*Editor’s Note:  The following article corrects descriptions of academic findings in a previously published version.

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

What is it? A commonly used accounting calculation for multinational corporations called permanently reinvested earnings (PRE) that multinationals have been using for years. Such corporations label profits earned overseas as PRE when those earnings are funneled back into the company’s business abroad. Companies benefit by delaying repatriation of foreign earnings and avoiding costly taxation in the United States.

Until now, though, pinpointing exactly how much is 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 suggests that multinationals using PRE in financial statements are repatriating 20% less to the United States than what they would have if they had not used the calculation. The paper, which was conducted by Professor Leslie Robinson, associate professor of business administration at the Tuck School of Business at Dartmouth College; Professor Jennifer Blouin, associate professor of accounting at the Wharton School of the University of Pennsylvania; and Linda Krull, associate professor of accounting at the University of Oregon, included 577 MNCs. 

The same authors further address PRE in *a new working paper, which according to Robinson, estimates that more than 75% of the approximately 1100 MNCs’ PRE in the study was located  in lower-tax jurisdictions than in the United States. Tax credits in those jurisdictions were also important. For those MNCs in the working study that didn’t have excess foreign tax credits available to them in their jurisdictions, PRE was more likely to be used to manage earnings compared to those companies who had foreign tax credits, says Robinson.  The working paper looked at data going back 10 years contained in MNC financial statements as well as in reporting of foreign-affiliate assets.

The stakes in the uses of PREs indeed 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 United States, it could be taxed at the corporate rate of 35%. But if it 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 questionable when companies need to use those funds in the United States or when they disguise any part of the earnings as something else.

The authors’ 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 one of the motivators for using PRE, since having less of a tax liability can help a company look better on paper.  

Lewis Kevelson, partner in the tax and business services division of accounting advisory Marcum LLP, sees immediate benefits to firms’ bottom line from using the accounting calculation. “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 firms. Since most MNCs 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 that to the United States.

“Because there’s this game that goes on, people just wonder what this label (PRE) means,” Robinson adds. “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 have any idea where those earnings are or what the tax liability associated with them is.” Companies, she says, routinely say it is too difficult to estimate the tax that would be due even though MNCs must report the amount of PRE and an estimate of the repatriation tax liability in their financial statement footnotes. Without this estimate, “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 what assets those funds may be held in, notes Robinson, since if investors knew if PRE was left in cash, they would presumably want some of that cash instead sent back to them in the form of a dividend.

The authors’ working paper found that the proportion of PRE held in cash was higher in company affiliates operating in low income-tax jurisdictions. According to Robinson, this is an important finding since knowing whether or not PRE is held in cash rather than other assets is crucial for tax policy reform, since members of Congress have been harping particularly on the notion of unused cash sitting untaxed abroad.

Politicians interested in tax reform have lately have jumped on the issue, eyeing MNCs as a potentially lucrative source of tax dollars. Senator Carl Levin (D-MI), chairman of the Senate’s Permanent Subcommittee on Investigations, in particular, has made tracking earnings abroad a pastime. Levin and other senators have attacked MNCs 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 from a U.S. company if the 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.

Levin noted in a letter last month to the U.S. Senate Committee on Homeland Security and Governmental Affairs 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.” He further noted that the companies do not leave the funds in the foreign jurisdiction, but instead the offshore funds eventually end up sitting in a foreign bank’s correspondent account (when one bank opens an account at another bank).

It’s 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 says 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, Levin added.

While large companies should be more concerned about any change in tax laws coming down the pike, smaller MNCs also use PRE though to a much lesser extent, notes Marcum’s Kevelson. For the larger companies, however, “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.”