levin (D–Mich.), chairman of the Senate’s Permanent Subcommittee on Investigations, has made tracking earnings abroad a pastime. Levin and other senators have attacked multinationals for keeping piles of cash overseas (which Levin says amounts to as much as $1.7 trillion offshore) and not appropriately investing that back into the companies.

Last year, Levin introduced a bill called the “Stop Tax Haven Abuse Act,” which sought to recoup taxes for the U.S. government if an American company was incorporated abroad but managed its operations domestically. Although a number of corporate abuses were outlined in the bill, he cited PRE as a source of potential tax abuse.

In a letter to the U.S. Senate Committee on Homeland Security and Governmental Affairs in October, Levin wrote that “instead of bringing the funds back directly, those corporations have directed their offshore subsidiaries to place the offshore funds in U.S. dollars in a U.S. account.” These firms do not leave the funds in the foreign jurisdiction, he noted, but instead put the offshore funds in a foreign bank’s correspondent account (when one bank opens an account at another bank).

It is too easy, he said, for such a U.S.-based multinational to direct a foreign subsidiary to open an account at a Cayman Island bank, deposit foreign earnings into that account, and ask the Cayman bank to convert the foreign earnings into U.S. dollars. Levin said that typically the Cayman bank complies by opening a U.S. dollar account at a U.S. bank. The funds in those U.S. dollar accounts then tend to get invested into U.S. government securities, he added.

Particularly for large companies, “it would be a big hit to their income statement if they were to change from being permanently reinvested to not being permanently reinvested. It could impact their earnings,” says Marcum’s Kevelson.